Obtaining Venture and Growth Capital

Results Expected

Upon completion of this chapter you will have:

1. Examined the capital markets food chain and its implications.

2. Identified informal and formal investment sources of equity capital.

3. Learned how to find, contact, and deal with equity investors.

4. Discovered how venture capital investors make decisions.

5. Analyzed “Hindman & Company,” a case about an entrepreneur’s multifaceted fund-rais-ing strategies to launch and grow a new franchising company in the quick-lube industry.

Lecture Outline

I. The Capital Markets Food Chain.A. The capital markets for equity can be viewed as a “food

chain.”

B. Founders have to decide whether to give up equity in order to create very significant value.

1. If founders have to give up 70% to 80% of equity, the market capitalization must be at least $100 million to create significant value.

2. The peak capitalizations during the 1990s were not sus-tainable.

C. In the recent venture capital food chain, the amount of capital invested is quite substantial.

II. Cover Your Equity.A. A tough trade-off for the young firm is to balance the need

for startup capital with preservation of equity.

1. Holding on to as much as you can for as long as you

Results Expected #2Identified informal and formal investment sources of equity capital.

can is good advice.

2. The earlier the capital enters, the more costly it is.

3. When evaluating risk capital, three issues should be considered:

a. Does the venture need outside equity capital?

b. Do the founders want outside equity capital?

c. Who should invest?

4. The decision whether the capital infusion will be debt or equity depends on the situation.

5. High-tech startups normally need some equity invest-ment.

B. Bootstrapping is an attractive source of financing.

1. Some entrepreneurs suggest getting customer to pay quickly.

2. Bootstrapping is desirable if the management team members believe a loss of equity would adversely af-fect the company.

3. The team should identify those investors who bring ex-pertise to the venture.

C. There are both informal and formal investors, private and public markets.

1. With angels, or wealthy individuals, the minimum in-vestment required may be less.

2. Only 30-40% of the companies seeking private equity actually receive it.

III. Timing.A. A venture should not wait to look for capital until it has a se-

rious cash shortage.

B. This delay can be viewed by investors as a lack of planning.

C. But obtaining early equity capital can unnecessarily dilute the equity position of the founders.

IV. Angel and Informal Investors.A. Who They Are.

1. Wealthy individuals are probably the single most im-portant source of capital for startup and emerging busi-nesses.

a. Angel investors are required by the Securities and Exchange Commission to have assets of at least $1 million.

b. There are approximately 400,000 active angels in

Results Expected #3Learned how to find, contact, and deal with equity investors.

the U.S.

2. Research by Bill Wetzel on angels is summarized in-typical informal investor will invest from $10,000 to $250,000 in any one deal.

4. These investors may demand considerable equity or may try to dominate ventures.

a. They also can get very impatient when sales and profits do not grow as they expected.

b. These informal investors will be knowledgeable and experienced in the market.

5. The evaluations of potential investments by wealthy in-vestors tend to be less thorough that those undertaken by venture capital groups.

B. Finding Informal Investors.

1. Informal investors are a diverse group with a prefer-ence for anonymity.

2. The Internet has provided an effective method of locat-ing such investors.

3. Financial backers are also found in an entrepreneur’s own network of business contact.

a. The best way to find informal investors is to seek referrals from attorneys, accountants, business associates, and entrepreneurs.

b. One informal investor contact can lead the entre-preneur to contacts with others.

4. In most larger cities there are law firms that syndicate investment packages as Regulation D offerings.

5. Articles on angel investors can also be found in numer-ous business magazines.

C. Contacting Investors.

1. The entrepreneur needs to get permission to use the name of the person making a referral.

2. At the first meeting, the entrepreneur needs to make a concise presentation of the key features of the proposed venture.

3. Entrepreneurs need to avoid meeting with more than one informal investor at the same time.

4. At this meeting, the entrepreneur should try to obtain the names of other potential investors.

D. Evaluation Process.

1. An informal investor will want to review a business plan, meet the management team, and see any product design.

2. The investor will conduct background checks on the

venture team and its product potential.

3. The new venture entrepreneur should try to select infor-mal investors whose objectives are consistent with those of the entrepreneur.

E. The Decision.

1. After the investment decision, an investment agreement will be drafted by an attorney.

2. The agreement will likely include some form of a “put,” giving the investor the right to require the ven-ture to repurchase his or her stock.

V. Venture Capital: Gold Mines and Tar Pits.A. The best investors add value well beyond the money.

B. Careful screening is needed to determine how potential in-vestors might fill some gaps in the founder’s know-how.

C. The text gives the example of an international telecommuni-cations venture that landed a private investor who also ser-viced as an advisor.

D. Venture capitalist can:

1. Open doors to key accounts and vendors.

2. Help in negotiating licensing or royalty agreements.

3. Find key people to build the team.

E. The venture can suffer if it goes after quick cash rather than wait for the right value-added investors.

VI. What Is Venture Capital?A. This type of capital involves a degree of risk and even some-

thing of a gamble.

B. Venture capital firms seek to add value by:

1. Identifying and evaluating business opportunities.

2. Negotiating and closing the investment.

3. Tracking and coaching the company.

4. Providing technical and management assistance.

5. Attracting additional capital, directors, management, and other key stakeholders.

C. The process usually takes up to 10 years to unfold.

VII. The Venture Capital Industry.A. Most industry observers credit Ralph E. Flanders with creat-

ing the venture capital industry.

1. In 1946 Flanders founded American Research and De-

velopment Corporation, the first firm to provide risk capital for rapidly growing firms.

2. The industry did not experience a growth spurt until the 1980s, which the industry boomed.

3. At its peak in 1987, there were more than 700 venture capital firms.

B. The Booming 90s.

1. The industry experienced an eightfold increase in the 1990s.

2. By 2001 the industry was more specialized and fo-cused.

3. Major structural trends emerged in the late 1980s and through the 1990s.

a. The average fund size grew larger.

b. The average size of investment also grew much larger.

c. The specialization pattern expanded to main-stream and megafunds.

4. Another trend emerged during the 1990’s: Startup and early stage funds experienced a major rebirth.

C. Beyond the Crash of 2000: The Venture Capital Cycle Re-peats Itself.

1. The crash of the NASDAQ began in March 2000, re-sulting in more than a 60% drop in value.

a. Many companies that went public in 1998 and 1999 at high prices saw their values plummet.

b. The list of dot.coms that went bankrupt is long.

2. Also, young telecommunications companies saw their stocks decline rapidly, losing 90% or more of their value in less than a year.

3. By mid-2001, the amount of money being invested had dropped by half from 2000, and valuations plummeted.

4. Even companies performing on plan saw share prices drop 15-30%.

5. The time taken for due diligence on companies in-creased from 45 days to six to eight months.

6. The venture capital cycle seems to repeat itself.

VIII. The Venture Capital Process.

A. The venture capital process is the collision of entrepreneurs, opportunities, investors, and capital.

1. The venture capitalist beings money, experience, net-works, and industry contacts.

2. A venture capital firm also has deep pockets and con-tact with other capital providers.

3. This process occurs in private, quite imperfect capital markets.

4. The availability and cost of this capital depend on a number of factors.

5. No more than 2-4% of those contacting venture capital firms receive financing from them.

6. Megafunds stay away from seed and early-stage invest-ments because those deals tend to require relatively small amounts of capital.

7. After several rounds of venture financing, an entrepre-neur may own no more than 10-20% of the venture.

8. Venture capital investors:

a. Look for ventures with very high growth poten-tial where they can quintuple their investment in five years.

b. Place a very high premium on the quality of man-agement in the venture.

c. Like to see a management team headed by some-one who has previous entrepreneurial experience.

B. Identifying Venture Capital Investors.

1. Venture capital corporations have an established capital base and professional management.

a. Most funds are organized as limited partnerships.

b. These funds prefer to invest from $1 million to $5 million and some do not consider investments of less than $5 to $10 million.

c. The investigation and evaluation of potential in-vestments is thorough and professional.

2. Sources and Guides.

a. A good place to start is with Pratt’s Guide to Venture Capital Sources, published by Venture Economics.

b. Entrepreneurs also can seek referrals from ac-countants, lawyers, and others.

c. Sometimes professional investors find the entre-preneur to commercialize a product or technol-

Results Expected #4Discovered how venture capital investors make decisions.

the venture capital process—the interaction between en-trepreneurs, opportunities, in-vestors, and capital.

ogy.

3. What to Look for.

a. Entrepreneurs should screen prospective in-vestors to determine the preferences of these in-vestors.

b. Early-stage entrepreneurs need to seek investors who:

• Are considering new financing proposals.

• Are interested in companies at the particular stage of growth.

• Have a preference for investments in the par-ticular industry.

• Can provide good business advice and con-tacts.

• Are reputable, fair, and ethical.

• Have successful track records of 10 years or more.

c. Investors should have both patience and bravery.

4. What to Look Out for.

a. Poor attitude toward the venture.

b. Overcommitment to other ventures.

c. Inexperience in dealing with entrepreneurs.

d. Unfavorable reputation, such as replacement of the founders.

e. Predatory pricing, forcing large share price de-creased in the new firms.

5. How to Find Out.

a. The best source is the CEO/founders of prior in-vestments.

b. Contact with CEOs in ventures whose results were only moderate to poor can help understand the value of the venture capital firm.

D. Questions the Entrepreneur Can Ask.

1. Venture capitalists have an enormous legal and fidu-ciary responsibility to their limited partners.

2. They are thorough in their due diligence.

3. The founders can learn a great deal by asking a few simple questions.

4. The answers will reveal how knowledgeable the in-vestors are and how they can add value to the venture.

E. Due Diligence: A Two-Way Street.

1. It can take several weeks or even months to complete the due diligence on a startup.

a. Facts, backgrounds, and reputations of key peo-ple, market estimates, and the like are verified.

b. Investors will want to talk with directors, advi-sors, former bosses, and previous partners.

c. Have detailed resumes of 10 to 20 references, and prepare extra copies of published articles, studies, and technical information.

2. One recent research project examined 86 venture capi-tal firms and their due diligence efforts.

a. To evaluate the opportunity, firms spent from 40 to 400 hours, typically 120 hours.

b. This included careful checks of the manage-ment’s references and verification of track record and capabilities.

3. The entrepreneur should do their own due diligence.

a. Investigate some of their successful deals and some that did not work out.

b. What is their quality, reputation, and record in adding value to the companies in which they in-vest?

c. The chemistry between the management team and the general partner is crucial.

IX. Other Equity Sources.A. Small Business Administration’s 7(a) Guaranteed Busi-

ness Loan Program.

1. The Small Business Administration’s 7(a) Guaranteed Business Loan Program promotes small businesses by guaranteeing long-term loans.

2. The 7(a) program is almost exclusively a guarantee program.

3. Banks and certain nonblank lenders make loans that are then guaranteed by SBA for between 50 and 90% of each loan, with a maximum of $1 million.

4. SBA programs have benefited the economy and en-trepreneurship by helping entrepreneurs start, stay in, expand, or purchase a business, thus creating jobs.

B. Small Business Investment Companies.

1. Small Business Investment Companies (SBICs) are li-censed by the SBA and can obtain debt capital from the agency.

.

2. Many U.S. companies, including Intel, Apple, and Fed-eral Express, received early financing from SBICs.

3. An SBIC’s equity capital is generally supplied by com-mercial banks, wealthy individuals, and the investing public.

a. Small businesses that qualify for assistance from the SBIC program may receive equity capital, long-term loans, and expert management.

b. Venture capitalists participating in the program can borrow funds at favorable rates through the federal government.

4. Since 1958 the SBIC program has provided approxi-mately $27 billion of long-term debt and equity capital.

5. SBICs must take minority shareholder positions and can invest no more than 20% of their equity capital in any one situation.

6. SBICs prefer to make some form of interest-bearing in-vestment.

7. These companies tend not to finance startups and early-stage companies.

C. Mezzanine Capital.

1. A company that has overcome early-stage risks may be ready for mezzanine capital.

2. Mezzanine financing refers to capital that is between senior debt financing and common stock.

a. This is usually subordinated debt that carries an equity element.

b. This subordinated-debt capital also can serve as equity for senior debt.

c. The variables involved include the interest rate, the amount and form of the equity, maturity, call features, put/call options, and the like.

3. Disadvantages to mezzanine capital:

a. The interest is payable on a regular basis and the principal must be repaid.

b. Subordinated debt often contains covenants relat-ing to net worth, debt, and dividends.

4. Mezzanine investors look for companies that have a demonstrated performance record.

5. Mezzanine financing is used most often by the broad middle spectrum companies rather than high-tech, high-growth companies.

D. Private Placements.

1. Private placements are an alternative for a private com-

pany that doesn’t want to go public.

2. In this option, the company offers stock to a few private investors.

3. The private placement can be distributed among a small group of friends, family, or acquaintances.

4. Or the company may have a broker circulate the pro-posal among a few investors.

5. Groups of investors who might be interested in a pri-vate placement include:

a. Dealers, franchisors, or wholesalers who buy to assure continuation of product supply.

b. Professional investors who are looking to buy a good small company in its formative years.

c. Investors seeking to buy shares of smaller growth companies in the expectation that the company will soon go public.

d. Venture capitalists who hope to benefit when the company goes public.

E. Initial Public Stock Offerings.

1. An initial public offering raises capital through feder-ally registered and underwritten sales of the company’s shares.

a. Federal and state securities laws and regulations govern these offerings.

b. It is important to consult lawyers and accountants familiar with current regulations.

2. During past strong bull markets, it was possible to raise money for an early-growth venture.

a. Booms occurred in 1983, 1986, 1992, and 1996.

b. Following the stock market crash on October 19, 1987, the new-issues market for entrepreneurial companies shrank.

3. The text gives an example of a firm that had to delay its IPO several times due to these economic fluctuations.

4. In 2000 the NASDAQ collapsed and the IPO market shut down.

5. The more mature a company when it makes a public of-fering, the better the terms of the offering.

a. A higher valuation can be placed on the company.

b. Less equity will be given up by the founders.

6. There are advantages to going public.

a. To raise more capital with less dilution.

b. To improve the balance sheet and/or to reduce or

eliminate debt.

c. To access other suppliers of capital and to in-crease bargaining power.

d. To improve credibility with customers, vendors, key people, and prospects.

e. To achieve liquidity for owners and investors.

f. To create options to acquire other companies with a tax-free exchange of stock.

g. To create equity incentives for new and existing employees.

7. There are also disadvantages.

a. The legal, accounting, and administrative costs of a public offering are higher.

b. A large amount of management effort, time, and expense are required to comply with SEC regula-tions and reporting requirements.

c. Management can become focused on maintaining the price of the company’s stock rather than in running the company.

d. The liquidity of a company’s stock may be lim-ited.

e. The investment banking firms willing to take a new company public may not be suitable for long-term partnership.

F. Private Placement after Going Public.

1. Sometimes a company goes public, then suffers finan-cial reverses, and the price of the stock goes down.

2. Some sophisticated investors will offer a private place-ment.

3. Regulation D was developed by the SEC and the state securities associations to provide uniform exemption from registration for small issuers.

4. Under Regulation D companies are required to file a short form, Form D, with the SEC.

5. Regulation D provides exemptions from registration in certain circumstances.

a. Rule 504: Issuers that are not subject to the re-porting obligations of the Securities Exchange Act and that are not investment companies may sell up to $1 million worth of securities over a 12-month period to an unlimited number of in-vestors.

b. Rule 505: Issuers that are not investment compa-nies may sell up to $5 million worth of securities over a 12-month period to no more than 35

nonaccredited purchasers and to an unlimited number of accredited investors.

c. Rule 506: Issuers may sell an unlimited number of securities to no more than 35 unaccredited but sophisticated purchasers, and to an unlimited number of accredited purchasers.

G. Employee Stock Ownership Plans (ESOPs).

1. An ESOP is a program in which the employees become investors in the company, thereby creating an internal source of funding.

2. An ESOP is a tax-qualified retirement benefit plan.

3. An ESOP borrows money and uses the cash proceeds to buy the company’s stock.

4. The stock then becomes collateral for the bank note.

5. The ESOP has tax advantages for both the lender and the purchasing company.

X. Keeping Current about Capital Markets.A. Capital markets are very dynamic, volatile, asymmetric, and

imperfect.

B. The venture should keep current on trends in capital markets.

C. Sources include:

1. National Venture Capital Association (www.nvac.org.)

2. Venture Capital Journal.

3. INC.

4. Red Herring, a Silicon Valley magazine.

XI. Chapter Summary.

Answers to Study Questions

1. What is meant by the following, and why are these important: cover your equity; angels; venture capital; valuation; due diligence; IPO; mezzanine; SBIC; private placement; Regulation D; Rules 504, 505, and 506; and ESOP?

Cover your equity refers to preserving as much of your equity as you can for as long as you can.

Angels are wealthy individuals who invest in startup and emerging businesses through the informal market.

Venture capital are private investment firms that supply capital and other resources to en-trepreneurs in businesses with high growth potential in hopes of achieving a high rate of return on investment fund.

Valuation of a company is the value that capital markets place on the venture (number of shares outstanding times share price.)

Due diligence is the process by which the potential investor verifies the capabilities of the venture, the backgrounds of the management team, and technical specifications of the product.

IPO stands for initial public offering, the process by which a company raises capital through federally registered and underwritten sales of the company’s shares.

Mezzanine financing refers to capital that is between senior debt financing and common stock, usually subordinated debt with an equity element.

SBIC stands for Small Business Investment Companies, firms licensed by the SBA to provide debt capital to small emerging enterprises in exchange for equity.

Private placements are an alternative to going public; the venture sells shares of its stock to a small group of investors rather than to the public as a public offering.

Regulation D was developed through the cooperation of the SEC and the state securities associations to provide a uniform exemption from registration for small issuers.

Rule 504: Issuers that are not subject to the reporting obligations of the Securities Ex-change Act and that are not investment companies may sell up to $1 million worth of securities over a 12-month period to an unlimited number of investors.

Rule 505: Issuers that are not investment companies may sell up to $5 million worth of securities over a 12-month period to no more than 35 nonaccredited purchasers and to an unlim-ited number of accredited investors.

Rule 506: Issuers may sell an unlimited number of securities to no more than 35 unac-credited but sophisticated purchasers, and to an unlimited number of accredited purchasers.

ESOP stands for employee stock ownership plans in which the employees become in-vestors in the company, thereby creating an internal source of funding.

2. What does one look for in an investor, and why?

The entrepreneur should look for investors that add value to the venture well beyond money. Investors may add or detract value in a young company. They can fill some gaps in the founders’ know-how and networks. Adding key management, new customers or suppliers, or re-ferring additional investment are basic ways to add value.

3. How can the founders prepare for the due diligence and evaluation process?

Potential investors will want to talk with a venture’s directors, advisors, former bosses, and previous partners. The firm should provide very detailed resumes and lists of 10 to 20 refer-ences such as former customers, bankers, vendors, and so on. They should also prepare extra copies of published articles, reports, studies, market research, contracts, purchase orders, techni-cal specifications, and the like.

4. Describe the venture capital investing process and its implications for fund-raising.

The venture capital investing process begins with the conception of a target investment opportunity or class of opportunities, which leads to a written proposal or prospectus to raise a venture capital fund. Once the money is raised, the value creation process moves from generating deals to crafting and executing harvest strategies and back to raising another fund. The process usually takes up to 10 years to unfold. The process occurs in the context of mostly private, quite imperfect capital markets. During boom times, such as existed in 1998 and 1999, venture capital investment was readily available. During market downturns, venture capital becomes harder to

acquire. The crash of the NASDAQ, which began in March 2000, resulted in more than a 60 per-cent drop in value by summer 2001. Even companies exceeding expectations found it difficult to attract venture capital as the investing pace slowed dramatically. The venture capital cycle seems to repeat itself.

5. Most venture capitalists say: There is too much money chasing too few deals. Why is this so? When does this happen? Why and when will it reoccur?

Scarcity of capital leads to high returns, which attracts an overabundance of new capital, which drives returns down. The venture capital investment cycle repeats itself.

Venture capital firms stay away from seed and early-stage investments because those deals tend to require relatively small amounts of capital, and the megafunds like to make larger commitments. They have a large fund of capital which needs to be invested. There are fewer large high-growth, high potential ventures than small high–potential ventures. The venture capital available competes for the bigger superdeals.

6. What other sources of capital are available and how are these accessed?

Entrepreneurial ventures have many potential sources of capital. The best source for the entrepreneur is bootstrapping financing, finding creative ways to conserve the founders’ capital. Angel investors, wealthy individuals seeking to invest in high-growth potential firms, can be lo-cated through the Internet, through one’s own network of contacts, and through referrals from professionals such as lawyers, accountants, and current investors.

Venture capital funds provide funding for entrepreneurs in businesses with high growth potential. Guides such as Pratt’s Guide to Venture Capital Sources and ventureone’s Web site can identify potential venture capital investors. Entrepreneurs can also seek referrals from ac-countants, lawyers, investment and commercial bankers, and knowledgeable businesspeople.

Other sources include the Small Business Administration’s 7(a) Guaranteed Business Loan Program, Small Business Investment Companies, mezzanine capital, private placements, initial public stock offerings, private placements, and employee stock ownership plans (ESOPs.)

7. Explain the capital markets food chain and its implications for entrepreneurs and in-vestors.

The various capital sources have preferences as to the stage of the venture’s development, the amount of capital they provide, and the portion of the company and share price expected from the eventual initial public offering. At the R&D stage—when the company has a valuation of less than $1 million—ventures are limited to capital from founders; angels; friends, family, and fools; and SBIRs. The earlier the capital enters, the more costly it is. By the time the venture reaches high growth, more sources and more capital is available.

At IPO the capital markets are typically willing to pay $12 to $18 per share. Share prices are lower during tight IPO periods, as low as $5 to $9. In hot IPO periods, share prices can be over $20. Founders have to decide whether to give up equity in order to create very significant value. If founders have to give up 70 percent to 80 percent of equity, the market capitalization must be at least $100 million to create significant value.

The peak capitalizations during the 1990s were not sustainable. In the recent venture cap-ital food chain, the amount of capital invested is quite substantial.

Notes on Case

“Hindman & Company”

Use of the Hindman & Company Case

This is an actual case that can be used for a conventional case discussion. The case intro-duces the Jiffy Lube business four years after its founding. It provides a look at how a business opportunity was developed and what financing alternatives were used to launch it.

Positioning and Objectives

This continues the entrepreneurial finance portion of the course. Its aim is to introduce students to the concept that the business strategy sets the pace for the financial requirements. Af-ter completing this case and chapters 13-16, students should be able:

1. To develop an overall financial strategy directed toward the creation of long-term value and determine how well the potential sources of financing available would fit into this overall strategy.

2. To identify and evaluate the potential sources of financing available, determine the most advantageous and likely source based on the business' current situation and goals, and explain why other sources are less advantageous.

Preparation Questions

Students are asked to consider the following questions:

1. Evaluate the business opportunity for the franchisee and the franchisor. How do they make money in this business?

2. Evaluate the company’s growth and financial strategy. What have been the conse-quences?

3. Evaluate the current strategy, both for growth and for financing. How much money is needed and when?

4. What should Hindman do?

The key questions for the business at this point are: When will it run out of cash? Where does Hindman want to take the company? What are the financial implications of this strategy? what are the potential sources of financing available? What are the advantages, disadvantages, and long-term implications of each of these sources? This progression will bring into focus the amount of time the company has to work with before it runs out of cash (approximately a month and a half after the end of its fiscal year, March 31), a critical examination of Hindman's business strategy, the proportions of its short and longer-term financing requirements (Jiffy Lube needs a lot of cash, both for immediate survival and to meet their growth plans), and what the alternatives open to Hindman are and what each implies for the company, Hindman, and the investors.

Class Session

This case provides a good opportunity to analyze the business strategy as it relates to the financing alternatives. It provides students with a chance to weigh different sources of financing and determine which is best suited to the company's current situation and goals. It should also help the class develop a strategy for the company to meet a financial crisis. What follows is one approach to managing the class discussion while incorporating the above questions.

Introduction/Current Situation

Begin the discussion by asking a class member to briefly summarize the background of the case. Continue the discussion by asking the class:

What can you tell us about Jiffy Lube's current situation?

What does its "financial pulse" tell us?

Record the class's comments on a flipchart or blackboard. The discussion should center around the following two points:

1. Jiffy Lube is in the midst of a severe financial crisis.

2. The company is out of cash.

Use the following figure to summarize the current situation: (Also presented as Trans-parency Master 14-12 in Part IV of this manual.)

Hindman & Company Figure #1:

MARCH 1983 PROFILE

New Industry Layoffs (40% of Payroll)

Losses:

$2.6 Million in 1983 (on 65.5 Million in Sales)

Cumulative Losses of 85.1 Million

Miserable Balance Sheet:

Net Worth: $ (2.4M) 1:4

Current Ratio: 1:4

Cash on Hand: Less than $200K

(How Long Will It Last?)

Continue with the following questions:

How close is the company to bankruptcy? Is it going under?

What are Jiffy Lube's biggest needs?

Obviously everyone's immediate response will be that Jiffy Lube needs CASH. However, the discussion should address another immediate need:

Jiffy Lube needs to determine when it will run out of cash.

Ask the class when Jiffy Lube will run out of cash. Ask anyone responding to briefly ex-plain any calculations they performed. Continue by explaining that it is obvious that Jiffy Lube is in trouble because it is running out of time. Therefore what is important is to determine approxi-

mately how fast the company is using up its cash. Jiffy Lube needs to know how much longer it can last. The following overhead shows how to calculate the "burn rate."

(Encourage the class not to get too "hung up" on the actual calculations: the calculations are rough and are constrained by the limited facts in the case. The overall concept is what's im-portant.)

Hindman & Company Figure #2

CASH “BURN RATE”

April 1994 (000s)

RECEIPTS*Royalties ($20K x 96 x 5%) $91*Initial Fees ($20K x 2) 40*Rent ($775 x 120) 65

196

DISBURSEMENTS*S, G & A ($2,100K x 12) 175*Service Center Lease Commitments

($150K x 12) 13*Interest 102

290Net Cash from Operations (94)*Debt Maturities 6

MONTHLY BURN RATE $(100)**approximately $20 - $25K per week!

(Also presented as Transparency Master 14-13 in Part IV of this manual.)

Royalties were calculated assuming that the 96 units in operation will average ap-proximately $20K in sales per month for the first quarter of fiscal 1984.

The company plans on selling at least 25 franchises in fiscal 1984. The initial fee calculation assumes that two new franchises would be sold per month.

S, G, & A, are expected to be constant throughout the year.

Interest and debt maturities were estimated from the summary schedules.

Summarize the key point of the figure: According to its projected balance sheet, Jiffy Lube estimates that it will have approximately $140K on hand at March 31, and it appears (based on the above calculations) that it will run out of cash in a little less than a month and a half after that.

Point out that the above calculations demonstrate that the traditional annual or quarterly cash flow projections are insufficient for a company facing a financial crises like the one facing Jiffy Lube. The company needs a much shorter planning horizon.

Current Strategy

Explain that now that the class has analyzed where Jiffy Lube is, we need to take a look at where Jiffy Lube thinks it is going. Ask the class:

What direction does Hindman want to take this company?

What are his goals?

Key goals include:

Seize the perceived opportunity represented by the quick oil change market.

Build a large, independent franchisor of quick-change service centers.

Do it aggressively, swiftly.

Continue with:

What is Jiffy Lube's business and operational strategy?

Record the class's comments on a flipchart. After listing all of the class's comments on the flipchart, ask the following question about each characteristic of Jiffy Lube's strategy that they have identified:

What are the financial implications of this strategy?

Common observations about Jiffy include:

Strategy Financial Implications

Franchise (rather than operate service centers)

Dependent on the 5 percent royalty fee for the majority of its revenues.

Rapid Growth (without concern for immediate profitability)

Largest franchisor in the country but strat-egy requires large amounts of cash. It also has resulted in heavy losses to date and a precarious financial position.

Clustering Although not obvious at this point in time, the clustering strategy creates the opportu-nity to sell the “Area Development Rights” highlighted in the BCI case.

Independence Limits the number of financing alternative (Pennzoil example.)

Heavy Personal Investment of Founder (Hindman)

This source will run out eventually.

High Financial Leverage Heavy interest payments; limits the future “degrees of freedom”; need equity.

Direct the discussion toward an analysis of Jiffy Lube's early financing strategy with the following overhead. This figure, which can be presented as an overhead transparency, summa-rizes the major financing sources Jiffy Lube has used since it was founded. For each of the sources highlighted ask the class: What was Jiffy Lube's apparent financing strategy in using this source?

Hindman & Company Figure #3

FINANCING SOURCES USED TO DATE

1. Hindman's Personal Resources

2. Friends and Employees

3. Private Placement

4. Pennzoil Investment and Loan Guarantee

5. Build-Up of Accounts Payable and Other Current Liabilities

(Also presented as Transparency Master 14-14 in Part IV of this manual.)

Apparent Financial Strategy for these:

1-3: Helped maintain independence. Were probably the few sources immediately acces-sible at the company's early stage of development. Also the fastest source, with fewer constraints.

4: An attempt to create an alliance with a potential competitor. Accelerated growth.

5: Emergency, short-term source.

We've looked at Jiffy Lube's current situation and current strategy. Next we'll analyze what steps they should take next, and what their needs are.

Needs/Action Steps

What decisions does Jiffy Lube need to make?

What action steps do they need to take? What do they need to analyze, and what can we do to help them?

Record responses on flipchart.

(Although "Get Cash" is likely to be the first action proposed by the participants, they should be directed to identify the steps Jiffy Lube will have to take to obtain financing and sur-vive the current crises.)

The following should be identified as immediate priorities for Jiffy Lube:

Action Steps Additional Discussion Points

Cash Flow Projections A. Calculate weekly burn rate, "out of cash" date (similar to overhead above)

B. Extend cash flow projections over the next 90 days; the next year; the next three years

Extend the "Out of Cash" date Identify opportunities:

A. For additional cutbacks

B. To accelerate or increase receipts

C. Payments which can be delayed

Challenge goals, and business strategy Help the company challenge its goals and strat-egy

Determine operating and asset Determine the requirements to carry out Jiffy Lube’s strategy requirements

Evaluate debt obligations Evaluate the current and future debt obligations

(amounts, maturities, terms, covenants)

Identify sources of financing Identify alternative sources available to resolve crises (but recognize the long term implications of these sources)

Develop financing strategy Develop a longer-term financing strategy (as-suming the company can and wants to continue):

A. 3-year plan

B. Estimate cost, relative bargaining position, and compatibility of goals with each po-tential source.

Direct the discussion to the first action step. “Cash Flow Projection.” Explain that earlier we estimated Jiffy Lube’s burn rate and when it was going to run out of cash. The next step is to quantify how much cash they are going to need to survive and to meet their growth plans.

Ask the class if any of them have estimated what Jiffy Lube’s financing requirements are. Discuss any of their estimates, and then use the following figure to illustrate the primary determi-nants of the Jiffy Lube’s financing requirements. (Also presented as Transparency Master 14-15 in Part IV of this manual.)

Hindman & Company Figure #4

FINANCING REQUIREMENTS

Working Capital Deficiency XXX(Restore Solvency) Each of these 3

Operating Requirements XXX are (Net Cash Flow)

interdependentAsset Requirements XXX(Real Estate, etc.)

Stress that working capital deficiency, operating requirements, and asset requirements are all interrelated. Ask for examples of how these three components affect each other? For example, the financing Jiffy Lube uses to fund is asset requirements will affect its operating cash flows (additional interest, etc); the company’s liquidity and net operating flows will affect its ability to

raise financing for its asset requirements. Refer to Transparency Master 13-4 “Financial Strategy Framework” in Part IV of this manual.

Remind the class that the business strategy set the pace for the financial requirements. Ask the class about what changes in business strategy would affect Jiffy Lube’s financing re-quirements. Examples would be changes in the growth rate, selling Area Development Rights, in-creasing the royalty fee, increasing or decreasing the number of franchises that Jiffy Lube pro-vides real estate financing to. The last example will affect both asset and operating requirements.

Display the following overhead which shows a calculation of Jiffy Lube’s cash flow from operations. Explain that this is a “rough” projection (as with all the projections in this session), but serves as a starting point for analyzing Jiffy Lube’s needs.

Three key points are that the projections:

1. Assume that the current strategy does not change and that no refinancing has oc-curred.

2. Exclude any additional long-term real estate financing needed for Jiffy Lube’s ex-pansion plans.

3. Will change based on the long-term financing strategy chosen and on any changes in the business strategy.

Hindman & Company Figure #5

OPERATING REQUIREMENTS (000s)

Projected Cash Flow:Fiscal Year

1984 1985 1986 RECEIPTS Royalties, Initial Fees, andRoyalties $1,400 $2,45 $3,750 S, G, & A were calculatedInitial Fees 580 1,500 2,000 based on management’sRent 775 775 775 projections

2,755 4,725 6,525

DISBURSEMENTSS, G, & A 2,100 2,600 3,100 Interest and Debt Maturities Lease Commitments 150 150 150 take into account only thatInterest 1,321 1,299 1,246 debt existing in March 1993.

3,571 4,049 4,496 The interest payments and maturities are based on the

Net from Operations (816) 676 2,029 existing debt agreements.

LT Debt Maturities 86 199 523

NET CASH FLOW $(902) $ 477 $1,506

(Also presented as Transparency Master 14-16 in Part IV of this manual.)

Ask the class what the danger is in using this annualized cash flow projection in deter-mining what Jiffy Lube's cash requirements are going to be for the year. Often a business’s cash

flow is not consistent throughout the year. For example, the revenue per service center will proba-bly be much lower during the first part of the year. It often is necessary to calculate cash require-ments monthly or even weekly during the periods of heaviest cash needs. For simplification we will use just the annual cash flow in this case study.

Direct the discussion toward Jiffy Lube's "asset requirements" by asking if anyone esti-mated Jiffy Lube's Asset Requirements based on the current business strategy. Discuss any of the class's estimates. (At a minimum they should recognize that the financing requirements will de-pend on how many franchises Jiffy Lube elects or needs to assist with real estate financing.) Use the following figure to illustrate a quick estimate of the asset requirements. (Also presented as Transparency Master 14-17 in Part IV of this manual.)

Hindman & Company Figure #6

ASSET REQUIREMENTS

Fiscal1984 1985 1986

New Franchises 29 75 100

% Financed By Ready x50% x50% x50%

15 38 50

Real Estate Cost x $.3 x $.3 x $.3

ASSET NEEDS $4.5 $11.4 $15.0

Dollars in millions

What factors will affect the type of financing Jiffy Lube will want to obtain to finance these real estate requirements? Key factors will include:

Strategic Issues:

Will franchises be able to obtain their own financing once the franchise is op-erating?

Or will they have to lease the real estate from Jiffy Lube?

Affect on operating cash flows; how much interest can they afford?

After performing an initial analysis of the operating and asset requirements, we can estimate Jiffy Lube's overall financial requirements. Show the following calculation of Jiffy Lube's financing requirements over the next year. (Also presented as Transparency Master 14-18 in Part IV of this manual.)

Hindman & Company Figure #7

CURRENT AND FISCAL 1984 FINANCING REQUIREMENTS

The “deficiency” amount excludes the WORKING CAPITAL DEFICIENCY note payable to Hindman (and the

$3,039 related partnership). Hindman and his partners may be willing to convert these loans to equity.

OPERATING NEEDS 902

$3,941 The deficiency includes the $1.25 million in bank lines of credit (it is

ASSET NEEDS $4,500 uncertain whether they can be renewed: the banks may call the lines after they see the current financials).

'Asset Needs' represents real estate financing that Ready Change will have to provide—or somehow make available—for its new franchisees.

In summary, Jiffy Lube needs a lot of cash, both for immediate survival (at least $2.6 million) and to meet their growth plans ($4 million in fiscal 1984). Now we will look at what po-tential sources of financing are available.

Financing Alternatives

Explain that before we look at specific sources, we need to review the factors that affect the alternatives available. Jiffy Lube's alternatives are going to be influenced by:

1. The goals and criteria of potential investors and lenders, and

2. Their perception of Jiffy Lube and the potential opportunity.

Ask the class what questions a banker would ask when looking at Jiffy Lube. Acknowledge any re-sponses, then use the following overhead to summarize the discussion. The main point of the next figure is that Jiffy Lube is not going to obtain any more debt financing until they get a major in-fusion of equity. (Also presented as Transparency Master 14-19 in Part IV of this manual.)

Hindman & Company Figure #8

BANKER'S QUESTIONS

FOUR KEY QUESTIONS:

1. Does Jiffy Lube have adequate interest coverage? (Will they generate enough cash to safely cover loan payments)

2. Do they have collateral? (How much?)

3. Is our risk covered?

4. What if Jiffy Lube goes bankrupt or liquidates? (What do we end up with?)

The next question would be “What is an investor getting when he or she purchases equity in Jiffy Lube?” Again, an overhead transparency can be used to summarize the discussion. (Transparency Master 14-20 in Part IV of this manual.)

Hindman & Company Figure #9

WHAT AN INVESTOR GETSFOR INVESTING IN JIFFY LUBE:

Jiffy Lube has:

Cumulative losses.

Working capital deficiency.

Investor's honey would be used to:

Restore solvency.

Pay off past losses.

Insure immediate survival.

Accordingly, the investor is not financing “hard assets”, but is paying for:

Largest network of oil-change centers in U.S.

The chance to participate in Jiffy Lube's perceived opportunity.

In summary, any investor has to understand Jiffy Lube's business and be as much of a be-liever in its concept (and the management team) as Jiffy Lube is.

Next, direct the discussion toward an analysis of the sources available. Based on what we've discussed, what sources of financing are available to Jiffy Lube? Specifically, what sources are available to help them deal with their imminent cash crises (buy time)? Summarize the financ-ing alternatives on a flipchart.

After listing all the potential sources identified by the class, ask the following question about each: What are the advantages, disadvantages, and long-term implications of each of these sources? The following summary encompasses many of the alternatives the class might identify:

Source Comments/lmplications/Timing

Hindman's personal resources Will soon run out. The approximately $3 million of partnership interests is a very promising source, but there are the tax implications to con-tend with. (Fastest: <1 month)

Private Placement: with Midwest Group

Could be completed in a relatively short time pe-riod. Must be certain that investors have similar goals and realize that the investment will not be liquid for the near future. (Fast: < 9 months)

franchises. Compatibility of goals would be an issue. The majority of franchise owners are indi-viduals and probably have limited resources. (Fast: <3 months)

Strategic alliance An alliance has the potential advantage that an oil company (or other partner) may have strate-gic goals and be just concerned with return on investment (accordingly it may have a lower cost to Jiffy Lube). Failure of the arrangement with Pennzoil demonstrates the problem of in-compatible goals. (6-12 months)

Venture Capital The amount of money Jiffy Lube needs would probably limit it to the larger venture capital firms. Even if the company could interest a VC (unlikely with its current profile), it could be ex-tremely expensive in terms of ownership sold. (6-12 months)

Sale of real estate Once the franchise is up and operating, fran-chisees leasing the property from Jiffy Lube may be able to obtain their own financing for purchasing the property. It may be difficult to find a third party buyer for the property since us-age would be limited to the service center al-ready in place. (3-6 months)

Public offering 1983 will become the hottest year for IPOs in years (although that may not have been evident in March 1983). It is conceivable that Jiffy Lube could complete a public offering despite the poor financial profile. The cost (ownership sold) would be extremely high and the proceeds rela-tively limited. (4-9 months)

Assuming that Jiffy Lube can get past its current crises, what sources of financing are available to fund the company's growth plans over the next three years? Remind the class that as the case detailed, once the immediate crises and short-term operating needs are taken care of, the company will have to address how it will meet its real estate financing needs. According to man-agement's estimates at least 25 to 50 percent of the franchisees will require assistance with their real estate financing. Common responses would include:

Source Comments/Implications

Bank S & L mortgage financing on real estate

Jiffy Lube will need to be able to generate suffi-cient cash flow to meet mortgage payments. The company also will have to determine what its long-term goal is in financing real estate pur-chases: does it want to own and rent these prop-erties to franchisees, or does it want to sell to

franchises once they are operating and can af-ford to purchase its real estate.

Public Offering When Jiffy Lube starts generating profits, it may be able to complete a public offering under more favorable terms. However, it may be difficult to market a public offering that was to be used pri-marily for real estate development.

Change in business strategy Accelerate sale of franchises; sale of Area De-velopment Rights.