STRATEGIC RATIONALE Should a Firm Build a Strategic Alliance?

1STRATEGIC RATIONALE

Should a Firm Builda Strategic Alliance?

1

In Brief

Today’s business environment has changed. Amid rapid and dramatic change heavily drivenby globalization, increased business complexity, diversified customer needs—and simplyspeed—companies need to respond and adapt accordingly if they are going to survive andgrow. Alliances serve as an important business strategy to respond to the business environ-ment, and they increasingly define the structure of entire industries, as is the case in themultimedia, telecommunications, automobile, and biotechnology industries.

And they work. Companies that successfully embrace alliance strategies consistentlyperform better than those that do not. These companies benefit from alliances in a varietyof ways, including sharing cost and risk, pooling their respective strengths, and leveragingcomplementarities. How much importance and stake is placed in forming an alliance shouldbe directly proportionate to the degree to which the alliance supports a company’s overrid-ing business strategy. Simply stated, if it is going to be instrumental in achieving its long-termbusiness objectives, the company managers will want to put into it suitable time and resourcecommitment to ensure its success. In contrast, if it is not as strategically important, prudenceneeds to be exercised in making a commitment.

Deciding to commit is only part of the readiness question. It is essential to take aclose look at the internal structure, policy, and culture of the organization to make sure theinternal machinery is indeed setting the company up for success. Sometimes, managers maydiscover they must first get their house in order before they should entertain forming analliance with another organization because those alliances that are not managed well canprove to be very costly!

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Firms of all sizes are looking to create and maintain a competitive edge in a businessclimate where the abilities to adapt and respond are critical to survival. Traditionalorganizational boundaries and business models have been redefined, with more

emphasis being placed on alliances. Among large companies, alliances have become thenorm, with companies engaging in anywhere from 30 to 100 alliances each.1 Why? Thebelief is that alliance models are highly flexible, are generally lower risk, and enable com-panies to respond to rapid and sometimes radical changes in the marketplace and technology.

WHAT ARE STRATEGIC ALLIANCES?

A strategic alliance is a formal and mutually agreed to commercial collaboration betweencompanies. The partners pool, exchange, or integrate specific business resources formutual gain. Yet partners remain separate businesses.2 Alliances can be either equity ornon-equity based and typically start with one cooperative agreement that evolves into aportfolio of arrangements built over time.

Alliances are not risk free, however, and many studies cite 40% to 50% success rates.3

Other research points out these rates are not dissimilar to alternative strategies, includingwholly owned subsidiaries,4 but the bottom line is there is much opportunity for improvement.Managers are well served to invest effort in managing their alliances well. If poorly managed,they can be very costly distractions wasting resources, destroying morale, and resulting in aloss of competitiveness. Even ventures that ultimately succeed are seldom problem free, andat least half can expect to see serious operational challenges within the first 2 years.

In spite of this sobering rate, enthusiasm for alliances continues to grow. A 2004PriceWaterhouseCoopers study of 201 senior finance executives finds that nearly two

thirds of respondents were more willing to strikealliances than they were 3 years earlier.5 Another studyof Fortune 500 companies shows that the top 25 thatsuccessfully embrace alliance strategies consistentlyperformed better than those that do not.6

Why alliances? Alliances are viewed as an excellentvehicle to obtain market growth amid market conditionsthat are rapidly and dramatically changing worldwide.Globalization, the growing complexity of the businessenvironment, increasingly diverse customer needs, andthe need for speed and momentum are the underlyingfactors. In this climate, alliances are an excellent way fororganizations to share risks, pool strengths, and integratebusiness operations for their mutual benefit.

While growth and profitability are typically thecommon end goal, alliances satisfy a variety of needsfor individual companies and can be a valuable toolacross a company’s entire business system, as indicatedbelow. Moreover, alliances have been increasingly usedto construct broader business systems by linking acompany’s internal core competencies with the “best ofbreed” capabilities of allies.

2 • CASES IN ALLIANCE MANAGEMENT

Partnering for Growth

Ask Jeeves is a highly popular Internet site thatallows visitors to type questions in ordinarylanguage and receive relevant answers. Thecore strength of the Web site is the company’snatural language search technology. In 2000,the company enjoyed a strong brand within acompetitive search engine space. Managementwanted to capitalize on their leadership positionand swiftly expand into the lucrative enterprisemarket. Using alliances as a vehicle to achievemarket growth, Ask Jeeves announcedpartnerships with several customer supportoutsourcing companies already serving Fortune1000 companies. While alliance partners gainedaccess to leading-edge search technology toimprove their outsourcing solutions, Ask Jeevesgained accelerated entry, forecasting a 20%increase in its customer base over the next12 months as a result of the alliances.

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Strategic Rationale • 3

Knowledge Markets

EfficiencyValue Gaps

Research & development Complementary technology Intellectual property

Market knowledge Market reach Customer base

One-stop solutionExpressed customer needs

SpecializationNoncore functions

Scalability

Figure 1.1 Why Cooperate?

Design Purchasing Production Marketing Distribution

fun

ctio

ns

in t

he

org

aniz

atio

n

Subcontracting/Bundling

EngineeringContract

ManufacturingAgreements

ExpertiseContract

Patent License

TrademarkLicense

JointMarketing

ResearchContract

JointResearch

DistributionAgreements

JointPurchases

Figure 1.2 Where You Might Cooperate

Source: Sabine Urban and Serge Vendemini, European Strategic Alliances: Cooperative Strategies in the New Europe (Oxford,UK: Blackwell, 1992), 131.

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The growth of alliance-based businesses has led some experts to conclude thatcompetition is becoming as much a battle between competing and often overlapping coali-

tions as it is between individual firms. Alliance networks,or business webs, increasingly define the very structureof an industry, as is the case with industries includingmultimedia, telecommunications, networking, automo-bile, and biotechnology. Cisco, Dell, and, more recently,Nortel are examples of virtual integration, where noncorecompetencies in the value chain are distributed acrossalliance partnerships. For smaller companies, this meansunderstanding—and targeting—the ideal ecosystemwithin which they want to participate and understandingwhat the resulting implications of membership are.

Outsourcing is another form of alliance that hasevolved particularly in the area of information systems(IS). What is remarkable is that industries, such as bank-ing, are choosing to outsource IS while they consider itto be a core competency that, intuitively, one expectswould not be outsourced.7 In these instances, the strategicdrivers, which include changing organizational bound-aries, organizational restructuring, and risk mitigation,supersede the traditional view.

THE BENEFITS AND CHALLENGES OF STRATEGIC ALLIANCES

When successfully built and managed, alliances can provide both strategic and financialbenefits to participating firms:

• Reduced costs and risks• Access to needed technology and distribution• Access to new markets and customers• Faster acceptance of new technology• Enhanced credibility• Increased investment• Boost in stock market value• Opportunities to learn• Opportunity to build new skills

From a financial perspective, the evidence of the impacts on the bottom line due toalliances is impressive, pointing to substantial impacts on return on investment (ROI) andreturn on equity (ROE). Among large alliances, there was a substantial share price changein 52% of the alliances, and 70% of these were share price increases. It is interesting tonote that this figure represents substantially higher effects than from acquisitions.8

It is clear that, when managed well, alliances can create tremendous value. In termsof revenue, in a 2002 International Data Corporation study, 90% of survey respondentsreported their alliances contributed between 5% and 50% of corporate revenue.9

So although there are cautionary statistics on alliance failures, there is also evidence ofsignificant potential. Alliances will remain a strategic business model. The fundamental


Competing Industry Alliances

Juniper Networks develops high-performancenetworking products for the growing Internetmarket. The Mountain View, California, firm hasdirected its technology at the heart of Cisco inthe Internet core. In 1998, it raised venturefinancing and partnered with a number of Ciscocompetitors, including Ericcson, Nortel, theSiemens/Newbridge alliance, 3Com, Lucent,VVNET Technologies Inc., and ATT Ventures. ForJuniper, this represented a partnership withcompanies that collectively represented morethan $75 billion in annual sales to virtuallyevery major networking customer. Thesealliances provided a foundation for the deliveryof Juniper’s technology around the world. Itspartners had the opportunity to integrateJuniper’s leading-edge technology with theirexisting product lines and services worldwide.

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question therefore becomes, What drives successful alliances for both large and smallcompanies?

Problematic alliances can be the result of many factors, including industry dynamics(e.g., regulatory changes), new technologies, new entrants, or economic cycles. The abilityto weather external forces as well as maximize internal alliance potential is heavily drivenby establishing a solid alliance foundation that includes experience, mutual trust, strongrelationships, and sound business rationale.

UNDERSTANDING WHAT A FIRM REALLY NEEDS FROM AN ALLIANCE

The rationale for a strategic alliance needs to be firmly grounded in a clear strategicunderstanding of a company’s current capabilities and those it will need to be successfulin the future. First, managers need to establish their company’s strategic objectives andthen evaluate their resources and capabilities to see if they are capable of executing ontheir own. The clearer the significance of the alliance for the success of a company’s futurestrategy, the more committed it will be to work at its success.

The process starts by developing a realistic appraisal of what resources are requiredto meet a company’s long-term strategic goals; that is, what capabilities will provide acompetitive advantage in 3 to 5 years?

These capabilities might include credibility, geographical presence, distribution,technology, or money. Then managers need to objectively state what their firm’s currentcapabilities really are.


What kind of infrastructure willbe required? (e.g., manufacturingcapacity, service fleet processes, etc. )

What financial resources willbe required? (e.g. capitalinvestments, working capital, etc. )

What human resources andexpertise are needed? (e.g.,technical skills, industryexperience, etc. )

What Is Needed? Measure Gap Current Capability?

1.2.3.

What market strengths areneeded? (e.g., credibility,channels, offering, customer &industry relationships, etc.)

1.2.3.

1.2.3.

1.2.3.

1.2.3.

1.2.3.

1.2.3.

1.2.3.

1.2.3.

1.2.3.

1.2.3.

1.2.3.

1.2.3.

1.2.3.

1.2.3.

What other competencies areof crucial importance toachieving our companyobjectives?

Figure 1.3 Analyzing Current Capabilities

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An understanding of the gap between what a company might be able to accomplishinternally and what it needs helps to develop the profile of the best partner (if any). Withthis undertaking, managers begin to establish their criteria for rating partnership opportu-nities if this is an option they choose.

ALLIANCE OR ACQUISITION?

Managers also need to assess their company’s readiness to embark on an alliance. Theprocess should involve an evaluation of various alternatives and the pros and cons of each.In many cases, a strategic alliance may not be the most appropriate vehicle for meeting acompany’s strategic needs. Studies show that alliances work best for companies enteringnew geographic markets or related industries. Acquisitions, which should be viewed as analternative to alliances, are more likely to be effective in core business areas or existing,highly competitive markets.10 Make note, however, that a study by McKinsey & Companyfound that using an alliance to hide a weakness—as opposed to leveraging strength—wasrarely a successful strategy.11

IDENTIFY THE REAL COSTS

Before deciding that an alliance is the way to go, the potential costs involved need to beconsidered—for example, technology transfer, coordination, and management costs, whichcan be particularly high in international alliances. Potential costs can also include reducedcontrol, reduced flexibility in optimizing global production and marketing efforts, lostopportunity costs, or even creating or strengthening a competitor. Moreover, if differingoperational and financial structures exist, an alliance may strain a company’s ability to dealwith more pressing internal, competitive, or operational issues that need attention. Managersneed to ask themselves what they are not going to be able to do if they pursue an alliance.

IS THE ORGANIZATION ALLIANCE FRIENDLY?

One of the greatest determinants of alliance success is the experience one or bothcompanies have in managing them. Experienced organizations know what it will take andwill likely have gotten their own house in order to support additional alliances. If thisis its first alliance, a company should look carefully at its internal policies and practicesand evaluate to what degree they will help or hinder an alliance. For instance, an organi-zation with shaky internal communications practices or with incentive programs focusedon individual performance can place significant strain on an alliance relationship. It is bestto modify internal practices as necessary before introducing a third party.

Even if the review shows a firm that it is not capable of managing an alliance right now,it should clarify what capabilities it needs to develop, what capabilities the firm brings tothe table, and the timeframe that it needs to achieve a specific partnering goal.

In the end, alliances are only one strategic approach. They make most sense whenother internal options are not viable or when it would be foolish to go it alone. In today’senvironment, however, it is frequently the case that going it alone is less and less a viableoption.


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2. Organizational Readiness

� Do we have experience in collaboration? Has it been positive?

� Are our organizational practices conducive to collaboration? (e.g. Do our incentive and appraisal systems encourage collaborative behavior?)

� Does our company have healthy communications (horizontal and vertical)?

� Do we promote organizational learning? Are we good at assimilating new ideas from external sources?

� Do our policies encourage continuity?

� Do we have strong project management skills?

� Do we promote team-based work?

� Do we have someone with the necessary technical and relational skills to manage an alliance?

Is our organizationculturally andstructurally

ready?

3. Timing

4. Commitment

� Is it too late?

� Can we do it later?

� What is the opportunity cost of doing it now?

� Will managing an alliance jeopardize our core operations?

� Do we have the funds to pursue and engage in an alliance over the long term?

� Do stakeholders support it?

Step through these questionsto assess the strategic meritof forming an alliance.

1. Strategic Importance

� What is our strategy?

� What are our capability gaps that will prevent us from achieving our objectives?

� Is an alliance the best alternative? Why?

� What do we expect an alliance to achieve?

� Exactly how does that support our strategy?

Have we clearlyidentified the strategicimportance an alliance

will play?

Strategic Rationale

Is the timing right?

Proceed toPartner Selection

Are we preparedto commit the

necessaryresources?

Strategic Rationale Partner Selection ImplementationNegotiation

Figure 1.4 Strategic Rationale Flowchart

CASES

Cambridge Laboratories: Proteomics

Cambridge Laboratories is essentially a fee-for-service provider of laboratory tests.It spends less than 0.5% of revenues on research and development and holds relativelyfew patents for a biotech company. It now has an opportunity to invest $5 million toestablish a joint venture with an Australian proteomics company that operates on a drug

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discovery (royalty) model. The founder of this company believed that his technology couldeventually result in the discovery of new drugs that would generate significant royalties.While the proteomics firm has superb technology, some of the intellectual leaders in thefield on its staff, and partnerships with some impressive companies, its technology is yetunproven. Cambridge Labs is also concerned that its existing relationships with big pharmaceutical companies could be jeopardized if it begins to take an intellectual propertyposition in proteomics. In addition, the Australian company consists primarily of Ph.D.sin molecular biology, while Cambridge Labs is dominated by business executives whoseprimary focus is generating strong financial returns for shareholders. The cultural differ-ences between an Australian science-oriented laboratory and a publicly traded Americanoutsourcing company become apparent during the negotiation phase of the joint ventureproposal. Students are asked to evaluate the joint venture and consider whether the culturaland strategic differences can be reconciled.

Assignment Questions

1. Should Cambridge Laboratories (Cambridge Labs) invest in Canterbury Proteomics Ltd.(CPL)? Why or why not?

2. As Paul Henderson, what questions do you want more answers to before investing in CPL?

3. Compare the respective business models of the two companies.

4. Compare the cultures (organizational and national) of the two companies.

Fishery Products International Ltd.—A New Challenge

Fishery Products International (FPI) is one of the largest seafood companies in NorthAmerica. FPI has experienced its best performance in a decade and has recently surviveda hostile takeover bid by three competitors who acted in concert. The chief executive offi-cer (CEO) has just returned from New Zealand, where he was visiting a major competitorto see if there was the possibility of a strategic alliance. The CEO knew he had to do some-thing to prevent another hostile takeover and to continue to grow shareholder value whilestill maintaining the social conscience of FPI. Some of the issues facing FPI were perfor-mance, strategic leadership and corporate governance, and implementing an integratedproduct differentiation/cost leadership strategy.


1. Complete an analysis using the value chain and Value, Rareness, Imitation, Organization(VRIO) framework (see table on page 11 in Barney, 2002) and discuss FPI’s sources of sus-tainable competitive advantage (SCA). Refer to Barney’s VRIO framework.12

2. Sources of SCA include legitimacy and reputation, strategic leadership, quality image/reputation, and brand loyalty (see table on page 11 in Barney, 2002). How would you describeFPI’s performance? Why hasn’t FPI been able to create shareholder value?

3. FPI’s performance is comparable with its competitors’ performances—below the industry’sin some respects and below other industries. The most significant challenges in creatingshareholder value include industry difficulties in the early 1990s (stock depletion, quotarestrictions) and the nature of the industry (overcapacity, volatility of natural resource supply,uncertain pricing). As Vic Young, what business and/or corporate strategies might youconsider? Which would you select and why?


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NonStop Yacht, S.L.

NonStop Yacht, S.L. is a Web site that provides e-commerce service to the mega-yachtindustry. Originally, the founder had planned to run NonStop Yacht (NSY) as an Internetbusiness. However, success with this business model is proving elusive, and investors aregrowing restless as performance continues to fall short of the business plan. Substantialpressure to improve the company’s performance had the founder considering a variety ofalternative business models that would enable him to more effectively capture value fromthe concept of nonstop parts procurement for high-end yachts. These options involve keydecisions about the strategic positioning of the company and the relative advantages anddisadvantages of pursuing strategic alliances with players at different points in the indus-try value chain.


1. What is NSY’s strategy?

2. Why didn’t the NSY Web site receive a positive market response?

3. What are the key success factors in the parts procurement segment of the mega-yacht industry?

4. Does NSY have the basis for competitive advantage?

5. Which business model makes the most sense for NSY?

6. To what extent does your answer differ if you are evaluating these options from the perspec-tive of Metcalf? His investors?

Strategic Direction at Quack.com (A)

Quack.com was in dire straits. An early entrant in the voice portal market, Quack wasquickly running out of money. The company’s management team had just returned from aroad show for a second round of venture financing, but they had been unsuccessful. Toexacerbate this issue, Quack’s two major competitors had each received substantial fund-ing. At the current burn rate, Quack could survive on its bridge financing for only 3 moremonths. Moreover, after the first few months of running the voice portal, Quack’sbusiness-to-consumer (B2C) model for voice portals was already showing signs of weak-ness. Quack’s management believed the failure of its road show could be related to its B2Cfocus. The company was facing many major decisions that would reshape and dictate thefuture of the firm.


1. Where do you see the market unfolding, and where do you see each of the major players onthe industry value chain?

2. How should Quack deal with its financing issues?

3. What strategic direction should Quack take? Specifically, on which products and marketshould it focus?

4. What do you foresee as the best and worst scenarios for Quack?

5. What is your contingency plan?


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Pharma Technologies Inc.

A new biotechnology firm, Pharma Technologies, has developed a competingmethod for the treatment of erectile dysfunction that promises significant advantagesover Pfizer’s blockbuster drug, Viagra. With deep-pocketed pharmaceutical compa-nies also pursuing product development efforts, the president of Pharma Technologiesis charged with deciding how to leverage his company’s superior proprietary tech-nology into a viable product before the window of opportunity closes. Students canexplore the trade-offs in pursuing internal versus external development of new tech-nology, the strategic implications of in-licensing and out-licensing, and the criteriaused in identifying potential alliance partners to expedite the commercialization ofnew technology.


Assume the position of Blair Glickman, president of Pharma Technologies, Inc.(PTI). Develop a plan for commercializing Factor X as a treatment for male erectiledysfunction. Your plan should include the following:

• A clear explanation of PTI’s strategy for taking the technology to market, in termsof the role that in-licensing, out-licensing, and/or partnering should play in movingforward, including whether you would make any trade-offs in the other areas oftechnology development the company is pursuing

• A detailed set of action priorities that will support your strategy, including timeframesfor their execution

• An estimate of the resource implications of your intended strategy

ALPES S.A.: A Joint Venture Proposal (A)

The senior vice-president for Corporate Development for Charles RiverLaboratories (CRL) must prepare a presentation to the company’s board of directorsrequesting up to $2 million investment in a Mexican joint venture with a family-ownedanimal health company. However, the chief executive officer views the proposed jointventure as a potential distraction while his company continues to expand rapidly in theUnited States. He is also worried about the risks of investing in a country such asMexico and about the plan to partner with a small, family-owned company. Moreover,the Mexican partner is unable to invest any cash in the joint venture, which would needto be fully funded by Charles River Laboratories.


1. As a member of the CRL’s Board of Directors, should CRL go ahead with thisproposed joint venture? Why or why not? Be prepared to argue your position.

2. As Alejandro Romero, why do you want this joint venture? Are there realistic marketopportunities? What issues or problems do you foresee?

3. If the board approves the joint venture, what advice would you give Dennis Shaughnessyas to how to proceed?


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NOTES

1. Jim Bamford and David Ernst, “Measuring Alliance Performance,” The McKinseyQuarterly, Web Exclusive, October 2002.

2. Jordan Lewis, Partnerships for Profit: Structuring Alliances (New York: Free Press, 1990).3. Marloes Borker, Ard-Pieter de Man, and Paul Weeda, “Embedding Alliance Competence:

Alliance Offices,” 2004, http://www.cgcpmaps.com/papers/embeddingalliance.pdf.4. Andrew Delios and Paul W. Beamish, “Joint Venture Performance Revisited: Japanese

Foreign Subsidiaries Worldwide,” Management International Review 44, no. 1 (2004): 69–91.5. “PricewaterhouseCoopers Research Findings: CFOs Embrace Strategic Alliances as Major

Growth Tool and Alternative to Higher-Risk M&A,” Business Wire, May 7, 2004, http://www.businesswire.com/photowire/pw.050704/241285485.shtml.

6. Gabor Garai, “Strategic Alliances: The Path to Success or Disaster,” Corporate BoardMember Magazine, April 2001.

7. Kerry McLellan, Barbara L. Marcolin, and Paul W. Beamish, “Financial and StrategicMotivations Behind IS Outsourcing,” Journal of Information Technology 10, no. 4 (1995): 299–321.

8. David Ernst and Tammy Halevy, “When to Think Alliance,” The McKinsey Quarterly 1(2000): 47–55.

9. Nicole Gallant, Marilyn Carr, and Stephen Graham, Measuring the Financial Impact ofStrategic Alliances: An Evaluation Framework, Document 28635 (Framington, MA: InternationalData Corporation, 2002).

10. Jeffrey H. Dyer, Prashant Kale, and Harbir Singh, “When to Ally & When to Acquire,”Harvard Business Review 82, no. 9 (2004): 109–17.

11. J. Bleeke and David Ernst, “The Way to Win in Cross Border Alliances,” in Collaboratingto Compete (New York: John Wiley, 1993), 21–2.

12. Jay Barney, Gaining and Sustaining Competitive Advantage, 2nd ed. (Upper Saddle River,NJ: Prentice Hall, 2002).


Paul Henderson scanned the headlines ofThe Boston Globe before beginning his Mondaymorning commute to Cambridge, Massachusetts,where he served as senior vice-president forcorporate development and general counsel forCambridge Laboratories (Cambridge Labs).What caught his eye this morning was a headlinetitled, “Midsize Biotech Firms Take Hit, ManyStruggling to Raise Cash.”1

As Henderson scrutinized the newspaperarticle, he could not help but notice the con-tradictions. On the one hand, the paper rightlypointed out that biotech firms “are strugglingto raise cash, and many are trading at a smallfraction of what they were worth just two yearsago during the biggest boom in the industry’shistory.” Yet, “there’s been a resurgence ofinterest . . . in early-stage companies,” an industry

CAMBRIDGE LABORATORIES: PROTEOMICS

Prepared by David Wesley under the supervision ofProfessors Henry W. Lane and Dennis Shaughnessy

Copyright © 2004, Northeastern University, College of Business Administration Version: (A) 2004-03-23

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analyst was quoted as saying. The journalistadded, “Investors are placing a premium on com-panies that are focused on producing drugs.”

The Globe article reiterated much of whatHenderson already knew: namely, that manygenomics and proteomics firms had benefitedfrom a short-lived “irrational exuberance”2 thatcreated spectacular valuations and allowedsome laboratories to raise significant capitalthrough public offerings. Investors eventuallyrealized that drug discovery was a long processand that many years would pass before most ofthese companies would ever recognize revenues.As suddenly as they had risen to prominence,many labs had become pariahs of Wall Street.Meanwhile, researchers remained optimisticabout the potential to revolutionize health careby treating disease at the molecular level.

As head of his company’s mergers andacquisitions, Henderson reviewed many poten-tial biotech partnerships and acquisitions.Recently, he had received a joint venture pro-posal from Canterbury Proteomics Ltd. (CPL), asmall Australian proteomics firm that wanted toenhance its drug discovery research by establish-ing a presence in the United States. CanterburyProteomics had patented technology that thecompany’s founders believed would eventuallylead to the discovery of blockbuster drugs. Inexchange for start-up capital amounting to US$5million,3 CPL promised millions of dollars indownstream drug royalties for Cambridge Labs.

Although CPL’s managers seemed confident intheir ability to deliver a competitive product,Henderson wondered if a drug development “pre-mium” was really warranted. Was proteomicsanother scientific fad that consisted of more hypethan substance, or would it usher in a new andunprecedented age of discovery leading to thedevelopment of new drugs to treat everythingfrom infectious disease to cancer? The CambridgeLabs management team constantly receivedinvestment proposals from high-potential firms,but only invested in five per cent to 10 per cent ofthe proposals reviewed. Henderson wondered ifCanterbury Proteomics should be one of them,and if so, under what terms.

CAMBRIDGE LABORATORIES

Founded in 1947, Cambridge Laboratoriesprovided laboratory services for use in drugdiscovery research and the development andtesting of new pharmaceuticals. At the height ofthe technology stock market bubble, CambridgeLabs launched an initial public offering (IPO)that raised $257 million, facilitating furtherexpansion (Financial summaries are provided inExhibits 1–3). When the economy began to falterin 2001, Cambridge Labs remained one of thefew companies that continued to grow.4

Cambridge Labs served hundreds of laborato-ries in more than 50 countries worldwide. Thesewere primarily large pharmaceutical companies,including the 10 largest pharmaceutical com-panies (based on 2001 revenues). Together withbiotechnology firms, pharmaceutical companiesaccounted more than 75 per cent of the company’ssales. The remaining customers included animalhealth, medical device and diagnostic companies,as well as hospitals, academic institutions andgovernment agencies. The company did very littleof its own research and development in the creationof new laboratory services.5 Instead, most of thecompany’s technology was licensed or purchasedfrom third parties, or developed through collabo-ration with universities and biotechnology firms.

As a result of its leadership position inthe laboratory outsourcing services, Cambridgehad not lost any of its 20 largest customers inmore than 10 years, while its largest customeraccounted for less than three per cent of totalrevenues. The company maintained 78 facilitiesin 16 countries and had nearly 5,000 employees,including approximately 250 with advanceddegrees such as DVM, PhD or MD.

The Cambridge Labs publicly announced itsstrategic growth objectives to grow its existingbusinesses by between 12 per cent and 15 per centannually and its entire business by 20 per cent. Thisleft a “strategic growth gap” of five per cent to eightper cent each year. Cambridge Labs then pursuedtechnology platform acquisitions, joint ventures,technology licensing and strategic partnerships tofill the gap. Henderson commented:


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If we were satisfied with just growing our existingbusiness we would be too risk averse. Our investorshave come to expect that we will deliver on ourcommitment each quarter, which creates additionalpressure to perform particularly when the stockprice reached $40 in 2002 from an IPO price of $16.

In 2001, Cambridge Labs increased revenuesto $465 million, a 50 per cent improvementover the previous year, and enjoyed a profitmargin of about 20 per cent. Much of the com-pany’s growth was due to two large acquisitionsthat enhanced revenues by $100 million. Thecompany was also the recipient of numerousaccolades and honors from prominent businessjournals and newspapers.

Laboratory Services Division

Laboratory Services was Cambridge Labs’largest and fastest growing division (a summaryof other services offered by the company is

provided in Exhibit 4). By employing techno-logies that were licensed or purchased fromuniversities and biotechnology firms, LaboratoryServices sought to predict the potential successof new drug candidates. Laboratory servicefirms, such as Cambridge Labs, expanded inorder to meet demand from biotechnology andpharmaceuticals firms. The company’s chiefexecutive officer (CEO) commented on theimpact this was having on Cambridge Labs:

Laboratory Services is our fastest growingbusiness, which is well in excess of 40 per centannually. Much of this expansion is driven bygenomics, which is a field that is growing world-wide, and we expect to see this growth continue forthe foreseeable future. Our facilities here, as wellas in California, Japan and France have all had toexpand to meet demand.

Pharmaceutical clients were interested in out-sourcing many routine trials as long as labora-tory service firms were able to provide quality,


Period Ending 2001 2000 1999

Total Revenue $465,630,000 $306,585,000 $219,276,000 Cost of Revenue (298,379,000) (186,654,000) (134,592,000)

Gross Profit $167,251,000 $119,931,000 $84,684,000

Operating ExpensesSelling General and Administrative Expenses (68,315,000) (51,204,000) (39,765,000)Other Operating Expenses (8,653,000) (3,666,000) (1,956,000)

Operating Income 90,283,000 65,061,000 42,963,000 Total Other Income and Expenses Net 2,465,000 1,715,000 489,000 Earnings Before Interest and Taxes 92,748,000 66,776,000 43,452,000 Interest Expense (22,797,000) (40,691,000) (12,789,000)Income Before Tax 69,951,000 26,085,000 30,663,000

Income Tax Expense (27,095,000) (7,837,000) (15,561,000)Minority Interest (2,206,000) (1,396,000) (22,000)

Net Income From Continuing Operations $40,650,000 $16,852,000 $15,080,000

Nonrecurring EventsExtraordinary Items (5,243,000) (28,076,000) 2,044,000

Net Income $35,407,000 $(11,224,000) $17,124,000

Exhibit 1 Cambridge Laboratories Income Statement (for years ending December 31)

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reliable service. Cambridge Labs prided itselfon that ability as Henderson commented, “Wecan conduct these trials faster and cheaper thanpharmaceutical companies can internally, andwithout sacrificing quality.”

With demand for outsourced laboratoryservices continuing to grow, expanding existingfacilities became a priority, and Cambridge Labscould not hope to meet that demand alone. Thecompany’s CEO explained:

We absolutely need several players to service theoutsourcing trend. We have backlogs of severalmonths across the board in our toxicology busi-ness and a lot of that is contractual in nature, con-tracts lasting from 90 days to a year. In response,

we continue to add space, as do other companies.It’s clear that biotech companies want to continueoutsourcing these services. And as long as theyhave good companies to outsource to, I’m surethey will.

DRUG DISCOVERY

The Role of Chemistry

The growth of the pharmaceutical industrydepended on its ability to develop new drugs.Thus, drug companies spent from 10 per centto 20 per cent of revenues on R&D, or some$50 billion a year industry-wide. Despite



Net Income $35,407 $(11,224) $17,124

Cash Flow Operating ActivitiesDepreciation 28,578 25,370 15,643

Adjustments To Net Income $28,246 $28,928 $7,723

Changes in Operating ActivitiesChanges In Accounts Receivables (27,505) (843) 5,346Changes In Liabilities 13,227 (1,965) (3,547)Changes In Inventories (3,762) (2,343) 133Changes In Other Operating Activities (2,893) (4,155) (4,854)

Cash Flows From Operating Activities $71,298 $33,768 $37,568

Cash Flow Investing ActivitiesCapital Expenditures (36,406) (15,565) (12,951)Other Cash Flows From Investing Activities (55,515) 989 (21,217)

Cash Flows From Investing Activities $(91,921) $(14,576) $(34,168)

Cash Flow Financing ActivitiesDividends Paid (729) — —Sale Purchase Of Stock 118,954 235,964 102,993Net Borrowings (70,995) (235,182) 323,086Other Cash Flows From Financing Activities — — (437,583)

Cash Flows From Financing Activities 47,230 782 (11,504)

Effect Of Exchange Rate $(1,465) $(1,855) $(1,697)

Change In Cash And Cash Equivalents $25,142 $18,119 $(9,801)

Exhibit 2 Cambridge Laboratories Cash Flow Statement (for years ending December 31) ($000s)

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generous increases in annual R&D budgets,few new drugs reached the market, while the costof bringing a single drug to market increasedto more than $800 million in 2001 from $230million in 1987.6 Jim York, a senior scientistfrom Cambridge’s Discovery Services division,explained:

The industry is in a well-publicized R&D produc-tivity trough, and hence there is great interest insmall companies that are well along in the devel-opment of new compounds. The lack of R&D pro-ductivity has also led to the increased valuationsfor those small companies with well-developedcompounds to serve as stopgaps for large Pharma’spipeline woes.



Current AssetsCash and Cash Equivalents $58,271 $33,129 $15,010 Net Receivables 107,179 48,087 38,158 Inventory 39,056 33,890 30,534 Other Current Assets 5,648 4,631 6,371

Total Current Assets 210,154 119,737 90,073

Long-term AssetsLong-term Investments 3,002 2,442 21,722 Property Plant And Equipment 155,919 117,001 85,413 Goodwill 90,374 41,893 36,958 Other Assets 18,673 16,529 13,315 Deferred Long-term Asset Charges 93,240 113,006 115,575

Total Assets 571,362 410,608 363,056

Current LiabilitiesPayables And Accrued Expenses 75,389 58,685 58,550 Short-term And Current Long-term Debt 933 412 3,543 Other Current Liabilities 22,210 5,223 7,643

Total Current Liabilities 98,532 64,320 69,736 Long-term Debt 155,867 202,500 382,501 Other Liabilities 14,465 13,531 2,469 Deferred Long-term Liability Charges — — 4,990 Minority Interest 12,988 13,330 304

Total Liabilities 281,852 293,681 460,000

Stockholders’ EquityRedeemable Preferred Stock — — 13,198 Common Stock* 442 359 198 Retained Earnings (283,168) (318,575) (307,351)Capital Surplus 588,909 451,404 193,742Other Stockholders’ Equity (16,673) (16,261) (9,929)

Total Stockholders’ Equity 289,510 116,927 (110,142)

Net Tangible Assets $199,136 $75,034 $(147,100)

*Outstanding shares numbered approximately 46 million.

Exhibit 3 Cambridge Laboratories Balance Sheet (for years ending December 31) ($000s)

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Meanwhile the expiration of patents led topricing pressures as more generic drugs enteredthe market. Even when drug companies loweredprices, they often saw their market share declineby as much as 80 per cent during the first yearfollowing the launch of an equivalent genericbrand.

In the past, drug discovery was focused onchemistry, as researchers attempted to identifycompounds that could target specific diseases.Improved instrumentation allowed the numberof compounds being reviewed to increase sub-stantially in the 1980s and 1990s. Nevertheless,

higher throughput did not deliver many promis-ing drug prospects. Henderson recalled a recentvisit by a lead scientist from a major pharmaceu-tical company:

This person was in charge of 400 chemists allworking on identifying new drugs. In more than20 years, his team has yet to identify one candidatefor a new drug. He seemed discouraged by the factthat 20 years of work had been wasted. And hisexperience was not unusual. In the last 50 years,drug companies have only brought 500 new drugsto market, and most of those have been improve-ments on drugs that already existed.


Pharmacokinetic and Metabolic Analysis conducted pharmacokinetic studies to determine the mechanismsby which drugs function in mammalian systems to produce therapeutic effects, as well as to understand howdrugs may produce undesirable or toxic effects. Metabolic studies also revealed how drugs are broken down andexcreted, and the duration that drugs or their byproducts remain in various organs and tissues. These studieswere often performed as part of the drug screening process to help identify lead compounds, as well as later inthe development process to provide information regarding safety and efficacy.

Bioanalytical Chemistry Services supported all phases of drug development from discovery to non-clinicalstudies and clinical trials. Researchers designed and conducted projects, developed and validated methods usedto analyse samples, conducted protein studies and performed dose formulation analysis.

Pharmacologic Surgery studied drugs designed to be administered directly to a precise location within thebody using surgical techniques. The development of these and certain other drugs required the use of surgicaltechniques to administer a drug, or to observe its effects in various tissues.

Specialty Toxicology Services were undertaken by a team of scientists that included toxicologists, pathologistsand regulatory specialists who designed and performed highly specialized studies to evaluate the safety andtoxicity of new pharmaceutical compounds and materials used in medical devices.

Medical Device Testing provided a wide variety of medical device testing required by the Federal DrugAdministration (FDA) prior to the introduction of new materials. Cambridge Labs maintained state-of-the-artsurgical suites where custom surgery protocols were implemented on behalf of medical device customers.

Pathology Services identified and characterized pathologic changes within tissues and cells as part of thedetermination of the safety of new compounds.

Biotech Safety Testing determined if human protein drug candidates were free of residual biological materials.The bulk of this testing work was required by the FDA before new drugs could be approved. As more biotech-nology drug candidates entered development, Cambridge expected demand for these services to increase.

Biopharmaceutical Production Services maintained production facilities for the development and manufactureof drugs in small quantities for clinical trials.

Exhibit 4 Other Services Offered by Cambridge Laboratories

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The Shift TowardGenomics and Proteomics

In the 1990s, drug discovery began to moveaway from its roots in chemistry to rely increas-ingly on biological research. Advances in genet-ics, for example, gave researchers new hope thatthe foundation for many diseases could be foundin a person’s genes. They sought to identify mea-surable changes in biological systems, known asbiomarkers, which increased the propensity fordisease. High cholesterol, for example, would beconsidered a biomarker for heart disease. In thiscase, cholesterol reduction through medicationand diet could help patients to reduce the riskof heart attack. Genetic biomarkers worked onthe same principle. By identifying differencesbetween healthy individuals and diseased indi-viduals at the molecular level, new drugs couldbe developed to specifically target key genes andproteins. Some chemical compounds that couldbe used to treat disease probably already existedin large pharmaceutical laboratories around theworld, but had yet to be matched with appropri-ate biomarkers.7

The greatest challenge for researchers was toprocess the massive amounts of data encoded inliving cells.8 Cataloguing that data in large rela-tional databases consumed all the resources ofmany of the most advanced computers avail-able.9 One such process was the sequencing ofthe human genome, which began in earnest in1988 as a government-funded project adminis-tered by the National Institutes of Health (NIH)and the Department of Energy (DOE). By 1998,advances in computer systems10 allowed aprivately funded company, known as CeleraGenomics, to enter the fray with a promise tosequence the entire human genome by 2001.With great fanfare, both organizations publishedtheir results in February 2001.

Amazing as this feat was, it represented asmall (but important) step toward understand-ing the role of genetics in regulating biologicalprocesses. According to industry analyst, Dr. KevinDavies:

Mining the human genome is a massive compu-tational problem, but nothing compared to thedaunting problems posed by proteomics—the totalcharacterization of the identities, structures, com-plexes, networks and locations of all the proteinsin the body. Understanding the properties of asingle protein is hard enough. It takes a couple ofmonths for a Cray T311 to simulate the folding ofan average protein in [the lab]; the natural processtakes mere microseconds.12

Not only were proteins more complex thanDNA (genes had four bases while proteins weremade from 20 amino acids), the number of pro-teins in the human body was estimated at morethan one million, as many as 30 times the numberof genes. As well, although DNA remainedrelatively stable throughout the human body, eachcell expressed different proteins that interactedwith each other in different ways. Moreover, pro-tein expression changed with time, as aging, diet,stress and other external factors took their toll.

To characterize the sheer magnitude of thedifference between genomics and proteomics,when Celera and the U.S. government com-pleted the sequencing of the human genome in2001, proteomics researchers at various sitesaround the world were still struggling to identifythe proteome of a single strain of yeast (anorganism that contained only a fraction of thenumber of genes contained in the humangenome). “The mouse genome is more than 99per cent the same as the human genome,”explained Henderson. “But genomics doesn’tmatter because only four per cent of the proteinsexpressed from those genes mimic humans, andeverything about disease depends on the expres-sion of proteins.”

Leading Companies inGenomics and Proteomics Research

Beyond university and government lab-oratories, which tended not to commercializetheir discoveries, the number of entrants into thefield of proteomic research services was limited.


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A lack of technological expertise and/or capitaltended to act as barriers to entry.

Some of the more well-known companieswere Celera Genomics, Large Scale Biology,MDS Proteomics, Oxford GlycoSciences, Millen-nium Pharmaceuticals and GeneProt. The busi-ness models for each of these were based uponlucrative royalty arrangements with partialpayments upon initiation and potentially largepayments upon the successful development ofnew drugs. All were in the process of becomingdrug companies to some degree.

Millennium Pharmaceuticals had essentiallybecome a drug development company, whileLarge Scale Biology and Celera were still at anearly stage of the process. For each of these com-panies, initial commercial deals were either col-laborations or based on the payment of royalties.These collaborations were few in number andlarge in scale. For example, approximately 80per cent of Large Scale Biology’s revenue wasderived from a single collaboration with DowAgroSciences (a division of Dow Chemical).Likewise, GeneProt derived most of its revenuefrom collaboration with Novartis.

After seeing meteoric valuations in 1999 and2000, shares for the entire sector plunged in 2001as investors pulled away from small loss-makingtechnology companies. Oxford GlycoSciences(OGS) was the first company to enter the field ofproteomics on a large scale, raising $230 millionfrom stock offerings in 1999 and 2000.

With its primary focus being drug discovery,OGS had already amassed a large database ofpatented biomarkers. The company planned torelease its first drug in early 2003, a compoundused to treat a rare illness known as GaucherDisease.13 Eventually, OGS hoped that additionaldiscoveries would allow it to compete with lead-ing pharmaceutical firms.14 In the first half of2002, Oxford GlycoSciences reported a loss of$31 million on $9.3 million in revenues. Thecompany’s market value plunged from morethan $4.5 billion in March 2000 to just over$138 million in 2002, even though the companyhad more than $240 million in cash and noappreciable debt.15

Toronto-based MDS Proteomics, anotherimportant player in the proteomics field, posteda loss of $35 million on revenues of $2 millionfor 2001. The company said that its main chal-lenge was “the building of relationships withpotential pharma and biotech partners”16 in itsquest “to become a world-leading proteomicsdrug-discovery business.”17

Large Scale Biology of New Jersey wasnearly bankrupt after its contract with Dow Agro-Sciences, which accounted for more than 80 percent of the company’s revenues, ended in August2001. The company posted average annual lossesof more than $23 million from 1999 to 2001, andsaw its stock price decline by more than 97 per centbetween August 2000 and June 2002. In the future,the company hoped to be able generate revenuefrom contract research and licensing agreements.18

Other companies did not fare much better.Millennium Pharmaceuticals’ stock was downmore than 90 per cent after posting losses ofnearly $200 million in 2001. Celera Genomics,which moved away from genetic sequencingafter completing the Human Genome Project,was down more than 93 per cent on a loss ofmore than $40 million for the same period. Aspokesperson for Celera Genomics commented:

We believe that Celera remains the most promisingcompany to discover and develop pharmaceuticalsand diagnostics from an understanding of diseasethrough molecular biology.19

Investors were skeptical that a research labo-ratory could compete with large pharmaceuticalcompanies. Celera founder Craig Venter sharedthat opinion. Shortly after resigning as CEO,he reflected on his own situation. “I made a mil-lion dollars the hard way. I started with a billiondollars and worked my way down!”20

GeneProt described itself as “a global indus-trial-scale proteomics company” involved “in thediscovery and development of new therapeuticproteins, protein drug targets and protein bio-markers.” The privately held company used tech-nology licensed by OGS and housed the world’slargest commercial supercomputer at its facilities


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in Geneva, Switzerland. The company’s partnersincluded several leading biotechnology andpharmaceutical firms, including Novartis.21

Few companies developing proteomics tech-nology were interested in providing outsourcingservices to large pharmaceutical and biotech-nology companies. Instead, most believed thatthe identification of potential drug targets wasworth far more in terms of future royalties thancould be gained by selling testing services ortechnology.

Two companies that did provide researchand testing services on a fee-for-service basis orthrough contracts were Genomic Solutions andProteomic Research Services, both based inMichigan. Proteomic Research Services was arelatively new company with a small staff andlittle instrumentation. Genomic Solutions, acompany that designed and manufacturedgenomic and proteomic instrumentation, hadbeen around longer, but services were minorcomponent of the company’s overall business,accounting for approximately eight per cent ofrevenues ($1.2 million in 2001).

THE JOINT VENTURE PROPOSAL

The PMC Acquisition

In February 2001, Cambridge Labs purchasedPremier Medical Corporation (PMC) for $52 mil-lion, making it the company’s largest acquisitionto date.22 Based in Amherst, Massachusetts, PMCwas an international contract research organiza-tion that provided pre-clinical drug discovery anddevelopment services to the biopharmaceuticalindustry. Services included safety, efficacy andquality control testing for early stage pharmaceu-tical products. Reflecting on the acquisition, onePMC scientist noted:

We had been bought and sold a number of timesbefore by organizations that didn’t know what wedid. Cambridge certainly knew what we did. Theyhad a really good brand name and that made it agood fit for us because it got us through the doorwith important clients.

Cambridge has very disciplined businesspractices. That was probably the biggest organi-zational adjustment for us. They brought a higherlevel of discipline and a higher level of expectationthan the companies we were with before.

Even while the integration of PMC was still awork in progress, three senior PMC scientists,Jim York, John Post and Peter Kingston, beganevaluating proteomics companies and technolo-gies that they believed could provide importantgrowth potential for their business. They con-cluded that Canterbury Proteomics Limited ofAustralia provided the best fit with their exist-ing business and began talks with CPL manage-ment about ways that they could work together.After several discussions, CPL proposed thatCambridge Labs invest in a new U.S.-based jointventure to conduct high throughput proteomicanalysis in order to identify drug targets thatcould lead to important new discoveries.

Canterbury Proteomics Limited:Company Background

CPL was founded in 1999 by a group ofscientists from Monash University in Australia,under the direction of biologist Dr. LewisEdwards. In the 1980s, Edwards was involvedin a biotechnology company that attempted toproduce biological agents that could be usedto treat parasitic infections. When the venturefailed, Edwards joined Monash University asdirector of the Center for Biochemical Analy-sis. Established in 1992 with funding from theAustralian government, the center’s goal wasto develop improved instruments for the analy-sis of proteins. Clark Wilson, a PhD student atthe center, soon began investigating proteomicsas a counterpart to genomics. Specifically,proteomics referred to the study of “the completeset of proteins encoded in a genome.”23 Edwardscommented on the significance of that event:

When Clark Wilson presented his work at a confer-ence in Italy in the fall of 1994, our intention was todraw attention to the need to focus on proteins as


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the functional molecules of biology. We did this ata time when much of the scientific world’s attentionwas focusing on genomics. Of course, developersof drugs had always been interested in proteins asthey are the major targets for new drugs.

In 1997, the center submitted a proposal tothe Australian government for approximately$44 million to expand the center. When the pro-posal was rejected, Edwards became concernedabout his ability to retain skilled researchers atthe center. Ultimately, his solution was to sepa-rate from the university and establish CPL as aprivately-funded proteomics company. Initiallyfive other scientists from the center joinedEdwards, including Clark Wilson. The companylater grew to more than 70 scientists and staffmembers, the majority of whom were PhDs.

After receiving a government grant for newtechnology start-ups and initial venture capitalfunding, CPL successfully solicited its firstresearch contract from Dow AgroSciences.24

At the time, Dow was eager to capitalize onimproved agricultural products through geneticmodification. Monsanto and others had alreadycreated crops that resisted disease, parasitesand herbicides. However, Dow pulled out ofthe venture in 2001 on growing public oppositionto genetically modified food.25 The companythen turned its attention to proteomics, improv-ing on its existing technology to create a fullyintegrated protein analyser (see Exhibit 5).

The Proteomics Analyser was used to identifyand analyse proteins as they are expressed fromDNA. CPL partnered with several other com-panies, including IBM and Japan BiotechCorporation (JBC) to provide a complete prod-uct. IBM provided the information technologyplatform needed to store biological informationin very large databases and compute the interre-lationships between various protein components.Over a period of five years, proteomics researchwas expected to generate 1,000 times the datagenerated from genomics.26 JBC was responsiblefor constructing much of the analyser systemfrom specifications provided by CPL. Theanalyser would sell for as much as $8 million for

a complete unit. Canterbury Proteomics heldmore than 20 technology and process patents forcomponents of the system, some of which werebelieved to provide the company with distinctcompetitive advantages (see Exhibit 6).

The Proposal

The senior PMC scientists, York, Post andKingston, had been discussing the technologywith CPL. They proposed to Henderson that ifCambridge Labs were to invest $5 million for a20 per cent share of a new U.S.-based proteomicsventure, CPL would contribute the technologyand expertise needed to bring products (i.e., bio-markers) to market. In return, Cambridge Labswould provide capital, industrial knowledge andclient relationships. Henderson, who was by nomeans an expert in the field of proteomics, had torely on the expertise of his scientists. However,he wondered whether the company was ready toenter into a joint venture so soon after the PMCacquisition.

“You know that every $1 million in earningsequals one cent in earnings per share (EPS),” heexplained.

If we end up writing off the goodwill on this invest-ment, it will cost us five cents a share, and that isprobably equivalent to about $1 billion in marketcapitalization, because I’ll miss the numbers byfive cents. For a company our size in this market,investing $5 million is very risky. Having said that,I rely on you guys to tell me if this is the right tech-nology for us. Is this the best technology?

Without hesitation, York responded:

Absolutely! We have looked at other companies,such as BioRad, but frankly they are not very inno-vative. I may be wrong, but I think the folks at CPLhave the best long-term vision of where this field isheaded.

Kingston added:

I don’t know about their business or their man-agement abilities, but their technology is superb,


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Product newsreceived on 5 June 2002I from Canterbury Proteomics Ltd.

Next generation proteomics platform

Combination of separation technology, robotics, mass spectrometry and enter-prise level computing delivers “comprehensive outcomes” through its ability todecipher proteomic complexity

Canterbury Proteomics has announced the release of the Proteomics Analyser, an integrated compre-hensive solution designed to accelerate proteomics research and the discovery of new drugs to treatdiseases such as cancer, infectious diseases and others.

The analyser brings together niche sample preparation and analytical technologies with enterprise levelcomputing and extensive training and support programmes to offer an end-to-end solution for proteomicsresearch.

Clark Wilson, executive vice president of bioinformatics, said: “We have created the analyser from theground up for proteomics, combining the latest proteomics technology into one seamless platform. Thecombination of separation technology, robotics, mass spectrometry and enterprise level computing isunique to the analyser, which delivers comprehensive outcomes through its ability to decipher proteomiccomplexity.”

Alliances with key partners such as IBM, Japan Biotech, Millipore, Sigma-Aldrich, and ThermoFinniganenabled Canterbury Proteomics to accelerate the development of the Protein Analyser.

Lewis Edwards, CEO, Canterbury Proteomics said “The analyser will revolutionise and accelerate researchin the pharmaceutical and biotechnology sectors, through its broad application in the discovery of diagnosticand prognostic markers, and an ability to identify and validate drug targets.

“Our technology has been developed by practitioners of proteomics, specifically for proteome research,and has been rigorously tested in our in-house projects in cystic fibrosis, cancer, infectious diseases andaging.

“Our ability to test our approaches in demanding in-house discovery programmes sets us apart from othervendors of proteomic technology,” he said.

The Proteomics Analyser includes patented technology for protein separation, analysis and informatics,which together delivers faster, more reproducible results.

This empowers researchers to focus on their discovery outcomes while the analyser produces data andassembles it into useful biological information.

The Proteomics Analyser is integrated via a sophisticated informatics package that controls laboratoryinstrumentation and centralises all research outcomes into an IBM DB2 database software hosted on IBMeServer pSeries systems.

The software provides sophisticated analysis tools that allow information and projects to be shared betweensites.

Mike Svinte, vice president of worldwide business development for IBM Life Sciences said: “CanterburyProteomics has delivered a powerful solution for rapidly deciphering complex protein data. The ProteomicsAnalyser brings together leading edge technologies, including an information technology infrastructure basedon IBM eServer and DB2 data management systems, that will support proteomic research today and scale tomeet future requirements.”

Exhibit 5 Canterbury Proteomics Press Release


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absolutely superb. And their people are unsurpassedintellectually. In terms of integrated systems, CPL’stechnology is the best. What we don’t want is tobuy instruments from vendors that we have to piecetogether ourselves.

York rejoined:

My only concern is that CPL is a small entre-preneurial company. They are ambitious, but I amnot sure that they have the business discipline todeliver a sophisticated system on the scale that we

need. On the other hand, I am more confidentknowing that they have strong partnerships withcompanies like IBM and Japan Biotech.

Henderson agreed that Cambridge Labsshould meet with CPL to evaluate the opportu-nity for a joint venture. He first presented theplan to the board of directors, which gave itsapproval to begin negotiations. Two weeks laterEdwards and some of his colleagues met withHenderson and the PMC team.


Electrophoresis

• Electrophoresis Apparatus Method (pending)• Cassette for Electrophoresis (pending)• Increased Solubilisation of Hydrophobic Proteins (pending)• Improved Gel for Electrophoresis (pending)• Immobilized Enzyme Reactor • US patent 5,834,272 and Italian patent M195A0113• CPL has agreed to purchase the above patents from a consultant• Multi-Compartment Electrophoresis (pending)• Improved Electrolyser (pending)• Coated Hydropholic Membranes for Electrophoresis Applications (pending) • Electrophoretic Apparatus (pending)• Electrophoresis Apparatus Incorporating Multi-Channel Power Supply (pending)• Electrophoresis System (pending)• Electrophoresis Platform (pending)

Image Analysis

• Imaging Means for Excision Apparatus (pending)• Analyzing Spots in a 2-D Array (pending)• Method for Locating the Edge of an Object (pending)• Methods for Excising Spots from a Gel Under White Light (pending)• Method for Locating the Coordinates of an Object on a Flat Bed Scanner or the Like (pending)

Protein Processing

• Liquid Handling Means for Excision Apparatus (pending)• CPL and Japan Biotech are joint owners/applicants• Sample Collection and Preparation Apparatus (pending)• CPL and Japan Biotech are joint owners

Bioinformatics

• Method and System for Picking Peaks for Mass Spectra (pending)• Annotation of Genome Sequences (pending)

Exhibit 6 Patents and Patent Applications Related to the Proteomics Analyser System

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The Meeting

Edwards began with a presentation aboutCPL, its technology and the analyser platform.

He explained:

Our primary goal is to be a discovery companywhich develops new diagnostics and drug targets.We have a team of highly skilled problem-solversand we expect to be amongst the first proteomicscompanies to provide valuable and interestingoutcomes. Many of the best-selling drugs eitheract by targeting proteins or are proteins them-selves. In addition, many molecular markers ofdisease, which are also the basis of diagnostics,are proteins. The analyzer will automate much ofthe process of identifying potential targets. Thiswill have major implications for pharmaceuticalresearch and development.

Although the system was currently only ableto process a few samples per hour, Edwardsbelieved that it could be improved to a rate of1,000/hour (the minimum effective rate neededfor drug discovery) within a year. He continued:

Imagine the potential. This is an emerging tech-nology that will result in lucrative deals for earlyentrants. For example, early entrants in the field ofhigh throughput combinatorial chemistry and highthroughput screening struck attractive intellectualproperty positions and royalty arrangements. Thesame is true for genomics companies like Celeraand Millennium. If we sell a marker to a pharma-ceutical company that eventually results in a drugworth $1 billion in revenues, we stand to gain $100million in royalties. If you are willing to invest inour technology, eventually we think we can giveyou $50 million a year in royalties.

Henderson was concerned about howCambridge’s clients would react to the idea ofpaying royalties:

Drug companies are already seeing their marginseroded by generic competition for many block-buster drugs. They can ill afford to give away theirintellectual property and downstream revenue.

He was interested in the technology however.He explained:

Most of our clients have begun their ownproteomic programs and would probably be inter-ested in outsourcing much of the routine lab work.But it’s really proteomic fee-for-service analysisthat we are interested in providing to pharmaceuti-cal and biotech clients. They would be the oneslooking at new targets. I think it could help themwith their early screening, but it’s really the service,as opposed to the product, that we’re interested in.

Henderson knew that most pharmaceuticalcompanies had already announced proteomicsprograms in one form or other, and that the totalproteomics market was estimated to be more than$2 billion in 2002, growing to $6 billion in 2005.Laboratory services had the potential to eventu-ally win as much as 20 per cent of that business.

Henderson adjourned the meeting for lunch,giving both sides an opportunity to consider anddiscuss the morning’s issues amongst them-selves. Shortly afterward, he confided in his teamthat he didn’t think the two companies werecompatible:

I really have a hard time understanding Edwards.Forgive me for saying this, but he is too much of anacademic. This is a university spin-off company.That doesn’t necessarily make them great busi-nessmen. Are they going to meet deadlines? Theyhave a great concept in theory, but as they are talk-ing about all this cutting-edge technology, all I canthink about is deadlines and deliverables.

Expertise Versus Capital

After lunch, the two sides reconvened.Henderson began:

One of my big concerns is whether you will bearound to support this venture. You’re not a publiccompany, so I can’t see you’re financial records.It doesn’t seem like you have raised any capital.If I put $5 million into this venture, what happensif you go away next year?

Edwards was sure that CPL could raise thecapital they would need. “We are going to raise$15 million from one investor, and possiblyanother $5 million from another.”


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Henderson asked, “Have you raised anymoney recently?”

Edwards replied, “Well, not yet. This is a toughmarket to raise capital in. However, we have somevery strong partners in IBM and Japan Biotech.They wouldn’t have partnered with us if theydidn’t believe in our long-term potential.”

Anne Chifley, head of Discovery Programsfor CPL, interrupted the conversation to suggest-ing that CPL’s business model had the best long-term potential. She explained:

If we discover biomarkers through this joint ven-ture, that is IP (Intellectual Property). It is our biol-ogists, our scientists coupled with pharmaceuticalcompanies and other partners who are discoveringthese biomarkers. We believe that pharmaceuticalcompanies will want to partner with us becausethis is not an easy field to get into. It is a verydifficult space to work in and you really have tounderstand what you’re doing. The timing to capi-talize on proteomics is extremely ripe right now.

Henderson was unconvinced. He countered:

Pfizer has 5,000 scientists searching for targets,while the joint venture would initially only have five.Cambridge Labs has never sought to earn royaltiesin any of its businesses and I doubt that we would bewilling to diverge from our business model.

My biggest concern, however, is whether thiswill really work, because if it doesn’t I’ll miss myquarter. How is this going to impact my financialstatements, if it doesn’t work?

“So what if you miss the quarter,” Edwardsretorted. “This will work; it is just a matter oftime.”

Henderson explained:

You don’t understand, I have to show a 20 per centmargin in the first quarter. No place in the worldis like the U.S. with our focus on quarter to quarterresults. Unfortunately, in American business thefocus is on what this will do to my financial state-ments right now, not three years from now.

Edwards was adamant. “That’s so short-sighted. It’s going to work. Either you’re in oryou’re out.”

Henderson explained that much more hadto be done before a decision could be made.For one, Cambridge Labs had to be sure that thetechnology did not infringe on any existingpatents. Within 10 days, CPL had to prove that itowned the patent rights for the ProteomicsAnalyser system.

“We won’t get sued. And if we do, we’llstop,” they replied.

Being a lawyer, Henderson knew all toowell the pitfalls that CPL’s approach implied. TheUnited States was a much more litigious countrythan Australia, and any patent infringement dam-ages under American law could prove costly.

After the meeting, Henderson asked his teamfor alternatives.

Post suggested, “We could go ahead with thejoint venture, but until their technology is provento work, I don’t see any reason to pay goodwillon the IP.”

Kingston responded:

We could buy a Proteomics Analyser system forbetween $8 and $10 million and do it ourselves.However, there are several problems with thatapproach. First, we don’t know if the system willactually work. We also will probably not be able toget fee-for-service exclusivity if we go that route.And finally, we don’t have the same level of exper-tise in proteomics that they have.

York sat back in his chair with a facetious lookon his face. “Or we could buy their company!”

“I hate that idea!” exclaimed Henderson.Everyone laughed.

Although he still had doubts in the back ofhis mind, Henderson was comforted by CPL’sstrong external partnerships. Therefore, at thenext board of directors meeting he soughtapproval to enter into a joint venture with CPLunder the following conditions:

1. The joint venture would provide proteomicstesting and analysis on a fee for service basis topharmaceutical and biotechnology clients.

2. Cambridge Labs would purchase 80 per centof the shares for $4 million and CPL wouldpurchase 20 per cent for $1 million.


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3. The joint venture would be prohibited frompursuing drug discovery and development, butCPL could still pursue drug discovery outsideof the joint venture.

4. The joint venture would have exclusive world-wide rights (with the exception of Japan whereCPL already had assigned rights to its Japanesepartner) to any proteomics services using CPLtechnology.

5. CPL would have the right to sell their systemsto pharmaceutical companies that wanted todo their own, in-house proteomics services.However, these services could not be offered bythe purchaser to other customers or spun offinto a stand-alone company to provide servicesfor a fee.

The Offer

Later that month Henderson again met withthe CPL team to present his offer. Prior to themeeting, Kingston expressed concern.

I don’t know how Edwards is going to react to ourproposal, but I know that most companies wouldprobably drop it and walk away.

Nevertheless, Henderson felt strongly thatboth parties brought equally valuable resourcesto the deal. Therefore, the equity stake of eachpartner should reflect its financial contribution.

When Kingston presented the terms of the dealto CPL, they were stunned. Did Cambridge Labsnot value the technology, patents, and uniqueexpertise that it would bring to the joint venture?Not only did Canterbury Proteomics own theintellectual property and patents that were thebasis for the venture, it had the technical expertisethat would allow Cambridge Labs to access thisemerging scientific field. In addition, CPLbrought valuable partners, such as IBM and JapanBiotech. One employee of Japan Biotech had evenwon a Nobel Prize for his work on protein analy-sis. With its assembled expertise, finding valuabledrug targets would only be a matter time.

Kingston explained:

Proteomics Analyser is a new and unproventechnology. Cambridge, because of its brand, has

access to a lot of customers that, frankly, youwill have a hard time getting through the door with.These relationships, along with our reputation asa premier quality service provider, have created apowerful brand image in the industry.

Edwards was incredulous:

Our scientific staff alone, along with the ProteomicsAnalyser technology platform could potentiallyfind several important drug targets. This will beworth hundreds of millions of dollars in royalty feesto be shared between the partners. By the third yearof the venture the two companies will likely besharing millions of dollars in revenue. Royaltiesclearly offer the greatest long-term payoff.

To prove Edwards’ point, the CPL team pro-duced a spreadsheet showing annual projectedearnings from royalties.

Henderson conceded:

I don’t doubt your projections, but we don’t wantto charge our customers royalties. We want to sayto anybody that is interested in this technology,“Come and get it. Just pay us X number of dollarsper sample.” With more and more samples, we candrive the cost per sample down.

On the other hand, if you go off and do a dealwith somebody and take a royalty, typically thosepeople are going to say, “Well, you’re not going tobe able to do for somebody else what you did for us.We’re paying you five per cent of the drug revenue,so you can’t do the same for our competitors.”

Beyond that, charging royalties is inconsistentwith Cambridge’s reputation in the pre-clinicalindustry. We don’t take intellectual property posi-tions with customers.

Finally, Henderson raised the issue of pro-viding options to the PMC scientists who wouldmanage the joint venture. They also wanted theright to spin off the joint venture through an IPOthat would also grant them founders’ shares.“These people will be critical to the joint ven-ture,” Henderson explained. “If they were toleave, the joint venture would be finished.”

At first, the CPL team did not seem to under-stand what Henderson was saying. By Australianstandards, the management team would be earning


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very lucrative salaries. Now they wanted sharesin the company! For Edwards, this was the finalstraw. He suggested that if Cambridge Labs couldnot present more reasonable terms, CPL wouldhave no choice but to look for another partner.

Henderson replied:

Try raising $5 million in venture capital in the current market. I think you will find it very diffi-cult. It is a very tough environment for people towrite big checks.

NOTES

1. “Midsize Biotech Firms Take Hit, ManyStruggling to Raise Cash,” Boston Globe, June 10, 2002.

2. Alan Greenspan used the term “irrational exu-berance” to refer to stock market valuations that werenot supported by economic performance. From aspeech given at the Annual Dinner and Francis BoyerLecture of The American Enterprise Institute forPublic Policy Research, Washington, D.C., December5, 1996.

3. All monies in US$ unless otherwise specified.4. In early 2000, the failure of prominent Internet

companies, such as E-toys and Value America, causedmany investors to reevaluate the market. As bearish sen-timent began to take hold, the technology shares enteredinto an extended downward spiral. In March 2000, thetechnology laden Nasdaq exchange peaked at 5,000. Byyear’s end, approximately half of that index’s value hadbeen erased.

5. Research and development (R&D) expendi-tures were approximately $500,000 in 1999, $1 mil-lion in 2000 and $2 million in 2001.

6. “Research Cost for New Drugs Said to Soar,”The New York Times, December 1, 2001.

7. Biomarkers were commonly interpreted tobe different from drug targets. While biomarkers anddrug targets were often the same, usually biomarkerswere surrogate measures of the impact of dysfunc-tion generated by disease, condition or treatment.Treatments directed at the target can use biomarkers toassess their impact, efficacy, treatment scenarios, etc.

8. The genetic code of a human being comprisedmore than 200 times the data in a New York Cityphone book.

9. One example was the $45 million NationalScience Foundation-funded Terascale Computing

System in Pittsburg, Pennsylvania. Completed in2001, the system was roughly the size of a basketballcourt, used 14 miles of interconnect cable, seven milesof copper cable and a mile of fiber-optic cable for datahandling. It consumed 664 kilowatts of power (equiv-alent to 500 homes) and produced heat equivalent toburning 169 pounds of coal an hour. It was cooled by900 gallons of circulating water per minute and 12 30-ton air-handling units (equivalent to 375 room airconditioners).

10. For more information on supercomputersand their role in Life Sciences, see Note on Super-computing, Northeastern University Case Series No.9B03E004, Ivey Publishing, 2003.

11. The Cray T3 was ranked 15 among the 500most powerful computers in the world in 2001.

12. “Bio-IT: When Two Worlds Collide,” Bio-ITWorld, March 2002.

13. “From Proteins to Profits,” Business Week,December 26, 2002.

14. “The thing is: CAT/OGS,” Independent onSunday, January 26, 2003.

15. “From Proteins to Profits,” Business Week,December 26, 2002.

16. “MDS Reports Fourth Quarter Fiscal 2002Results,” PRNewswire, December 12, 2002.

17, “Science Firm MDS Eyes Drug Discovery,”Montreal Gazette, April 1, 2002.

18. Source: Large Scale Biology SEC filings.19. “Genome Pioneer Celera Lays Off 132,” The

Washington Times, June 12, 2002.20. “A Bubble Punctured by Realism,” The

Financial Times, November 11, 2002.21. “GeneProt Licenses OGS’ Automated

Proteomics Patents,” Oxford GlycoSciences PressRelease, February 8, 2002.

22. The PMC acquisition added $75 million torevenues, which was nearly double any previousCambridge acquisition.

23. “Prime Time for Proteomics,” Bio-IT World,March 2002.

24. Initial funding included a $2 million grantfrom the Australian government and $10.2 millionfrom private investors in exchange for 10 per cent ofCPL’s equity.

25. For a complete discussion of the issue ofgenetically modified food, see Ivey cases MonsantoEurope (A) & (B), Ivey #9B02A007 and 9B02A008,2002.

26. “Venture Capital the Cool-headed Way,” TheFinancial Times, June 21, 2001.


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FISHERY PRODUCTS INTERNATIONAL LTD.—A NEW CHALLENGE1

Prepared by Tammi L. Hynes and W. Glenn RoweCopyright © 2001, Ivey Management Services Version: (B) 2004-01-12


BACKGROUND

It was early September 2000, and Chief Execu-tive Officer (CEO) Vic Young was reflecting onthe past few months. Since 1984, Young had ledFishery Products International Ltd. (FPI) througha host of challenges, ranging from the fishery cri-sis in the early 1990s to a recent hostile takeoverbid by three united competitors. Though the bidwas rejected, Young recognized that anothertakeover attempt was very possible and wonderedif he could convince shareholders to remain confi-dent in FPI’s management team. FPI had experi-enced one of its best performances in more than adecade, with a projected annual earnings target ofnet income in excess of Cdn$0.75 per share. Thiscompared with Cdn$0.51 per share in 1999. Inlate August, Young traveled to New Zealand toexplore opportunities to give FPI a more interna-tional flavor in the fish-marketing business (seeAppendix E for more details).

HISTORY

From its beginnings in the Atlantic Canadian fish-ery, FPI had grown into an international seafoodcompany, producing and selling a complete rangeof seafood products around the world. Publiclytraded and among the largest seafood companiesin North America, FPI was headquartered inSt. John’s, Newfoundland, Canada. From itsoffices in Canada, FPI managed the operations ofits subsidiaries in the United States, the UnitedKingdom and Germany.

The fishing industry has a long history inAtlantic Canada, dating back to the 1500s. Bythe early 1980s, however, over-fishing, over-capitalization (i.e., an excess of production

plants), and a recessionary economy led to acollapse of fish stocks and a fishery crisis.Several fishing companies had gone under orwere near bankruptcy, and the federal andprovincial governments stepped in to restructurethe industry. In the mid-1980s, Fishery ProductsLtd., the Lake Group Ltd., John Penney and SonsLtd. and other seafood company assets wereamalgamated into Fishery Products InternationalLtd. Through a cash infusion and conversion ofdebt to equity, the federal government gained 63per cent of the new company; the Newfoundlandgovernment, 26 per cent; and a bank, 11 per cent.

For three years, Fishery Products InternationalLtd. operated as a crown corporation, untilbeing privatized in 1987, after a profitable 1986.The firm was restructured and in an attemptto preserve local interests and prevent privatecontrol of a government-funded company, theprovincial government passed the FisheryProducts International Limited Act, limitingFPI’s share ownership to 15 per cent of thevoting, common shares, a restriction mirrored inthe company’s bylaws. According to the Act,a single shareholder could not own more than 15per cent of the shares of the parent company FPILtd. and could not combine resources to acquirecontrol of FPI.

In the late 1980s and early 1990s, FPI facedongoing struggles. The whole industry was weak-ened by declining cod stocks, worker demandsfor wage increases and a high Canadian dollarthat hampered exports. FPI was already operatingbelow capacity when the federal governmentseverely reduced cod total quotas to 132,000tonnes on July 2, 1992. On September 6, 1993,the federal government and the North AtlanticFisheries Organization2 (NAFO) imposed amoratorium on flatfish species (e.g., American

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plaice, yellowtail, flounder) on the Grand Banksand further quota reductions in other groundfishstocks, including cod, a traditional key species.

Over time, FPI responded to these resourceissues by sourcing fish internationally (includingfish from Alaska and South America), by add-ing more value to its cod-based products and bymoving away from cod and into other types ofseafood, such as shrimp. The 1989 purchaseof Clouston Foods Canada Ltd., a Montrealseafood brokerage, was an example of this shiftin strategy, as was the company’s 1992 purchaseof Halifax-based National Sea Products’ U.S.food service operation to use as a shrimp plant.

INDUSTRY OVERVIEW

As a global commodity, seafood was sourced,processed, sold and consumed worldwide. Themarket was competitive, with buyers at all levelsdemanding high quality and service along withcompetitive prices. Processors purchased rawmaterial (fish) from seafood harvesters anddeveloped the primary product into basic orvalue-added packaged seafood products. Theseprocessors typically distributed and marketed theproducts to wholesale and/or retail buyers inestablished markets around the world. Typically,firms were vertically integrated, procuring somesupply from company-owned vessels, processingin company-owned plants and distributing andmarketing through in-house representatives posi-tioned in strategic markets. Generally, margins

remained higher with the fish harvesters on oneend and retail chains and restaurants at the otherend; processors, whose margins were typicallyless, were required to be highly efficient.

In 1998, Japan and the United States werethe top seafood importers. Most of Canada’s fishproducts were exported to the United States,where consumers spent approximately Cdn$50billion per year on fish and shellfish products,followed by Japan, then the United Kingdom.Export information is detailed in Exhibit 1.

Seafood companies encountered competitionboth in procuring raw materials and in market-ing end-products. In Canada there were nearly150 companies that varied widely in size,sales volume and product delivery. None ofNewfoundland’s 16 seafood companies had adisproportionate share of the market for rawmaterial and all competed with local and foreignprocessors.

Competition among different Newfoundlandproducers is particularly painful in this market.Because the market is somewhat fixed in size,when there is severe competition over price, allsellers have to lower their price, but they get virtu-ally no return in terms of increased volume sales.Instead, each seller is simply undercutting othersellers, all fighting for the same customers.

Presentation to Howard Noseworthy,Selector/Arbitrator for the 2000 Shrimp Fishery

Capital costs for startup were high, and aprocessing licence had to be obtained from the


Origin / Destination January 1998 January 1999 January 2000

Canada to United States 649 807 1,106

Canada to All Countries 1,480 1,603 2,052

Canada to All Countries—shrimp, 909 964 1,215 scallops, crab, filleted groundfish only

Exhibit 1 The Value of Canadian Fish Exports (in Cdn$ Millions)

Source: “Trade Data Online,” Industry Canada, 2000, retrieved at www.strategis.ic.gc.ca, June 26, 2000.

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provincial government. The provincial governmentwas inclusive in trying to give these licences to asmany communities as possible. New processorsmight have had difficulty obtaining raw material,as harvesters had established relationships with orfinancial ties to existing processors.

PROCUREMENT AND PRICING ISSUES

A critical issue in the seafood industry wasresource sustainability. Significant over-fishingin many parts of the world had caused seriousdepletions of certain species stocks, threateningthe viability of both harvesters and fish proces-sors who relied on those stocks. In countries suchas New Zealand, industry and government hadcollaborated to jointly manage fish resources andensure a sustainable resource base. In Canada,the Department of Fisheries and Oceans (DFO)established fish quotas through the “total allow-able catch” (TAC) while provincial and territor-ial governments issued processing licences. Itwas evident that DFO usually worked with theprovinces and territories to sustainably managefishery resources and balance quotas with pro-cessing capacity.

In most countries, raw material was purchasedthrough free markets, auctions and direct sales.Newfoundland legislation, in an attempt to protectharvesters, required joint processor and harvesternegotiation of minimum prices paid to harvestersfor raw material. Unique to Newfoundland,this negotiation between processors, throughthe Fisheries Association of Newfoundland andLabrador (FANL), and harvesters, through theNewfoundland Fishermen, Food and AlliedWorkers’ Union (FFAW), had occasionallydelayed the fishing season and caused lostrevenue for harvesters and processors alike.Beginning in 1998, both parties agreed to a task-force-recommended final offer selection process;in the event an agreement could not be reached, anarbitrator would determine a minimum price. InJune 1999, an arbitrator was required to establishcapelin prices and to establish and renegotiateshrimp prices in August 1999 and March 2000.

Market and economic conditions ultimatelydrive the market price of raw material. Driven bysupply and demand, global market prices drivewhat processors will pay for raw material orprocessed product. For example, in the UnitedKingdom (where 46 per cent of worldwidecooked and peeled shrimp is consumed), shrimpprices declined between 1996 and 2000. In addi-tion, foreign exchange rate fluctuations, oil priceincreases and even natural disasters can affectthe cost of raw material. Protective economicbarriers, such as tariffs, add costs and reducemargins and, therefore, influence the pricesproducers will pay to harvesters. Fluctuations inthe Canadian dollar versus the U.S. dollar alsoaffect prices foreign buyers are willing to pay toCanadian processors, though in recent years, theCanadian-U.S. dollar exchange rate has strength-ened seafood exports, adding flexibility to theprices that processors are willing to pay for fish.

Seasonal variations in yields and the level ofbuying competition also affect prices. Duringsummer months, shrimp yields decline as theybecome softer and harder to peel, effectivelyraising raw-material-per-pound or finished-product costs. Icelandic and Greenland compa-nies were competing with FPI for Newfoundlandshrimp supply, and this higher competitionhelped to raise shrimp prices. To avoid losingrelationships with fishermen for species such ascrab, processors invested Cdn$110 million inNewfoundland shrimp processing facilities.

While the negotiated prices were “minimums,”a shift in market prices might cause individualprocessors and harvesters to negotiate pricingarrangements above this minimum. The effectsof competition, economic conditions and othermarket volatilities made it virtually impossible toaccurately predict annual raw material costsfrom year to year.

INDUSTRY CONSOLIDATION

Industry mergers and consolidations increased ascompanies attempted to leverage the benefits oftechnology and the Internet. The fishing industry


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was highly competitive, and industry marginswere historically tight. Consequently, firms werelooking to merge with or acquire other seafoodcompanies. In mid-1999, a New Zealand firm,SIF Ltd., participated in several mergers andacquisitions, notably a merger with a majorIcelandic seafood player, Iceland SeafoodInternational. In late 1999, NEOS Seafoods Inc.(NEOS), a newly formed consortium of threecompanies from Newfoundland, Nova Scotiaand Iceland, attempted an unsuccessful takeoverbid for FPI Limited, which would have created asignificant global industry player and U.S. sup-plier. On May 6, 2000, Icelandic Freezing PlantsCorporation (IFPC) Plc., one of the companiesthat attempted the takeover, purchased 14.6 percent of FPI’s shares, citing an interest in FPI’sU.S. market presence. The FPI Act ownershiprestrictions prohibited an individual shareownerfrom owning more than 15 per cent of FPI’s out-standing common voting shares, and sharehold-ers could not act together to acquire FPI. IFPChad also bought five per cent of each of HighLiner Foods in Nova Scotia and Pescanova S.A.in Spain. To gain a stronger foothold in Europe’sfrozen flatfish market in the United Kingdom,IFPC purchased Árnes Europe, a subsidiary ofthe Icelandic fish and processing firm Árnes.Canadian firm High Liner Foods diversified itsholdings into non-seafood products by acquiringItalian Village, a pasta products operation.

Business-to-business commerce on the Internetwas generating substantial interest as companiescould bring buyers and sellers together and auto-mate transactions. In 2000, FPI, with eight playersin the seafood market, announced the formation of“SeafoodAlliance.com.” The participating compa-nies hoped the “vertical portal” would help reducetransaction and processing costs in the seafoodindustry and enhance the development of individ-ual e-commerce strategies. In addition to SanfordLimited, Scandsea and Young’s Bluecrest SeafoodLimited, which joined in July 2000, the groupincluded Pacific Seafood Group, AmericanSeafoods Inc., SIF Group, Pacific Trawlers/Crystal Seafoods Inc., Clearwater Fine Foods Inc.,Coldwater Seafoods (a subsidiary of IFPC), the

Barry Group of Companies, High Liner Foods Inc.and FPI. These major seafood competitors oper-ated globally and were headquartered in Canada,the United States, Iceland and New Zealand.

COMPETITION

Seafood Products

In addition to raw material competition, FPIfaced direct product competition from otherseafood products and seafood brands. Significantcompetitors were established companies offeringfull product lines of groundfish and shellfishand serving many or all levels of the food serviceindustry, including food service, industrial andretail. Alternatively, some served many segmentsbut also targeted niche markets. Branding wasimportant, and seafood companies generallydistributed and marketed their own recognizedbrands. All maintained rigorous quality stan-dards, frequently citing their adherence to theHazard Analysis Critical Control Point (HACCP)systems. Originally developed by the PillsburyCompany to provide safe food for Americanastronauts, the HACCP systems integratedinspecting food production at different levels ofprocessing (rather than simply at the end product)and were designed to improve quality output.

Because many seafood competitors wereprivately held, availability of comparative finan-cial information was limited. Several of FPI’scompetitors were involved in the e-commercealliance: U.S.-based American Seafoods Group(ASG), Frionor (an ASG Company), PacificSeafood Group and the Canadian-based firmsClearwater and the Barry Group. These firmsoffered complete lines of seafood products thatincluded primary-processed and valued-addedproducts. Value-added products includedprimary-processed seafood products that hadbeen further processed through the addition ofnon-seafood products such as batter, stuffingsand sauces. Frionor (“Frozen of the North”), anestablished Norwegian-based firm owned by pri-vately held American Seafoods Group, produced


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frozen fish fillets, as well as value-added products(from pollock and other groundfish), such asTortilla Crunch, marketed under the brand name,Ocean Cuts & Crunch.

Publicly held competitors included HighLiner Foods Inc., Sanford Limited, SIF Limited,

and Icelandic Freezing Plants Corporation(IFPC) Plc (see Exhibit 2). The Sanford groupwas vertically integrated, both harvesting andprocessing a wide range of seafood productswith its primary fillet products coming fromwhitefish species, such as hoki. New Zealand’s


High Liner Sanford SIFFirm1 FPI Ltd. Foods Inc. Limited Limited IFPC Plc.

Headquartered Canada Canada New Zealand Iceland Iceland

Revenue 708,911 302,392 265,555 675,982 760,125

Net Income 10,026 (4,067) 40,740 850 (3,731)

Total Assets 314,412 219,901 297,979 436,903 381,425

Current Ratio 3.32 1.68 1.25 1.14 1.14

Cost of GoodsSold/Revenue 0.89 0.74 Not Published 0.89 0.87

ROE (After Taxes) 6.14% (0.06)% 18.4% 0.01% (6.28)%

ROE (Before Taxes) 9.00% (0.05)% 22.0% N/A2 N/A3

Earnings per Share 0.66 (0.56) 0.41 0.03 (0.12)

Ownership/ Maximum of No restrictions 2547 shareholders; 1964 shareholders; N/AShareholders 15% of (2 shareholders no maximum maximum of

shares per own in evident 10% of shares/shareholder aggregate (1 shareholder shareholder

over 50%)4 has 37%)

Subsidiaries & 4 3 18 23 6Associates

Number of 3,000 1,500 1,3005 1,700 1,300Employees

Exhibit 2 FPI Competitors

Note:All figures in Canadian dollars with Sanford, SIF and IFPC foreign exchange conversions using nominal rate as of January 1,2000. With the exception of Notes 4 and 5, all data are from corporate Web sites. Web sites are: www.fpil.com; www.highlinerfoods.com; www.sanford.co.nz; www.sif.is; www.icelandic.is.

1. All figures shown are on a consolidated basis for 1999.2. SIF experienced an operating loss; i.e., net income before financial items was Cdn$1,916, but SIF was able to show net

income due primarily to the gain on asset sales and income tax carry-forwards.3. Write-offs, e.g., sale of Russian operations.4. C. Milton, corporate secretary and treasurer, High Liner Foods Inc., e-mail communication, July 26, 2000.5. E. Barratt, director, Sanford Ltd., e-mail communication, July 25, 2000.

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largest aquaculture company, Sanford, exportedprimarily to Europe (31 per cent of sales) fol-lowed by North and South America (23 per cent).The company credited success in the U.S. marketto its consistent quality and supply.

Headquartered in Iceland and with 10 sub-sidiaries, IFPC Plc., a global, vertically integratedfirm, offered more than 40 species primarily har-vested near Iceland. Primary customers includedlarge supermarkets, distributors, wholesalers,and restaurants and food processors in Europe,United States and Asia. Committed to customer-centered product development, the companysold whole frozen fish, fillets and fillet portions,shellfish and a wide variety of convenienceproducts.

Canadian-based High Liner Foods Inc. (for-merly National Sea Products) was the largestAtlantic Canadian supplier of fresh groundfishto the U.S. market. It processed and marketedseafood and frozen pasta products under HighLiner® and other brands and was strongly posi-tioned in the retail frozen seafood market. Thecompany operated in Newfoundland, Ontarioand the United States and employed 1,500people. Like FPI, it was vertically integrated,harvesting about 11,000 tonnes of seafood eachyear from Nova Scotia to Labrador. Though thecompany’s processing facilities, featuring flowline technology, operated at about 41 per centcapacity, High Liner procured most of its rawmaterial internationally.

Non-seafood Products

Non-seafood products that were typicalalternatives to seafood also affected seafood con-sumption. In 1999, the per capita consumption ofvalue-added seafood dropped from 1998, due tocompetition from lower-priced poultry and pasta.Rising seafood costs were partially passed onto the end-consumer, making seafood productsless competitive with their substitute products,poultry and pasta. Rising costs led FPI toincrease prices in 1998 and 1999, though itmanaged to minimize the price increases andmaintain market position.

Despite price increases, worldwide per capitaconsumption of seafood products continued togrow, indicating seafood was becoming a dietarychoice. In addition to being low in fat, choles-terol and calories, seafood was high in protein,easily digested and provided an excellent sourceof polyunsaturated fats and omega-3 fatty acids(believed to actively combat cholesterol buildupand reduce the risk of heart disease). As well,with an increase of disposable incomes world-wide, consumers had greater purchasing abilityfor more expensive seafood products. In Europe,there was concern that changes to the EuropeanCommunity’s Common Agricultural Policywould reduce livestock production costs andlower the price of poultry and pork, makingseafood exports to Europe less competitive.

FPI LTD.

Products and Marketing

To compete in its key markets, FPI maintainedsales offices in Canada (St. John’s, Montreal,Toronto, Calgary and Vancouver), the UnitedStates (Danvers, Massachusetts and Seattle,Washington), Reading, England and Cuxhavin,Germany and a brokerage and distribution net-work throughout North America and Europe (seeExhibit 3). Integrated information systems con-nected employees around the world (e.g., salesstaff could log on to the company’s intranet siteto gather product nutritional and ingredientinformation).

FPI produced and marketed primary- andsecondary-processed seafood products, includ-ing cold-water shrimp, snow crab, sea scallops,cod, flounder, sole, redfish, pollock, Greenlandhalibut, haddock and capelin. It also marketedand earned commission income on black tigerand warm-water farmed shrimp, king crab,farmed scallops, North Atlantic lobster, salmonand sea bass, sourcing these products from NorthAmerica, Southeast Asia, South America andEurope. FPI was also the exclusive distributor ofcrab products from Atlantic Queen Seafood,


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01-Schaan.qxd 8/14/2006 6:03 PM

based in Atlantic Canada and Quebec. Exhibit 4details FPI’s product range.

FPI sold primarily to wholesale and food-service markets, including family restaurants,airline caterers, warehouse clubs and majorgrocery chains. It was the leading supplier ofseafood to the North American foodservice mar-ket and Canada’s private label retail sector (e.g.,President’s Choice), and was a leading supplierin marketing cold-water shrimp and snow crabin Europe, North America and Asia. With three-quarters of its value-added groundfish andshrimp products going to the North Americanfoodservice market (mainly in the UnitedStates), the remaining 25 per cent was bought bythe retail and club store industry sectors in theUnited States, Canada and Switzerland. In 2000,Switzerland was the only tariff-free Europeancountry for Canadian seafood exports.

FPI had been regularly recognized by indus-try associations and independent trade associa-tions for its sales and marketing excellence.In 1999, FPI received several supplier awardsfrom North America’s largest independent

foodservice distributor, several national restaurantchains and North America’s largest retail chain,U.S.-based supermarket grocery retailer KrogerCompany. The company’s product innovationwas maintained by full-time food scientists andfood technologists.

FPI had developed a strong reputation forquality and brand leadership through newprimary products, such as FPI ice shrimp andthe reintroduced FPI flounder. Customersrequested FPI by name, reflecting a commitmentto brand loyalty. To fully incorporate customers’needs into product design, FPI’s developmentstaff would often act as an “extension” of thecustomer menu development department, com-bining efforts to generate new process conceptsand value-added products, such as Italian StyleMussels and Thaw’n Eat Seafood Medley. Suchvalue-added products typically generated morethan 15 per cent of sales.

A challenge for all large seafood companieswas that large customers, such as McDonald’s,Price Club and Red Lobster demanded top qual-ity and excellent service and competitive pricing.


Brand

FPI (e.g., FPI Ice Shrimp, Thaw ‘nEat Seafood Medley)

Mirabel (e.g., Catch of the Dayfamily of shellfish)

Luxury, Atlantic Queen and Classic

Clear Springs Idaho Rainbow Trout

Freshwater Fish

Acadian Supreme

Hillman

Products

North American groundfish (flounder,redfish, cod) and shellfish (cold-watershrimp, crab, scallops)

Premium, specialty products; easy toserve and versatile.

3 “quality lines of shellfish” from AtlanticQueen: snow crab, rock crab, Atlanticcrab

Rainbow trout

Whitefish fillets, white fish, pickerelfillets, dressed lake trout, northern pikefillets, dressed tullibee

Atlantic lobster—boiled and tinned meat

Oysters

Producer

FPI

FPI

Atlantic Queen Seafoods

Clear Springs

Freshwater Fish MarketingCorporation

Acadian Fisherman’s Co-op

Hillman Oyster Co.

Exhibit 4 FPI’s Product Range

Source: www.fpil.com/Canada/brand.htm, May 15, 2000.

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While customers tended to be flexible regardingprice (if they were assured of a stable, qualitysupply), there was a price point beyond whichbuyers would switch either to other seafoodcompanies, to other seafood products or tosubstitute products, such as chicken and pork.

OPERATIONS

FPI harvested, procured, produced and marketedseafood through three operations: primary pro-cessing, value-added processing and seafoodtrading. Primary processing included sourcingand processing groundfish (such as cod, flounder,and turbot) and shellfish (such as cold-watershrimp, snow crab and sea scallops) into eitherready-to-market products or further value-addedproducts. All primary processing was done inAtlantic Canada through nine processing plants.One issue for FPI was how to use its extra capac-ity. For example, could the batter currently beingused on fish be effectively used on other products,such as chicken, and be produced in one of thestate-of-the-art plants that operated only part ofthe year?

Value-added or secondary processing involvedsourcing, processing and marketing groundfish,shrimp and other shellfish. In other words, FPIincreased the value of the primary-processedproducts by adding non-seafood ingredients suchas batter, stuffings and sauces. FPI’s value-addedprocessing plant in Burin, Newfoundland, servedits Canadian market while its plant in Danvers,Massachusetts, served the U.S. market. Thecompany’s seafood trading business involvedbrokering internationally sourced seafood pro-ducts: warm-water shrimp, representing about60 per cent of seafood trading sales in 1999; andking crab, lobster, scallops, salmon, sea bass,cold-water shrimp and other shellfish andgroundfish accounting for, at most, eight per centof trading sales in 1999. A challenge for FPI’soperations was to increase the current level ofintegration between the operations group, whichwas cost-driven and the marketing group, whichwas revenue-driven. Through greater integration,

plants that were treated as cost centers might beable to operate as profit-driven centers. In 2000,the plants appeared to be given little, if any, infor-mation on the revenue-generating effect of whatthey produced.

QUALITY ASSURANCE

FPI’s strong reputation for quality seafoodproducts was the result of quality assurance prac-tices and processing facilities that continuallymet or exceeded the regulatory requirements ofthe Canadian Food Inspection Agency (CFIA).In addition, FPI was periodically audited by theCFIA, the U.S. Food and Drug Administration,the U.S. Department of Commerce and, of course,its customers. FPI’s quality management programswere based on the principles of HACCP. Manyimporters, such as U.S. companies, acceptedseafood products only from foreign suppliersusing an HACCP system.

PROCUREMENT

In addition to using 12 groundfish vessels, fivesea scallop vessels and one shrimp vessel toharvest seafood species off Newfoundland andNova Scotia and purchasing raw material frommore than 3,000 independent Newfoundlandfishers, FPI procured more than 25 seafoodspecies in over 30 countries. Vertically inte-grated, FPI could reduce volatility in rawmaterial costs and secure a certain volume ofsupply; however, environmental or natural con-ditions were beyond its control. In the past, iceconditions off the coast of Newfoundland andLabrador had delayed the fishery season.Furthermore, quotas restricted FPI’s catch. As inmany industrialized countries, Canada’s fisherieswere managed under a quota system, wherequota licences provided harvesters with a “quasi-property right” to harvest certain quantities offish. Processing licences were also required foreach species. Since the government relaxed afreeze on crab processing licenses in 1996, the


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number of licences had increased from 19 to36, all owned by 16 different companies. Al-though a company purchased a licence, it couldchoose not to use it if supply was not available orif processing was not economically viable.

Primary-processed shellfish had become anincreasingly important business for FPI. Cold-water shrimp resources off Newfoundland werethe world’s largest, and the DFO controlled thetotal allowable catch (TAC) of cold-watershrimp. Since 1995, the TAC for shrimp off thenortheast coast of Newfoundland and southernLabrador had increased by 166 per cent to108,300 tonnes. This was divided betweenthe inshore (small vessel) and offshore fisheries,with the inshore harvesters’ quota havingincreased from 3,500 tonnes in 1996 to 47,400tonnes in 1999. The Newfoundland govern-ment required that all of the inshore catch beprocessed (“cooked and peeled”) in the province.

FPI obtained cold-water shrimp from twomain sources: purchases from independentinshore harvesters and frozen-at-sea landingsfrom its fishing vessel, the Newfoundland Otter.FPI was Newfoundland’s largest cold-watershrimp processing company. Its 1999 supply was16,100 tonnes, of which the NF Otter harvested4,700 tonnes; more than 80 per cent was pro-duced in “shell-on market-ready form” forEuropean and Asian customers while the remain-der was processed at two FPI plants. In 2000,FPI’s total supply of shrimp was expected tobe nearly 18,000 tonnes. By offering competitiveprices and service, FPI purchased 9,300 tonnes ofsnow crab in 1999. While the TAC for snow crabhad increased by 95 per cent since 1995, quotaswere expected to decrease in 2000, due to recom-mendations based on scientific data. FPI’s maincompetitive region for snow crab was Alaska, andmarket prices were expected to remain constant.

Meanwhile, sea scallops were sourced offNova Scotia using five offshore vessels. In 1999,FPI was awarded 17 per cent of the 5,350 TAC.Due to an increase in sea scallop resources, FPI’squota was expected to increase by 20 per cent,and market prices were expected to drop in theUnited States, Canada and Europe.

Groundfish, including cod, greysole andyellowtail flounder, came from FPI’s offshoregroundfish fleet and independent inshore fishers.The government had slowly increased cod quotassince the early 1990s, but some scientistsindicated that stocks were not rebuilding andrecommended quota reductions.

TEAMWORK AND INNOVATION

FPI employed 3,400 people worldwide, with3,000 in Atlantic Canada. The company creditedits successes to employee commitment andteamwork, particularly through challengingindustry times. The company had co-packingarrangements in shrimp processing plants inThailand, Ecuador, Indonesia and Mexico; at fishprocessing facilities in Norway and Chile; andat aquaculture farms and secondary-processingplants in China. The company had sales officesthe United States, Europe and Canada. Therewas low turnover among staff and executivemanagement, reflecting FPI’s commitment toemployees. During an attempted takeover bidin November 1999, the company regularly adver-tised in local newspapers to publicly praiseemployees’ work and dedication. In 1997, FPIappointed its first female plant manager, AngelaBugden, at its scallop harvesting operation inRiverport, Nova Scotia. Bugden was also res-ponsible for the five scallop trawlers and therefit yard for the trawlers. Since 1997, FPI hadalso invested in teamwork training for theplant management teams at its two state-of-the-art shrimp plants in partnership with the Centrefor Management Development at MemorialUniversity of Newfoundland. FPI had to contendwith the close relationships among members ofthe plant management team, plant employeesand the fishers who supplied the plants. Suchinterpersonal relationships negated the sharingof sensitive cost information with outsiders, inturn, preventing the information from being usedin subsequent negotiations between FPI and theemployees’ unions and between FPI and thefishers’ association.


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Trawler workers, plant workers and fisherswere unionized through the Fishermen, Foodand Allied Workers (FFAW) or the CanadianAuto Workers (CAW). The company enjoyeda positive relationship with its employees andthe communities in which it operated as wellas with union representatives; this relationshipwas particularly evident during the takeover bid,largely due to Young, whose negotiating abilitiesextended beyond his company’s doors. As aspecial mediator for a 1994 labor disputebetween Newfoundland teachers and the pro-vincial government, Young was credited withpreventing a bitter strike.

INNOVATION AND

ENVIRONMENTAL AWARENESS

FPI believed in “quality, honesty, teamworkand innovation” and continually invested in itsprimary- and secondary-processing operations toremain competitive, having invested more thanCdn$65 million since 1995. Spending Cdn$11million to convert a groundfish plant and Cdn$6million for new flow line processing technologyin its largest primary-processing facility, FPI hadtwo state-of-the-art shrimp plants and a world-class primary-processing facility. It had madesignificant investments in new technologies suchas automated weighing, packaging and freezingtechnologies that had improved efficiency in itstwo value-added plants. These investments wereconsidered vital to remaining competitive andmeeting customers’ changing needs.

FPI also remained committed to sustainableresource management. Its environmental moni-toring committee’s operational practices ensuredregulatory compliance and sound environmen-tal policies. As well, the company had partneredwith the Marine Institute at Memorial Universityof Newfoundland to research and develop leadingand sustainable harvesting processes, and withMemorial University to research oceanographyand fish conservation. FPI had also worked withthe DFO to gather scientific resource data formore accurate allocation of quotas. In 1999, thecompany pioneered the use of groundfish seiningtechnology, reducing unwanted by-catches andunwanted contact with the ocean floor.

PERFORMANCE

In the early 1990s, the company struggledthrough severe industry supply shortages andrecorded provisions of Cdn$65 million andCdn$20 million in 1992 and 1993 respectively.With the exception of losses in 1995 (due tolower groundfish and scallop quotas, a drop incrab prices, and poor U.S. and Mexico marketconditions), profitability had slowly improved.From 1995 to 2000, operating and net marginsremained relatively stable, and income per sharehad slowly climbed (see Exhibit 5). Despite aspecial charge of nearly Cdn$1 million related tothe takeover bid, the company recorded a 1999profit of Cdn$10 million (Appendix A), and, forthe first time in 11 years, paid shareholders adividend.


1999 1998 1997 1996 1995

Weighted net income per share 0.66 0.55 0.51 0.37 −0.20

Operating margin 11.16% 10.19% 9.66% 9.30% 8.29%

Net margin 1.41% 1.24% 1.21% .92% −.51%

Exhibit 5 Net Income Per Share, Operating Margins, and Profit Margins 1995 to 1999

Source: FPI Ltd. (1994–1999) Annual Reports.

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In the next few years, FPI had shifted its focusfrom sales to margin growth, and these highermargins led to a Cdn$9 million increase in grossprofit, and a gross margin increase of nearly oneper cent. Both Canadian and U.S. earnings havegenerally trended up. There was a significantdrop in U.S. sales in 1998 when FPI focusedon margins rather than sales volume, as warm-water-traded shrimp margins were relatively lowand extremely volatile.

Canadian domestic sales grew 19 per centfrom 1995 to 2000, reflecting increased crabquotas and production. Over the same period,U.S. domestic sales rose less than 2.5 per cent,attributed to intense competition from lower-priced poultry and pasta products. See Exhibit 6for sales information segmented by line of busi-ness and dating back to 1996, when the companybegan capturing and publicizing this data. Anincrease in both the value-added and primary-processing lines reflected stable groundfish salesand a significant growth in shellfish sales, whichhad more than doubled since 1996. Sales ofprimary seafood products such as cold-watershrimp, snow crab and sea scallops increased

more than 23 per cent to Cdn$217 million in1999. Primary groundfish sales also increasedmore than Cdn$8 million in 1999, mostlybecause more groundfish was sourced domesti-cally than internationally. Commission sales onshellfish declined by nearly eight per cent overthe four-year period.

Financial ratios were generally comparablewith industry averages or slightly below indus-try averages, with debt and liquidity levelsremaining strong (Appendix B and Exhibit 7).Like other local seafood companies, FPIfinanced independent harvesters and securedthese by mortgages over vessels. Credit riskwas minimized as FPI’s 10 major customerscontributed less than 30 per cent to sales, andno single customer contributed more than sixper cent. In 1999, the majority of FPI’s com-bined sales were denominated in U.S. dollars,exposing the company to the impact of theweaker Canadian dollar. FPI maintained naturalhedges through operating, costing and borrow-ing in U.S. dollars as well as through foreignexchange hedging practices. FPI remained firm,stating that “Fishery Products International is


1999 1998 1997 1996

Primary Processing % % % %Groundfish $69,883 9.9 61,667 9.0 58,170 8.6 64,949 9.8Shellfish 142,078 20.0 105,375 15.5 72,619 10.7 68,098 10.2Other 5,145 0.7 9,102 1.3 8,664 1.3 11,119 1.7

217,056 30.6 176,144 25.8 139,453 20.6 144,166 21.7

Value-added ProcessingGroundfish 170,822 24.1 160,019 23.5 147,088 21.8 135,862 20.4Shellfish 53,641 7.6 58,487 8.6 57,724 8.5 47,844 7.2

224,463 31.7 218,506 32.1 204,812 30.3 183,706 27.6

Seafood TradingShellfish 200,728 28.3 210,623 30.9 260,851 38.6 236,871 35.6Other 66,664 9.4 76,290 11.2 70,828 10.5 99,884 15.0

267,392 37.7 286,913 42.1 331,679 49.1 336,755 50.6

Total Sales $708,911 100.0 681,563 100.00 675,944 100.00 664,627 100.00

Exhibit 6 Segmented Sales Information (In Cdn$000s)

Source: Data from FPI Annual Financial Statements, 1996–1999.

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committed to maximizing long-term shareholdervalue.”

Over all, share prices had declined sincethe company’s initial public offering in April1987, ranging from Cdn$5 to Cdn$7 from 1995to 2000, with the exception of a price increaseduring late 1999 because of the hostile takeoverbid by NEOS. Daily trading volume was com-paratively low, ranging from approximately61 to 1,500 trades versus 20,000 to 200,000 forNortel; however, this did not appear to influenceshare price. Although EPS has increased eachyear since 1996 from Cdn$0.37 in 1996 toCdn$0.66 in 1999, the Total Return Index Valueschart (see Exhibit 8) demonstrates that FPI hasnot afforded shareholders the same return asother food processing companies or the equitiesmarket.

Stern Stewart offers an alternative methodof corporate valuation through “market valueadded” or MVA. The greater a company’s MVA,the higher its ranking versus other firms acrossindustries. Nortel Networks Corporation hasmaintained strong and consistent rankings andcreated value for its investors while FPI has not

(see Exhibit 9 and Appendix C). Additionally,both FPI’s and High Liner’s rankings havedropped since 1989. However, as can be seen inAppendix C, costs of funds for both firms havedecreased significantly since the early 1990s.

Ownership

The Takeover Bid

On November 5, 1999, FPI announced it wasthe target of an unsolicited takeover bid. NEOSoffered Cdn$9 per share to acquire 100 per cent ofFPI’s 16 million outstanding shares. This bid wassubject to the provincial government and FPI’sshareholders approving removal of the 15 per centownership restriction. CEO Vic Young promptlyresponded that the offer was below book value ofCdn$10.75 and “extremely low.” He pointed outthat the FPI Act required any successful bid onFPI to have approval from FPI’s shareholders andthe provincial government to lift this restriction.The 15 per cent shareholder restriction wasknown as a “poison pill” and made a significantequity purchase of FPI impossible.


FPI Fish and Prepared Fish or Frozen Fish Ratio (%) Seafoods Industry (%) and Seafoods Industry (%)

Gross Margin 10.69% 17.30% 11.00%

Profit Before Taxes2 1.99% 2.60% 1.80%

Current Ratio 2.32% 1.30% —

ROA Before Taxes 4.49% 5.30% 4.10%

ROE Before Taxes 8.65% — 21.70%

Exhibit 7 Comparative FPI and Industry Financial Ratios1

Source: Statistics taken from “Manufacturing—Prepared Fresh or Frozen Fish and Seafoods; Wholesale—Fish and Seafoods,”Robert Morris and Associates (RMA) Guide, 1999.

1. Canada, the United States and Mexico have adopted the North American Industry Classification System (NAICS) for indus-try product classifications; however, historical financial data is available only under SIC/ISC codes. SIC codes 5146 (Fishand Seafoods) and 2092 (Prepared Fresh or Frozen Fish & Seafoods) compare with FPI’s NAICS code, 31170.

2. Data are for companies with US$25 million and over in revenue.

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CD

N$

16.00

20.0018.00

14.0012.0010.008.006.004.002.000.00

87 88 89 90 91 92 93 95 96 97 98 99 094

Quarterly Share Price (March, June, Sept., Dec.)

Total Return Index Values 1994 to 1999

0

50

100

150

200

250

94 95 96 97 98 99

FPI TSE Food Processing TSE 300 Composite Index

Source: Data taken from the TSE Review, Toronto Stock Exchange, 1987 to 2000, July 20, 2000.

Exhibit 8 Quarterly Share Price 1987 to 2000

Source: BMO Investorline 2000b, bmoinvestorline.com/QuotesCharts, July 5, 2000.

Having set the 15 per cent ownership capduring FPI’s conversion from a crown to apublic corporation in 1987, the governmentstated it would not lift this restriction unless thetakeover group could show how it could add

value to Newfoundland’s economy versus FPI’sshareholders, in particular. The governmentindicated it would consider lifting the restric-tion, given a “deal specific” acquisition ormerger opportunity that was, in FPI’s point of

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view, in the best interest of both its shareholdersand the province.

During November and December 1999, FPIand NEOS appealed to shareholders, the publicand other stakeholders. To alleviate employeeconcern, FPI ran ads in Newfoundland news-papers praising employees’ commitment. NEOSran its own ads highlighting its intention forthe new private company. The two unions andseveral municipalities opposed the takeover andurged the government to maintain the ownershipcap. Both the FFAW and CAW cited a positivelabor relations climate at FPI as a primary reasonfor objecting to NEOS’s bid, expressed concernabout a concentration of fish-buying power andquestioned NEOS’s promises. FPI also beganexploring other options, including an alternativebid from a “friendly partner.” A few weeks afterthe initial bid, the government announced itwould not remove the ownership restriction, andNEOS withdrew its offer.

FPI later stated that the two argumentsagainst removing the restriction—concentrationof fish-buying power and negative communityresponse—were no longer relevant. It supportedlifting the restriction in order to develop inter-national alliances and partnerships, which other-wise could not be accomplished. FPI also feltthere were enough dual-level government restric-tions, making ownership restrictions unneces-sary. If FPI could not grow through international

partnerships, it might become unable to competewith larger firms.

Institutional Ownership

Canadian fishing companies were subject toforeign ownership restrictions and requiredmajority-ownership by Canadian interests; U.S.companies faced similar foreign ownershiprestrictions. Unlike FPI, some competitor seafoodcompanies were majority-owned by one or twoinvestors. As well, institutional investors were theprimary investors in many seafood companies.For example, ASG was controlled by an invest-ment firm, one shareholder owned 37 per cent ofSanford Ltd. and two corporate investors ownedthe majority of High Liner’s shares.

Occasionally, institutional owners had exer-ted pressure on a company’s board when theydisagreed with board decisions (e.g., in 1999,investors questioned an executive compensationscheme at Canadian pulp and paper firm, RepapInc.) As of December 31, 1999, two-thirds ofFPI’s shares, including mutual funds and pensionfunds, were controlled by institutional investorswho had the potential to exert pressure on theboard. During the takeover attempt, institutionalinvestors holding more than 50 per cent of FPI’sshares requested FPI hold a timely meeting toevaluate NEOS’s proposal. Many also lobbiedthe government to remove ownership restrictions.


Operating– Return on MVA EVA Capital Operating Cost of

MVA Ranking 1998 1997 1989 1998 1998 year end Capital Capital

Nortel Networks 1 1 6 23,369,461 156,402 30,306,396 12.3 11.7

FPI Ltd. 251 270 189 −133,365 −8,967 361,549 4.3 6.9

High Liner Foods 202 253 85 −26,933 255 281,468 7.0 6.8

Exhibit 9 Comparative MVA Data for Nortel, FPI and High Liner Foods

Source: Richard Grizzetti, e-mail communication and www.sternstewart.com, July 2, July 28, 2000.

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An interesting issue for Young and his seniormanagement team was that this share ownershiphad dramatically changed by July 2000. Sanfordstill owned 14.7 per cent, Hamblin Watsa owned14.6 per cent and the Ontario MunicipalEmployees Retirement Fund still owned 11 percent. Two new major shareholders were IFPC(an Icelandic seafood company) and Clearwater(a Canadian seafood company), both partnerswith the Barry Group in the unsuccessfultakeover bid in November 1999.

LEADERSHIP AND GOVERNANCE

In 1984, Young became chairman and CEO ofFishery Products International. He was notexpected to retire any time soon; however, itwas not immediately evident who might replaceYoung or whether that person would possessYoung’s ability to build a strong culture and teamcommitment.

As chairman, CEO and president, Young wasthe only management member on FPI’s boardof directors. The chairperson of the humanresources committee functioned as the leaddirector, overseeing the relationship between theboard and senior management. At each meeting,the board held discussions without the CEO inattendance. It was not unusual for senior man-agement to attend board meetings to presentbusiness information.

Board membership was fairly stable with agood mix of long-term members and newermembers. Of the 11 unrelated members of theboard, seven were from Newfoundland, three

were from Ontario and one was from NewBrunswick. Two new directors were elected tothe board in 1999. Appendix D presents adetailed summary of the current board.

The Future

Young believed FPI needed to focus on grow-ing shareholder value. To do this, he believedin motivating employees to embrace the conceptof growing shareholder value and “energizing”them to “make it happen.”

FPI was focused on growing its EPS andrestoring shareholder value by using key tradi-tional groundfish, value-added and seafood trad-ing operations, along with increasing shellfishoperations. Young also hoped to grow throughinternational alliances, mergers and acquisitions.The question now facing Young: how exactlyshould FPI increase shareholder value?

NOTES

1. This case has been written on the basis ofpublished sources only. Consequently, the interpreta-tion and perspectives presented in this case are notnecessarily those of Fishery Products internationalLtd. or any of its employees.

2. Founded in 1979, NAFO comprises 18 coun-tries including Canada, United States, the EuropeanUnion, Cuba, Korea, Denmark, France (St. Pierre andMiquelon), the Russian Federation, Iceland andNorway. Its goal is to guide management and to con-serve fishery resources in the northwest Atlanticwithin the 200-mile limit (NAFO Convention). A mapof this area is available at www.nafo.ca/imap/map.


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1999 1998 1997 1996 1995

Sales $ 708,911 681,563 675,945 664,598 643,009

COGS 633,124 614,467 613,617 606,473 593,096

Gross Profit 75,787 67,096 62,328 58,125 49,913

Commission Income 3,327 2,382 2,968 3,665 3,394

Operating Income 79,114 69,478 65,296 61,790 53,307

Administration and Marketing 45,456 42,152 39,963 39,865 39,711

Depreciation and Amortization 9,883 8,967 8,656 7,872 8,484

Profit sharing 1,541 1,088 1,063 840

Interest 7,146 7,467 5,890 5,669 8,242

64,026 59,674 55,572 54,246 56,437

Operating Income before undernoted 15,088 9,804 9,724 7,544 (3,130)

Exchange Gain

Gain (loss) on disposal of PP&E 21 438

Equity in loss of joint venture

Unusual item(s) (965)

Net income before taxes $14,123 9,804 9,724 7,565 (2,692)

Income taxes $4,097 1,378 1,531 1,455 587

Net Income $10,026 8,426 8,193 6,110 (3,279)

Weighted net income per share 0.66 0.55 0.51 0.37 (0.20)

Gross Margin 10.69% 9.84% 9.22% 8.75% 7.76%

Operating margin 11.16% 10.19% 9.66% 9.30% 8.29%

Net margin 1.41% 1.24% 1.21% 0.92% −0.51%

APPENDIX A: FISHERY PRODUCTS INTERNATIONAL LTD.,CONSOLIDATED FINANCIAL DATA (FOR YEARS ENDING DECEMBER 31) (IN CDN$000S)


Source: 1995 to 1999 Annual Reports.

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APPENDIX B: FISHERY PRODUCTS INTERNATIONAL LTD.,CONSOLIDATED BALANCE SHEET AT DECEMBER 31, 1999 (IN CDN$000S)


Assets

Current Assets

Cash $916

Accounts Receivable 80,664

Inventories 119,471

Prepaids 5,637

Total Current Assets 206,688

Property Plant and Equipment 93,677

Other Assets 14,057

Total Assets 314,402

Liabilities and Shareholders’ Equity

Current Liabilities

Bank Indebtedness 43,124

Accounts payable & accrued liabilities 37,252

CP LTD 8,351

Total CL 88,727

LTD 62,323

151,050

Shareholder’s Equity

Share Capital 48,044

Contributed Surplus 75,083

Retained earnings 41,535

Foreign Currency Translation Adj. (1,310)

Total Equity 163,352

Total Liabilities and Shareholders’ Equity $314,402

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APPENDIX C: 2000 STERN STEWART MVA RANKING INFORMATION,FISHERY PRODUCTS INTERNATIONAL LTD. AND HIGH LINER FOODS (IN CDN$000S)


MVA 1999 1998 1997 1996 1995

FPI Ltd (98,526) (130,317) (93,338) (105,870) (103,387)

High Liner Foods (70,809) (18,434) (24,250) (38,591) (45,074)

Stock Market Value

FPI Ltd 245,220 229,117 249,901 195,309 191,083

High Liner Foods 177,205 254,894 173,552 157,001 154,602

Operating Capital Year-End

FPI Ltd 342,830 358,502 337,630 296,198 289,010

High Liner Foods 240,540 272,969 191,235 195,321 197,870

EVA

FPI Ltd (5,465) (8,745) (9,455) (16,262) (30,764)

High Liner Foods (20,456) 499 (2,932) (7,842) (8,388)

Return On Operating Capital (r)

FPI Ltd 4.9% 4.3% 4.5% 3.7% 0.5%

High Liner Foods −1.0% 7.2% 6.1% 3.9% 4.1%

Cost of Capital (C*)

FPI Ltd 6.5% 6.9% 7.7% 9.3% 11.5%

High Liner Foods 6.5% 7.0% 7.6% 7.9% 8.4%

Source: Richard Grizzetti, e-mail communication, www.sternstewart.com, July 2 and 28, 2000.

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Committees of the Board of Directors

APPENDIX D: FISHERY PRODUCTS INTERNATIONAL LTD., BOARD OF DIRECTORS


James C. Ballie 1992 – present Partner, Tory, Tory, DesLauriers & Binnington, Toronto, ON

R. William Blake, PhD 1999 – present Dean, Faculty of Business Administration, Memorial University of Newfoundland, St. John’s, NF

Bruce C. Galloway 1999 – present Company Director, Oakville, ON

Janet C. Gardiner 1987 – present Treasurer, Chester Dawe, Ltd., St. John’s, NF

Michael F. Harrington 1998 – present Senior Partner, Stewart McKelvey Stirling Scales, St. John’s, NF

Albert F. Hickman 1984 – present President, Hickman Motors Ltd., St. John’s, NF

Thomas E. Kierans 1990 – present Chairman & CEO, Canadian Institute for Advanced Research, Toronto, ON

Rev. Desmond T. McGrath 1987 – present Education Officer, Fish, Food & Allied Workers, St. John’s, NF

Frances M. Nichols, FCA 1991 – present Chartered Accountant, Grand Falls-Windsor, NF

Elizabeth Parr-Johnston, PhD 1994 – present President & Vice-Chancellor, University of New Brunswick, Fredericton, NB

Vincent G. Withers 1995 – present Company Director, St. John’s, NF

Victor L. Young 1984 – present Chairman & CEO, Fishery Products International Ltd.,St. John’s, NF

Audit

Vincent G. Withers (Chair)

Janet C. Gardiner

Michael F. Harrington

Alfred F. Hickman

Rev. Desmond T. McGrath

Frances M. Nichols, FCA

Growth & Diversification

James C. Baillie (Chair)

R. William Blake, PhD

Bruce C. Galloway

Thomas E. Kierans

Elizabeth Parr-Johnston, PhD

Vincent G. Withers

Human Resources

Albert F. Hickman (Chair)

James C. Baillie

R. William Blake, PhD

Bruce C. Galloway

Michael F. Harrington

Thomas E. Kierans

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APPENDIX E: A NEWSPAPER INTERVIEW WITH

VIC YOUNG, THE TELEGRAM—AUGUST 26, 2000


Fishery: FPI Boss looking for business in New Zealand

Young seeks more international flavour: Telegram Correspondent

Fishery Products International (FPI) chairman and CEO Vic Young will travel to New Zealand next week toexplore opportunities that he hopes will give FPI a more international flavour in the fish-marketing business.

Young said the full week of discussions will include talks with several New Zealand seafood companies,including Sanford Ltd., which owns 14.7 per cent of FPI.

He said he will be exploring opportunities associated with the potential for FPI to market New Zealandproducts in North America and for New Zealand companies to market FPI products in New Zealand andAustralia.

Co-operation

He said the issue of international co-operation in the fishing industry is becoming increasingly important as thebattle with the chicken, beef, pork and turkey industries intensifies.

Recently, FPI and a consortium of 12 international seafood companies announced the formation of SeafoodAlliance.com.

Members of the alliance have agreed to investigate industry-wide opportunities arising out of the Internet andbusiness electronic commerce.

The total sales of the companies in the alliance is US$5 billion.The list of major shareholders of FPI has undergone significant change in the last several months. There are

now five shareholders that own approximately 64 per cent of the outstanding shares in FPI.These major shareholders include: Sanford; Hamblin Watsa (a Canadian investment firm) at 14.5 per cent;

IFPC (an Icelandic seafood company) at 14.6 per cent and Omers (a Canadian retirement fund) at 11 per cent.In addition, Clearwater Fine Foods, a Canadian seafood company, owns approximately nine per cent.

Clearwater and IFPC were partners in an unsuccessful FPI takeover bid that was launched in November lastyear.

FPI is experiencing one of its best performances in more than a decade this year.In its recently released second-quarter report, the company indicated its annual earnings target for 2000 was

net income in excess of 75 cents per share, compared with 51 cents per share earned in 1999.“If achieved, this would represent FPI’s best performance on a fully-taxed basis in over a decade,” said Young.The company has indicated it will continue to pursue potential mergers, acquisitions, international alliances

and other growth opportunities.He said that one of the things he will be exploring while in New Zealand is the use of New Zealand hoki

(whitefish) as raw material in value-added products in North America.He said he will also be looking at the potential for technological and personnel exchanges in the areas of

harvesting and fish processing.

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INTRODUCTION

On February 17, 2003, Paul Metcalf, founder ofNonStop Yacht S.L. (NSY), wondered how bestto pursue growth for his startup. NSY provided acentral, one-stop Internet e-commerce Web siteto service the mega-yacht1 industry. Metcalf’sbusiness concept was to provide captains andcrew with information and the ability to shoponline for any parts or services related to thefunctioning of their vessel: from finding a lightbulb, to selecting a new satellite system, toarranging a photographer in the Cayman Islands.

Based in Barcelona, Spain, NSY grewrapidly, achieving sales of US$200,0002 in itsfirst year of operation. But second-year saleswere below Metcalf’s expectations and thetwo-year-old NSY had yet to post break-evenresults. With cash becoming an issue andinvestors reluctant to provide further capital,Metcalf felt it was time to revisit whether hehad chosen the most appropriate business modelto capture value from the NSY concept. He waskeenly aware that he had to make a decisionquickly. There would be no margin for error.

THE RECREATIONAL

MEGA-YACHT INDUSTRY

A mega-yacht was loosely defined as any yachtgreater than 45 metres in length. Owning mega-yachts was a hobby of the immensely wealthy.Despite the global recession, the yachting worldwas still growing rapidly because “yacht ownerswere typically high net-worth individuals andcorporations with cash to burn.”3 In 2003, therewere approximately 5,000 mega-yachts in the

world, ranging in cost from an average of $10million to $50 million and higher. The industryincluded another 5,000 superyachts4 in its boatcount.

Examples of mega-yachts included the fol-lowing, rated by Power and Motoryacht as thetop two mega-yachts in 2002:5

• The Savarona: 124 metres in length, featur-ing a Turkish bath with 300-ton marble fountainsand basins that are more than 200 years old, 39bathrooms, 17 bedrooms and an exquisite goldand marble balustrade.6

• The Alexander: 121 metres in length,launched in 1976 and owned by Greek real estatebillionaire John Latsis. The mega-yacht was inthe headlines in 2000 when Prince Charles ofBritain and his lover, Camilla Parker Bowles,were photographed cruising in it.

Economic activity in the mega-yacht industrywas estimated at $1,035 million worldwide, ofwhich new builds accounted for $383 million.The maintenance, refit and repair business sectorsaccounted for the other $652 million. (At anytime, there were about 1,600 mega-yachts dockedfor service.) In September 2002, consultants esti-mated that demand in the worldwide marketwould continue to increase by six per cent peryear and even more in the near-term outlook.7

Ports of Call

There were a few key ports of call formega-yachts: South Florida, Majorca, the FrenchRiviera, and St. Maarten. The impact of mega-yachts was not to be underestimated: SouthFlorida alone claimed that mega-yachts were a


NONSTOP YACHT, S.L.

Prepared by Ken Mark and Jordan Mitchellunder the supervision of Professor Charlene Nicholls-Nixon

Copyright © 2003, Ivey Management Services Version: (A) 2004-06-22

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significant portion of the $9-billion per annumrecreational marine industry.8 Frank Herhold,executive director of the Marine IndustriesAssociation of South Florida, a trade group withabout 800 members, stated:

Mega-yachts are a very fragile, mobile community.About 900 mega-yachts visit South Florida eachyear, and 800 of them stay. They spend about$500,000 per visit.9

Various economic impacts included purchasesof goods and services, as well as maintenance,repairs, refittings and docking fees (between $7to $10 per foot per day) billed by local marinasand boatyards. In South Florida, the recreationalmarine industry directly employed an estimated39,000 people and generated indirect employ-ment for another 109,000.10

To attract visitors and support the community,South Florida also held the Fort Lauderdale BoatShow, displaying $1.6 billion of boats, mega-yachts and accessories to thousands of visitors.The show’s average $500-million annual impactwas welcomed by the city.11

Customers

Americans purchased 45 per cent of allsuperyachts and mega-yachts, up from 10 percent to 12 per cent a decade ago.12 Customersbought mega-yachts and superyachts in the sameway they bought other large-ticket items. Withintheir network of contacts and friends, theylocated yacht brokerages that could equip themwith the most impressive yacht they could afford.

Mega-yacht owners typically spent six to 10weeks a year onboard their yacht, frequentlyentertaining guests’ with the key but subtle aimof putting their immense wealth on displayduring this short period of time. Typically, noexpense was spared to provide the highest levelsof comfort and luxury for guests—fresh, pre-mium food was cooked by chefs, crews werefully staffed, and the mega-yacht had to be inpristine condition at all times. A typical mega-yacht would have six crew members, including acaptain, mate, chief engineer, cook, stewardess

and deck hand. In extreme cases, the mega-yachthad 90 to 100 full-time crew.

When not in use by the owner, mega-yachtswere often made available for charter. Duringthis three-to-four-month time period, the yachtowner turned over the care of the vessel to thechartering party and the yacht management ser-vice. The level of luxury depended on theamount the party was willing to spend.

For the rest of the year, the mega-yacht wasmoored in port, in dry storage or in dock forrepairs. The generally accepted industry rule wasthat operating expenses accounted for 10 per centof the yacht’s value per year. Of this amount, aquarter was due to spare parts, consumables andupgrades. The other three-quarters covered fuel,food, communication costs, docking fees, crewpayroll and repair and refit yard fees. Every fourto five years, a mega-yacht required a major refitcosting up to 20 per cent of the yacht’s value.

Yacht Builders

At any time, there were about two dozenspecialty yacht builders in the world constructingmega-yachts. Mega-yachts took between one andthree years to build. In 2002, 56 per cent of newmega-yachts were built in Europe, 35 per cent inthe United States, and the remainder were builtin Asia and South Africa. In 2002, industryobservers calculated that yacht builders werecompleting 482 mega-yachts for 2003, a 4.7 percent drop from the previous year.13 Althoughyacht builders focused on construction, relatedservices could add substantially to their bottomline. Rybovich Spencer, a West Palm Beach,Florida-based full-service shipyard and ship-builder, said its service and dockage business,consisting of repairs and refits for over 80 mega-yachts, brought in an additional $5 million insales during a six-month period between 2001and 2002.14 Yacht builders invested between $2million to $15 million to upgrade current facili-ties to serve mega-yachts.15

The growth in the industry had led to aproliferation in the number of yacht builders, andin 2002, signs of consolidation appeared. PalmerJohnson Inc., a shipbuilder and refitter based in


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Sturgeon Bay, Wisconsin, announced its intentionsto focus on the mega-yacht industry with itsacquisition of two Fort Lauderdale marinecompanies specializing in supplying parts,equipment and fuel to the yachting sector.16

Yacht Management Companies

There were dozens of yacht managementcompanies providing such services as partsprocurement, crew hiring and management, co-ordination of yacht maintenance, and organizingcharters. As an example of a service provided,organizing charters helped mega-yacht ownersrecoup some of the investment in their vessel:rental rates ranged from $50,000 per week to$584,000 per week for the 325-foot Christina O,a yacht for up to 36 people that once belonged tothe late Aristotle Onassis. These costs did notinclude tips, food, alcohol and fuel (which couldadd another 20 per cent to 40 per cent to costs).17

The fees for dockage in the Mediterranean couldrange from $1,000 to $2,000 per night. The yachtmanagement company’s commission, includedin the total amount, would be between 10 percent to 20 per cent.

Consolidation in this industry was also start-ing to take place, as transnational players beganmoving into the lucrative U.S. market. In 2002,the Rodriguez Group, a French yachting servicescompany, purchased Fort Lauderdale-based BobSaxon Associates Inc., a yacht management andcharter company with 27 employees.18

THE PARTS PROCUREMENT PROCESS

Given the nature of conspicuous consumption inthe mega-yacht industry, most mega-yachts werefilled with specially made and expensive parts(see Exhibit 1). There were three main categoriesof boat parts:

1. Spare parts—typically more urgent than any-thing else, this category referred to parts that hadunexpectedly broken down. Examples included:a replacement pump for the head (toilet), a

new hydraulic seal for the steering system, anon-standard valve in the sewage system or anew electronics board for the unit that closes thecurtains in the owner’s stateroom.

2. Consumables and stock spares—this categoryincluded parts that were less urgent but nec-essary to have in the case of a breakdownor replacement. Examples included: oil andfuel filters, light bulbs, pump seals, electronicswitches, crockery (pots and pans) for thegalley (kitchen), charts and tools.

3. Upgrades and refits—this category included arange of products from fire and safety to theentertainment or communication systems.

Because the range of products required bymega-yachts was so great, suppliers were locatedaround the world. The majority of the supplierswere located in the United Kingdom, Germany,Holland, France, United States, Australia,Scandinavia and Japan. As the industry contin-ued to mature, more standardization and consol-idation of suppliers was expected to occur.

There were four main suppliers to mega-yachts:

• Commercial/Industrial—engines, laundry, kitchenand electrical system suppliers

• Consumer Products—entertainment systems,fixtures in bathrooms, furniture, etc.

• Small Yacht Products—rope handling equip-ment, navigation equipment, electronic systemsuppliers

• Dedicated Suppliers—small number of manu-facturers that catered to the mega-yacht market

The thousands of parts and equipment manu-facturers sold their wares through exclusive dis-tributors. Analysts indicated that Germany hada 26 per cent share of the market, followed bythe United Kingdom and the Netherlands eachwith an 18 per cent share, the United States with14 per cent, Norway with nine per cent, Francewith six per cent and Finland three per cent.19

Owners rarely ever dealt with the purchasingof boat parts or servicing, leaving these dutiesto the crew (40 per cent of the time) and yachtrepair and refit specialists (60 per cent of thetime). The crew dealt with ongoing or emergency


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repairs while yacht repair and refit specialistshandled regularly scheduled maintenance. Thecrew had several ways to deal with parts pro-curement: They could leave the task to the yachtmanagement company; they could rely on apurchasing agent; or they could approach partsdistributors (see Exhibit 2).

Yacht management companies and purchas-ing agents would locate the products from theirdatabase or collection of catalogues. They wouldthen order the part, look after the paperworkand have the part shipped to their warehouse ordirectly to the yacht. Typically, they would add apercentage fee, ranging between five per cent to10 per cent of the cost of the part. For importantcustomers, the purchasing agent would have theclout to negotiate a cheaper price than the yachtowner would receive by dealing directly withthe manufacturer. Parts could also be obtainedthrough local yacht agents. Like purchasingagents, local yacht agents (who typically alsomanaged many other sideline businesses), gener-ally had local knowledge of their port, any localsuppliers and local import laws. The yacht agent

would add a small percentage to the cost of theproduct or service.

Alternatively, crews could pursue parts pro-curement independently. This approach usuallyinvolved a lengthy investigation period wherethey would have to track down products andproduct information through contacts, maga-zines, catalogues and the Internet. In some cases,crews were able to contact the distributor ormanufacturer directly and arrange to have theproduct shipped to the yacht. Although contact-ing parts suppliers was not simple (there werethousands of suppliers), extra commissions forintermediaries would not have to be paid.

Crews could also locate and purchase boat partsby directly contacting yacht builders and/or repairand refit yards. Yacht builders would typically spe-cialize in parts they used to equip the vessels theywere building. Repair and refit yards did notalways have a wide contact base of suppliers andwould add 10 per cent to 15 per cent onto the costof the product or service. Their businesses werebased on charging for the labor component of therefit or repair. In most major ports, there would be


The scope of supply included any parts for the following systems aboard a mega-yacht or superyacht:

• Main Engines• Propulsion Units• Generators• Air Conditioning• Refrigeration• Water Makers• Shorepower Conversion Units• Sewage Systems• Stabilization Systems• Bow Thrusters• Fuel Purification• Oil Purification• Fresh Water System• Hot Water System• Communication Systems• Navigation Electronics

• Compressed Air Systems• Entertainment Systems• Fire Fighting Equipment• Safety Equipment• Hydraulics• Sails and Rigging• Kitchen Equipment• Cranes• Tenders• Jet-skis• Diving Equipment• Anchor Handling Equipment• Alarm Systems• Charts• Helicopters• Other Sea Craft

Exhibit 1 Parts Requirements for Mega-Yachts

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one or two major refit yards. For example, thepredominant refit yards in Spain included MB 92in Barcelona and Izar in Cartagena.

THE NSY VALUE PROPOSITION

Because mega-yachts were transient sea craftthat sailed frequently from port to port, suppliesand equipment were often needed on a last-minute basis. Locating the right spare or replace-ment part was often a frustrating endeavor formega-yacht crews; there were literally thousandsof manufacturers worldwide, each making

non-standard boat parts. Attempting to describethe boat part while connected to procurementagents on satellite telephone was not the idealsolution. Often, agents themselves had to resortto haphazard guessing to correctly identify theitem requested. To compound the problem, mostparts suppliers did not have their cataloguesonline; the catalogues were often in paper formand updated annually.

Metcalf believed that his company’se-commerce Web site had an advantage overtraditional methods of procurement. Whileconnected to the Internet, mega-yacht crewscould browse the catalogues of a variety ofsuppliers on the NSY site. Instantaneous access


Distributors for thousands of parts

YachtManagement

Company

YachtBuilders

Mega-yacht Mega-yacht Mega-yacht Mega-yacht Mega-yacht

TraditionalProcurement

Agent


Agent

Exhibit 2 Traditional Parts Procurement Process

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to current product information would virtuallyeliminate many of the problems crews com-monly associated with parts procurement,including: how to find and contact the manu-facturer and local distributor, describing thepart, ensuring appropriate measurements (metricversus imperial), managing time zone differ-ences, dealing with communication problems,locating—sending and receiving agents, manag-ing customs clearance and arranging payment.

Metcalf explained why he chose to operateNSY as an e-commerce site:

I thought the Internet was the best method ofdelivery to a customer base that was located all

over the world and constantly moving. The fitwas perfect! I felt the problem of parts procure-ment could be better addressed using the Internet.The biggest problem in getting boat parts wasgetting the right information about the pro-duct. So, I figured if I could have an Internet siteand an up-to-date catalogue on CD that gave theinformation and delivered the product, it wouldbe better than the current method of finding theparts yourself or by using an agent who is servingdozens of other customers. My plan was to havea huge catalogue of everybody’s catalogue. Aperson from the boat would order a part and say,“Okay, I’m in this place,” and the product wouldbe dropped shipped from the supplier in that area.(see Exhibit 3).


NonStop Yacht Web Site

ShipbuildingYard

YachtManagement

Company

Mega-yacht Mega-yacht Mega-yacht Mega-yacht Mega-yacht

Distributors working for thousands of parts


Agent

Exhibit 3 NonStop Yacht Facilitates Parts Procurement

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Metcalf believed that NSY’s competitiveadvantage would be its database and networkof suppliers, the ability to ship anywhere inthe world from Barcelona, the flexibility of itscost structure and the transparency of billing.Taken together, the benefits provided a com-pelling value proposition to the crew of super-yachts and mega-yachts, which included:

1. Up-to-date catalogue on CD, allowing the crewto browse and shop off-line then upload theorder by fax, e-mail or through the Internet (thehard-copy catalogue of National Marine hadsome parts not available for the past six years);

2. Automatic accounting for the captain or yachtmanagement company;

3. Password-protected expenditure levels forcaptain, mate or engineer;

4. Automatic receipt copies, invoice copies andVAT20 receipts;

5. Links into maintenance scheduling software ifused on the yacht;

6. Easy reordering of parts or groups of parts;

7. Intelligent add-on sales with instant access toview the available options;

8. Product pictures and part diagrams; and

9. No time zone issues.

With the NonStopYacht.com Web site, Metcalfaimed to become the Web-based purchasing agentof choice to crew members and yacht manage-ment companies. NSY’s continually updated Website could be instantly accessed by customers,with orders placed online or by telephone.

NSY’S BUSINESS MODEL

Initially, Metcalf had envisioned buildingNSY as a virtual corporation. The Web sitewould be NSY’s only interface with thecustomer. Supplies would be procured from agrowing network of vendors that agreed to posttheir merchandise with NSY and then have NSYarrange the shipping directly to the customer.

NSY’s revenues were generated from dealermargins that were earned when merchandise wassold through the Web site. Suppliers were notrequired to pay listing fees. The business modelworked as follows: NSY would utilize the sup-plier’s country-specific distributor to ship productto customers. In the process, it would earn dealermargins on the wholesale prices of these products.NSY aimed to charge end-customers prices similarto those offered by local dealers. In the rare casethat the supplier did not have a distributor, NSYwould arrange for the part to be shipped directly tothe customer. In these situations, NSY would earnboth distributor margins and dealer margins.

Metcalf and his team worked feverishly formonths, making over 900 supplier contacts aroundthe world with a combined product offering thatincluded over 20,000 branded items. The processof getting all of the suppliers and their productshad been an arduous task. Metcalf recalled:

We basically rang up all the suppliers, told themabout the idea and many of them said “great.” Thebiggest challenge was convincing them of our mainobjective, which was not selling against theirdistributors. Once we convinced them that thecustomer would order from us, then we would gothrough their designated distributor in that country.

At the same time as agreements were beingsigned with a critical mass of suppliers, the Website was developed. Then, attention turned tobuilding traffic on the site:

When we finished the basic structure of the Website, we sent out passwords to various mega-yachtsand got their feedback on what they liked anddidn’t like about the site. The site was ugly becauseI designed it initially. We had three people workingon the back end, and before its final release, I hiredsomeone who improved the look and consistencyof the appearance.

We opened the Web site to resounding silencein June 2001. We had visitors but not many pur-chasers. We got the phone calls: “My boss was onyour site and he would like to order this.” TheWeb site did not work the way I wanted it to asan e-commerce site. However, it did provide partsinformation to crews.


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Since initial sales had been much slowerthan Metcalf had anticipated, he decided to movefrom a hidden office to a publicly accessiblearea. As soon as he had created a face for NSY todeal directly with customers, sales started to pickup. The business model quickly evolved from anInternet-based venture to a hybrid “bricks andmortar” enterprise:

What we were finding was that customers werelooking on the Web site to find the information;then we’d get a call saying, “Yes, we saw this boatpart on your Web site and would like to order it.”The decision to move from a strictly e-commercecompany to dealing directly with the customer wasquite simple, really. We were located upstairs in anon-public area and were trying to operate it as astrictly e-commerce business. But we kept on get-ting calls. We decided to move downstairs, and putin a free Internet access terminal for the crew touse. That helped out immensely. Once we saw thatthe e-commerce solution alone wouldn’t work, wedeveloped a face to the crews of the mega-yachts.Crews are able to come in, use our Internet, ask usabout products and do the order either over thephone, by fax or in person. The site is updated, butit’s in hibernation, since most of our sales aregenerated through the office.

Metcalf and the investors decided to openup the second NSY office in Palma Mallorca,Spain, in October 2002. Metcalf believed Palmato be a vital hub of activity for superyachts andmega-yachts and was confident that the newoffice was a natural extension of the Barcelonalocation.

The accessibility to information within themega-yacht industry made it possible for Metcalfto obtain the names and lengths of the yachts,the major equipment being installed, the yardwhere the yacht was built and the presentcaptain’s name. The only information that wasnot available was details relating to the owner.NSY advertised in three publications that werefrequently referenced and read by captains andcrews: Professional Yachtman’s Associa-tion News, The Yacht Report, and Showboats.Another important advertising method was the

attendance of Metcalf and his team at the majorboat shows in Europe and the United States.

THE NSY TEAM

In February 2003, the NSY management teamwas composed of Metcalf as chief executiveofficer (CEO) and president, Stephanie McKayas commercial manager and Sam Jones asmarketing and sales specialist. Contract employ-ees such as Robert Franks performed computingor administrative tasks. Each individual broughta unique and complementary set of skills andexperience to NSY.

Metcalf had spent six years in computer salesin his native United Kingdom before pursuing acareer in the sailing world in 1993. He workedfirst as a sailing instructor in Greece, and thenwent to work on a variety of small- and medium-sized yachts, ranging in size from 12 metres to52 metres. During this time, Metcalf’s travels tookhim throughout the Caribbean, North America andthe Mediterranean. The experience gave Metcalfa wide base of yachting knowledge includingelectrical, plumbing, engine rooms and generalmaintenance. It also gave him valuable contactswith owners, captains and engineers within theindustry. Metcalf was 30 years old when he beganwriting the NSY business plan in October 1999.He received his initial seed capital from Riva yGarcia on June 16, 2000 (see Exhibit 4).

In 2003, McKay had worked at NSY for twoyears. She was responsible for the establishmentof many of the relationships with suppliers dueto her savvy negotiation skills and ability tospeak three languages. Her prior experience hadbeen based in emergency assistance with a lead-ing insurance company, working in both theUnited Kingdom and France. Being with NSYfrom the beginning, McKay wrote an entire man-ual of procedures and established strong ties withyacht refit yards in the Mediterranean.

Jones had worked for NSY for nine months.During this time, he had managed to increasethe walk-in traffic and the direct-to-yacht busi-ness through his personable selling approach to


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By February 2003, there had been three rounds of investment in NonStop Yacht:

Round Investor Date Amount (US$)

1 Riva y Garcia +Barcelona EMPREN 06/16/2000 180,000

2 Riva y Garcia +Barcelona EMPREN 12/16/2000 180,000

3* Riva y Garcia +Barcelona EMPREN 04/01/2001 51,085

TOTAL 411,085

*The third joint small round of financing was in the form of a loan with the plan that the investment would bereturned in cash or equity, with valuation based on performance against target.

Riva y Garcia

Riva y Garcia was an investment banking boutique with offices in Barcelona and Madrid. Its primary focus wason corporate finance for Catalonian and Spanish companies as well as the operation of three institutional invest-ment funds, one of which was WebCapital, the fund that invested in NonStop Yacht.

Sebastian Waldburg, director private equity from Riva y Garcia, commented on why he gave Metcalf the funding:

He [Metcalf] had worked in the sector and had detected a serious need. He wanted to use the Internet asa tool to fill a gap. We thought it was a good approach and an interesting sector. It’s a small sector wortha lot of money. You don’t have to talk to a million customers.

VC firms invest in the person. Paul has the experience and knowledge in the industry. He has a strongcapacity in being flexible in terms of where the business will take him.

On his expectations of NonStop Yacht’s financial commitment, Walburg said:

The financial model we had built showed us a 34 per cent return. This year I want to see them breakeven. That would be sales of 70,000 Euros a month. And I don’t mean an average of 70,000 a month.Every month, at least 70, which would cover their fixed costs. By next year, I want to see a 50 per cent to80 per cent growth rate in sales.

Barcelona EMPREN

Barcelona Empren was an organization focused on providing start-up and seed capital to companies in telecom-munications, biotech, engineering and software companies. Its shareholders included pre-eminent leaders inSpain from the following sectors: public institutions (27.5 per cent), telecom (22.5 per cent), banks (35 per cent),industrial sector (10 per cent) and public utilities (five per cent).

Emilio Gómez I. Janer, analyst with Barcelona Empren, commented on giving funding to NSY:

He’s an innovator in the yachting industry, he has an excellent niche in the marketplace and Paul and histeam are experts in the sector. He knows what the problem in the industry is and he has the knowledgeand experience to make it successful.

On his expectations of financial results, Gómez commented:

Originally, we had planned a 30 per cent IRR.1 I wanted to see $500,000 in sales in 2002 and $1 million in 2003.

Exhibit 4 Financing of NonStop Yacht

1. Internal Rate of Return.

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the 30 to 40 mega-yachts sailing into Barcelonaeach year. In October 2002, he was placed incharge of the new Palma office. The team usedthe services of Robert Franks, an experiencedU.K. computer programmer based in Barcelona,for any issues with the Web site and for theintegration and set-up of any new technologiesrelevant to NSY.

COMPETITOR REACTION

Metcalf believed that NSY’s key competitorswould be the major traditional procurement agents,yacht builders or parts-related Web sites, but noneof these parties took visible action following thelaunch of NonStopYacht.com in June 2001.

Very little information was publicly availableabout the companies that acted as purchasingagents in the mega-yacht industry. Many of thesefirms were private companies or one-personoperations with closely guarded lists of clientele.Worldwide, Metcalf believed there were threemajor traditional procurement agents:

• National Marine, Florida, United States—This competitor was the largest purchasing agentin the world with annual sales of approximately$10 million, employing 35 people. Its focus wasalmost entirely U.S.-based and was not wellknown in Europe. National Marine published a1,000-page catalogue annually and sold parts tomega-yachts and superyachts throughout theworld.

• Alex Spares, United Kingdom—The opera-tion began in 1972 and was comprised of oneprincipal and one assistant. Annual sales wereestimated at approximately $1 million. Spare’scompetitive advantage was his experience ofover 30 years in the industry and his extensivepersonal network of contacts, including manymega-yacht captains and crews.

• Versillias Supplies, Viareggio, Italy—Theoperation relied mostly on dealings withMediterranean mega-yachts and suppliers. Theirsales were approximately $1 million.

In addition to these “majors,” there wereapproximately another 200 small local yachtagents located around the world that did not spe-cialize in locating and sourcing local parts andservices for yachts in their locale. Rather, theyacted as the “person on the ground” to arrangeeverything from getting fresh flowers to rentinga limousine for the boat’s owner. According toMetcalf, none of these small enterprises had theclout or worldwide name recognition of NationalMarine, Alex Spares or Versillias.

By February 2003, there was some industryspeculation about the possibility of strategicalliances between NSY and its major competi-tors, specifically National Marine, Alex Sparesand Palmer Johnson.

Emerging Competitors: VerticallyIntegrated Yacht Builders?

Two major yacht builders had started toincorporate a completely vertical operationincluding building, selling, chartering, servicing,refitting and ordering parts for the mega-yachts.Frequently, these parts were required for thebuilding projects in which the yard was involved.

Palmer Johnson Inc.

Started in 1918, this was one of the world’spreeminent builders, involved in yacht repair andsupport services of sailboats, superyachts andmega-yachts. With over $300 million in sales,Palmer Johnson usually built 40 yachts peryear. Their subsidiaries included companies thatbuilt production, semi-custom and custom lux-ury yachts; operated brokerage yacht sales acrossthe United States, United Kingdom, France andSingapore; refitted, repaired and painted mega-yachts; and operated a global logistical supportunit serving mega-yachts worldwide. Being oneof the biggest yacht builders, refit yards and bro-kerages in the world, Metcalf believed PalmerJohnson had a good reputation and significantclout with suppliers. In 2002, Palmer Johnsonwas expected to seek growth through expandingthe service side of their enterprise.


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Lurssen

Located in Bremen, Germany, Lurssen hada long history in ship building dating back to1875, with many of the world’s firsts in yachting,including the invention of the first motor boat in1886. Lurssen was another of the world’s majoryacht builders with sales of approximately $150million. A highly diversified company, they wereinvolved in the production, servicing and log-istical support of mega-yachts as well as Naval vessels. They typically built 30 mega-yachts peryear. Their competitive advantage was similar toPalmer Johnson’s in their worldwide reputation,history and clout with suppliers.

The Failed Alliance BetweenPalmer Johnson and Lurssen

Palmer Johnson and Lurssen had tried toform a strategic alliance in the mid-1990s, butit had failed due to differences in businessobjectives. Both companies were yacht builders,which meant they were competing for the samesuperyacht and mega-yacht contracts. As well,their repair and refit yards were not complemen-tary and both companies found it challengingto agree upon an efficient way to procure andsell boat parts. Last, management from both

companies was unable to reconcile the U.S.German management styles.

METCALF’S OPTIONS

In 2003, Metcalf was experiencing substantialpressure to raise NSY’s performance to meetinvestor expectations. Moreover, he was also per-sonally motivated to see a payoff for the exhaust-ing schedule he had been keeping since launchingthe venture two and half years earlier. So far,the results had been disappointing. Metcalf’soriginal plan for growth called for sales of $10million and profits of $1.97 million by the end ofthe 2003 fiscal year (see Exhibit 5). In the firstfull year of operation, NSY generated sales of$200,000, which was consistent with Metcalf’sbusiness plan. However, in 2002, the sales were$300,000, or 11 per cent of the original businessplan. NSY was just cash flow positive.

Metcalf was now wondering whether heshould revisit the NSY business model. Hebelieved there were three alternative businessmodels that had the potential to improve thecompany’s performance. Metcalf’s quandarywas deciding how to choose from among theseoptions.


Year 1 Year 2 Year 3 Year 4 Year 5

Sales 214,720 2,654,484 10,698,465 13,908,004 18,080,406

Sales Growth % 1136% 303% 30% 30%

Profit (414,188) 317,189 1,973,416 2,648,157 3,537,727

Profit Growth % −176.6% 522.2% 34.2% 33.6%

# of Yachts 1,600 1,712 1,832 1,960 2,097

“Total Mega-yacht Market Size (millions)” 160.0 171.2 183.2 196.0 209.7

Growth % 7% 7% 7% 7% 7%

NSY Market Share 0.13% 1.55% 5.84% 7.10% 8.62%

Exhibit 5 Original Financial Projections for NonStop Yacht

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Option #1: Signing anAgreement With PalmerJohnson or National Marine

Metcalf felt there were trade-offs associatedwith entering into a strategic alliance with PalmerJohnson or National Marine:

The problem is, if we sign an agreement withNational or Palmer Johnson to become theirEuropean arm, we become a third party. We haveto stop dealing direct with the crew of themega-yachts.

Signing the agreement with National or Palmerwould give us high volume and low margin. Wewould charge them a fixed cost of 5,000 to 6,000Euros a month and add an additional five per centmargin. The advantage of the mixture of dealingwith agents and direct to the mega-yachts is highermargin . . . an average of about 25 per cent versusthe current 15 per cent. The problem is slowgrowth.

The decision was not based purely on sales orgross margin dollars as Metcalf was confidentthat, by signing the agreement, his sales wouldreach $3 million immediately, with potentialfor 50 per cent growth in the second year, 30 percent in the third, tapering down to 10 per centgrowth per year in subsequent years.

To accommodate the increased volume,Metcalf would have to contract two extra admin-istrative people at $20,000 a year plus 25 per centin employee tax. In the second year, he wouldlikely add another person. Metcalf could gain sav-ings of approximately $10,000 per year on his rentby moving into an office without public access.New computers and additional office furniture,which were treated as expenses, would require anadditional outlay of $2,000 per terminal, includingtelephone and Internet hook-up. With this option,NSY would likely experience a five per centincrease in expenses each year. The main invest-ment would be the increased accounts receivables,estimated to represent approximately 20 days.NSY typically paid its bills in 15 days and did notcarry any inventory.

Option #2: Growth ThroughRepair and Refit Yards and DealingDirect to Yachts—a “Hybrid” Option

Metcalf felt there was a great opportunity toservice the yacht refit yards, local yacht agentsand yacht management services, while trying todeal directly with the mega-yachts at the sametime. But there were two potential problemswith this approach. First, if NSY contracted witha refit yard, the company might have to ceasedealing directly with the yachts in order to avoidconflict of interest. Second, NSY could lose itsname recognition with the end consumer if itrelied upon yacht refit yards, agents or man-agement services to generate sales. Metcalfexpected a margin of five per cent to 15 per centwhen dealing with a third party and a margin of25 per cent when dealing directly with theyachts, making a blended margin of approxi-mately 20 per cent.

With this growth option, Metcalf believed hecould generate sales of more than $2 million inthree years, with a growth rate of 15 per cent foreach subsequent year. NSY could accommo-date this type of growth with its current team inBarcelona, although Metcalf expected that eachadditional bricks-and-mortar office wouldrequire another two employees at $20,000 perperson. It was probable that, in addition to thePalma office, two more offices would be requiredin Antibes, France, and Monaco.

The start-up for each new office was esti-mated to be $10,000, plus $2,000 per employ-ee for the computer and office equipment. Theyearly amount of telephone, consumables andmiscellaneous expense was estimated at $20,000per office. Metcalf expected that NSY wouldrequire an average increase in travel expense of$5,000 per office. The rent and related expensesfor a small office per year in major ports in theMediterranean was estimated to be about $2,000per month. Since NSY expensed its computersand office equipment, the only working capitalrequirement would be an increase in accountsreceivable.


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Option #3: Organic GrowthThrough Opening Multiple Locations

Metcalf felt that the recently opened Palmaoffice would generate more walk-in traffic andwould continue to present a company “face” tothe crew of the mega-yachts. Metcalf furtherbelieved that yacht crews would be more apt todeal with NSY if they constantly saw a shop ineach major destination. Thus, an alternative busi-ness model was to expand by continuing to openlocations in key ports around the world. SebastianWaldburg, from Riva y Garcia, commented on theviability of expanding with a bricks-and-mortarapproach:

Yes, NSY is a relatively low-budget operation.If they replicate the small offices, say in Antibesor Monaco, and before they open up their office,if they can arrange to be the back-office for yachtrefit yards and yacht management services, theycould cover their fixed costs of running it. Theycould likely charge the yacht management servicesor the refit yard a fixed monthly fee with variablecharges for purchases.

It’s important to have the local touch and thelocal being-in-touch. With a little office, they cangive constant and consistent quality and service.

Emilio Gómez I. Janer from BarcelonaEmpren commented:

I’m the biggest proponent of this approach. Yes, Ibelieve it’s necessary to have brick-and-mortarpresence in each port. You need to have close prox-imity to where the sales happen.

Without actively pursuing the yacht refityards and yacht management services, Metcalf feltthat he could achieve sales of $500,000 with theBarcelona and Palma office. With two additionaloffices (each costing $15,000 to set up and $75,000to run per annum), he felt that he could reach $1.5million in annual sales five years from now.

NOTES

1. Defined as yachts over 45 metres in length.

2. All dollar amounts in U.S. dollars unlessotherwise stated.

3. Christopher Dinsmore, “Yard Gets Off ToQuick Start,” The Virginian-Pilot, February 6, 2002.

4. Superyachts were defined as being between25 to 45 metres in length and costing in the million-dollar range.

5. Michael Field, “Booming Super-YachtIndustry Getting Even More Extravagant,” AgenceFrance-Presse, June 28, 2002.

6. A ramp.7. “United Kingdom Report Says Superyacht

Boom is ‘Only The Beginning’,” Advanced Materialsand Composite News, September 7, 2002. (Note: Thereport uses the words “superyacht” and “mega-yacht”interchangeably.)

8. Joseph Mann, “Sturgeon Bay, Wis.-BasedMarine Firm Focuses on Mega-yachts,” Fort Lauder-dale Sun-Sentinel, June 4, 2002.

9. Joseph Mann, “Fort Lauderdale, Fla.-AreaSummit Seeks to Buoy Recreational Marine Industry,”Fort Lauderdale Sun-Sentinel, October 18, 2002.

10. Ibid.11. Linda Rawls, “Buoyant Nautical Market

Welcomes Lauderdale Show,” The Palm Beach Post,November 1, 2002.

12. Angus MacSwan, “Rich Sail ThroughTroubled Times on Superyachts,” Reuters News,November 3, 2002.

13. Dale K. DuPont, “Fort Lauderdale, Fla.-Based Magazine Says Mega-yacht Orders Are Down,”Miami Herald, October 23, 2002.

14. Joseph Mann, “West Palm Beach, Fla.-basedBoatyard, Boatbuilder, Logs Strong Sales Period,”Fort Lauderdale Sun-Sentinel, May 31, 2002.

15. Joseph Mann, “Fort Lauderdale, Fla.-ShipyardGets Upgrades,” Fort Lauderdale Sun-Sentinel,November 2, 2002.

16. Joseph Mann, “Sturgeon Bay, Wis.-BasedMarine Firm Focuses on Mega-yachts,” FortLauderdale Sun-Sentinel, June 4, 2002.

17. Dirk Wittenborn, “Chartered Waters,”Independent On Sunday, June 2, 2002.

18. Joseph Mann, “Fort Lauderdale, Fla.-basedYacht Services Company Sold,” Fort Lauderdale Sun-Sentinel, July 4, 2002.

19. “United Kingdom Report Says SuperyachtBoom is ‘Only The Beginning’,” Advanced Materialsand Composite News, September 7, 2002. (Note: Thereport uses the words “superyacht” and “mega-yacht”interchangeably.)

20. Value Added Tax (European).


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Quack.com is out to break the mold of Internetaccess and make it simple for consumers to findinformation they need, whenever and whereverthey are, in the most intuitive manner possible—byspeaking.

Alex Quilici, presidentand co-founder of Quack.com

It was June 2000, and Quack.com (Quack) wasin dire straits. An early entrant in the public voiceportal market, Quack was quickly running out ofmoney. Quack’s management team had justreturned from a road show to obtain a secondround of venture financing but had been unsuc-cessful. To aggravate this issue, over the pastmonth Quack’s two major competitors each hadreceived $50 million1 in funding. At the currentburn rate (expenses per month), Quack couldsurvive for only three more months on its exist-ing bridge financing. Alex Quilici, president andco-founder of Quack.com, sat in Quack’s SiliconValley offices scribbling doodles on a piece ofpaper as he weighed his options.

THE COMPANY

Quack was founded in 1998 on the premise of“providing customers quick and ubiquitous accessto the benefits of the Web” and the vehicle for thisaccess was the telephone. With constant access totelephones anywhere in North America, Quilicithought that the phone presented the perfect entrypoint for the Web.

Telephone penetration in this country is 99.9 percent. The computer rate isn’t anywhere near that.

Joe Racanelli of Bid.com,an early investor in Quack.com

What Quack envisioned was an application ofvoice recognition technology that would allowcustomers to use the Web simply by speak-ing. A user would call a phone number and beconnected to Quack’s computer. Then the userwould make a request such as, “What is theweather in San Francisco?” Quack’s computerswould then use voice recognition technology tounderstand the question, input the question into asearch engine (using the entire Web or an inter-nal database) and find the answer. Voice softwareapplications would then read the answer back tothe user. The goal for Quack was to support anytype of activity supported by the Internet such asinformation retrieval, e-commerce, communica-tion and personal information management, anduse the telephone as the interface (Exhibit 1).

The original business plan intended forrevenues to be derived from multiple sources.Advertising and sponsorship of the public voiceportal, commissions from sales purchasedthrough the voice portals, development fees forcreating third-party voice portals and a licensingfee for the Quack software suite were all plannedas revenue streams. Advertising, sponsorship andcommissions were the major projected revenuestreams for Quack.

Quack was founded by Alex Quilici,former professor of electrical engineering at theUniversity of Hawaii, and by Steve Woodsand Jeromy Carriere, former members of theCarnegie Mellon University’s Software Engineer-ing Institute. Quack’s management team hadextensive background in world-class artificialintelligence research, software research, proto-typing and product development.

After beginning product development,Quack’s software architects had realized that


STRATEGIC DIRECTION AT QUACK.COM (A)

Prepared by Benji Shomair under the supervision of Professors Kenneth G. Hardy and Amy Hillman

Copyright © 2002, Ivey Management Services Version: (A) 2002-02-27

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coding software for each individual site andservice would be too time-consuming. Instead,the Quack development team designed and builta comprehensive tools-based architecture thatwas built on SpeechWorks voice recognitiontechnology. It would automatically generatevoice applications from existing Web sites.

The Quack Voice Architecture comprised threemain components (tools). QuackCollect generatedWeb agents that automatically collected informa-tion from existing Web sites and brought it intothe Quack system for delivery to a user through avoice application. QuackFusion aligned differentdata formats such as html, xml and wav into a sin-gle voice application. QuackContext provided aninterface with SpeechWorks technology to man-age call sessions and other aspects such as callerprofiles, personalization and targeted advertising.

The architecture would support services inthree major applications: public voice portalsfor consumers, private voice portals for telecomcompanies and voice-enabled enterprise applica-tions for businesses.

VOICE PORTALS

Why do we have a dial tone?The dial tone originally served as an indica-

tor of being connected to the telephone network.

In reality, the dial tone was an internal technol-ogy. The earliest phones connected customersto a live operator who was eventually replacedby automatic switching and the dial tone. Thisswitch to automation was driven by cost issues.In 2000, many felt the next evolution of the dialtone would be back to its “live operator” rootsthrough voice portals.

The vision was to have users greeted by a com-puter instead of a dial tone. Voice activated dialingcould be used rather than tone dialing. Selectedcell phones already offered this ability, but thisfeature was built into the cell phone hardwarerather than into the telecommunication hardware.With a voice portal, voice activated dialing couldbe delivered to any phone in the world.

The possibilities for this technology wereimpressive. For example, voice portals couldbecome the “gatekeepers” to customers. If aperson wanted to order a taxi, the user couldsimply say “taxi” into the phone and be con-nected with the “preferred” taxi partner of thevoice portal.

The estimates of the future size of the marketsuggested a large opportunity. The Kelsey Grouppredicted that by 2005, speech portals wouldgross more than $5 billion. Infrastructureexpenditures in this area were expected to reach$6 billion by 2005. These sales would be drivenby the estimated 128 million people worldwide


MarketService to

Public

UserAccessService

OverPhone

VRTAccept

Request

QuackSoftware

FindsAnswer

SpeechTechnologyRead BackAnswer to

User

Exhibit 1 Quack Value Chain

VRT= Voice Recognition Technology

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(45 million Americans) who would be registeredto get information through voice portals (seeExhibit 2).

There were three main types of voice portals:public voice portals for consumers, private voiceportals for telecom companies and voice enabledenterprise applications for businesses. Publicvoice portals mimicked their online siblings byoffering a variety of services to the generalpublic. Audio e-mail, weather reports, sportsscores, traffic reports and restaurant guides wereall offered through voice access. Ads wereplaced intermittently through the service. Some

voice portals charged subscription fees foraccess, while others were supported by sales ofadvertising.

Private voice portals were targeted for sale totelecommunications companies. Both cell phoneor landline carriers were very interested in voiceportals. Because they both currently “owned” thedial tone, these companies were assumed to bevery interested in extracting more revenue fromtheir asset (the dial tone). When picking up aphone, rather than having to dial a phone number,users could be greeted by a voice portal thatwould house voice mail, address books and


2000 2001 2002 2003 2004 2005

Total Speech Users 16 22 32 48 96 128

Speech Portal Users 2 5 11 18 28 45

Speech Portal Shoppers 0 1 3 8 12 18

Source: The Kelsey Group 2000

Carriers31%

ASP13%

Advertising15%

Tranactions23%

Bounties8%

Infrastructure10%

Speech Portal Revenue Analysis (2005)

Exhibit 2 Market Predictions, Speech Portals: North America Usage Forecast (in millions)

Source: The Kelsey Group 2000

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would offer all the services of a public voiceportal. For wireless carriers, a voice portal wasespecially attractive because wireless carrierscharged by the amount of time used and a voiceportal could increase the number of minutes used.

Enterprise applications of voice portals couldprovide customer service, reduce costs and gen-erate new revenue streams for many busines-ses. The Goldman Sachs 2000 Mobile Internetreport indicated that there would be significantopportunity as corporations looked to supportincreasingly mobile workforces and leveragethe mobile Internet as a new sales channel. Manylarge volume and repetitive transactions (e.g.,stock trading) had already been automatedthrough touchtone dialing on the Internet, yield-ing huge cost savings.

Voice interfaces could be the next step toallow for the automation of even more services.For example, Ford and GM had identifiedthat consumers make a large portion of their cellphone calls from their vehicles and consumerswant to be connected to services such as drivingdirections. By June 2000, GM had launchedOnStar, a button on the dashboard of GM carsthat connected drivers to audio driving services.As of 2000, live agents answered OnStar calls,but automated voice solutions could reduce carmakers’ call centre costs and allow for location-specific services. In the travel industry, 24-houraccess to flight information, ticket purchase ortraffic updates could all meet customer needs.Voice automated services would make theseservices available without the high cost of callcentres. Furthermore, pure Internet companiescould use voice interfaces to extend their brandand services into the offline world. For example,Yahoo by Phone would allow non-Web usersaccess to Yahoo’s services.

QUACK’S POSITION

Quack was founded to focus on the public voiceportal markets. Quilici and the managementgroup envisioned bringing the utility and conve-nience of voice portals to customers everywhere.

On March 31, 2000, Quack’s services werefirst offered to the public. Launched in theMinneapolis/St. Paul twin city area, Quack wasthe first public voice portal in the world. Quackoperated a toll-free number (1 800 73 QUACK)for its customers and used the service as a testingground for its technology. With the success of thepilot project, on April 10, 2000, Quack quicklyfollowed by offering the first nationwide (U.S.)voice portal, thus beating its competitors by merehours.

As of April 10, 2000, Quack’s voice portaloffered nationwide weather, news, traffic, sports,stock and movie information. Quack also allow-ed users to personalize the voice portal. A usercould visit the Quack Web site and create a free“account” with their own preferences. Theuser could then access the Quack voice portaland use their account name to automaticallyreceive predetermined stocks, weather or otherinformation.

Quack’s major competitor, Tellme Networks,launched its nationwide voice portal on April 10,2000, the same day. Tellme’s voice portal offerednationwide personalized restaurant, movie,airline, stock, news, sports, weather and trafficinformation. Tellme offered one added servicenamed “phone booth.” After calling the toll-freeTellme access number, users were allowed freetwo-minute calls to anywhere in the UnitedStates. In an early trial of the Tellme service,users had to first sign up for the service on theInternet. Quack’s portal did not have this sign-uprestriction, making its service accessible to theentire offline population of the United States.

Financial Position

Like many of its peers, by June 2000, Quackhad yet to turn a profit. Moreover, it had pro-duced no revenue (see Exhibit 3). The companywas burning funds at a rate of $600,000 permonth. Voice portals had four types of costs: cus-tomer acquisition, infrastructure, telephony anddevelopment costs, of which customer acquisi-tion costs were by far the largest. Customeracquisition costs were predominantly sales and


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BALANCE SHEET (1999)

AssetsCurrent assets

Cash and cash equivalents $12,538 Short term investments in marketable securities —Accounts receivable 815,000 Prepaid expenses —

Total current assets 827,538

Property and equipmentComputer and equipment 2,500,000 Furniture and fixtures 50,000 Leasehold improvements 60,000

2,610,000 less: accumulated depreciation 390,000

Net property and equipment 2,220,000

Total 3,047,538

Liabilities and Shareholder’s Equity

Current liabilitiesAccounts payable 20,000 Accrued expenses and other current liabilities 137,000 Deferred revenue —

Total current liabilities 157,000

Shareholders Equity

Convertible Preferred stock, $0.001 par value; none and 7,750,072 sharesauthorized; none and 7,738,072 issued and outstanding 8,000

Additional paid in capital 9,076,000 Accumulated deficit (6,193,462)

Total shareholders equity and liabilities $3,047,538

Net revenues $— Cost of revenues — Gross profit —

Operating expenses:Sales and marketing (Customer acquisition) 3,156,000 Telephony expenses 1,656,000 Product development 1,272,000 General and administration 708,000 Amortization of computing infrastructure 390,000

Total operating expenses 7,182,000

Income (loss) from operations (7,182,000)Investment income —

Income before tax (7,182,000)Provision for taxes —

Net income (loss) (7,182,000)Net loss per share (0.32)Shares used in computing net loss per share $22,541,000

Exhibit 3 Income Statement (1999)

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marketing expenses. This involved businessdevelopment and publicizing the public voiceportal. Quack employed two sales peopleselling advertising and two business develop-ment people selling partnerships. The companydefined an acquired customer as a customerwho registered with Quack for personalizedvoice portal services. This service was free tocustomers but allowed Quack to charge a pre-mium to sponsors for more targeted advertising.

As of June 2000, 20,000 visitors had cometo the voice portal during the first two monthsand 200 of them had registered for personalizedvoice portal services.

In June 2000, Quack was in need of furtherfunding to continue operations. The founders ofthe firm went on a road show to promote theircompany to all the major venture capitalists inSilicon Valley. Leading venture capitalists suchas Sequoia Capital, Media Technology Ventures,Softbank, Atlas Ventures and Draper FisherJurvetson were all unreceptive to the deal. Thiswas worrisome for Quack for two reasons: first,the company was running out of money withonly three month’s of cash reserves left; andsecond, two of Quack’s major competitors hadjust closed funding deals for over $50 milliondollars each.

With a user population parallel to that of itsbiggest competitor (Tellme Networks) Quackwas currently tied for the market leadershipin voice portals. However, after the first fewmonths of running the Quack voice portal, thebusiness-to-consumer (B2C) model for voiceportals seemed to be showing signs of weakness.Quack’s management believed that the failure ofits road show could be related to its B2C focus.

The stock market already had reflected disap-pointment in Internet business models. On June1, 2000, Nasdaq index shares closed at $87.375per share, down from a high of $221.625 pershare on March 17, 2000. Leading Internet bulls,such as Goldman Sach’s Chief InvestmentStrategist Abby Joseph Cohen, were temperingtheir earlier optimism about Internet stocks.Government agencies were even beginning toscrutinize the new economy companies—most

notably, an antitrust ruling against Microsoft’smonopolistic activities. The B2C sector wasbeing hit hardest; online retail pioneers suchas Cdnow.com and Peapod admitted they wouldhave to fold if they couldn’t raise more funding.

It was also becoming apparent that, based onexisting revenue models, the cost structure forvoice portals was too steep to be profitable.Falling advertising rates lowered Quack’s esti-mated revenue per customers. This increased thenumbers of customers needed for Quack to breakeven. The new projected number of customersrequired for Quack to break even was consideredunrealistic by management (it required a highlyoptimistic 90 per cent+ penetration of target mar-ket in the United States). Moreover, it was pre-dicted that advertising rates would continue tofall. Quack had to lower its costs (beginning withthe largest cost, customer acquisition) or findnew revenue streams.

Quack’s executives examined new revenuemodels for voice portals such as subscriptionfees, but Quack’s competition was already offer-ing voice portal services free of charge. Anothersuggestion was to find a company with an exist-ing subscription-based revenue stream thatmight want to add to its product offering byincluding Quack’s voice portal for an additionalfee. In this scenario, Quack could sell or leaseits portal technology to businesses, so that busi-nesses could differentiate their product or servicein the marketplace.

Quack began to look more closely at a busi-ness-to-business strategy. Discussions began withvarious businesses and enterprises interestedin voice applications. On May 22, 2000, the firstmajor business deal was struck between Quackand Lycos. Lycos, a Web media company andInternet portal, licensed Quack’s technology tooffer its Web content over the phone. It was thefirst of the major Internet portals to move into thevoice portal market.

But Quack’s management was still unsureabout which strategic direction was most appro-priate. Both B2B and B2C strategies wereunder way. The company was founded with thegoal of delivering a voice portal to the masses.


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The technology and development teams weremotivated and driven to produce a consumer por-tal. Although it might be the path to profitability,B2B was not nearly as appealing as a consumerbusiness to Quack’s staff. Quack’s technologydevelopment team, in particular, was motivated todevelop a public portal. A strategy shift to empha-size the B2B market might be interpreted by thetechnology development team as “selling out.”The technology developers were the key asset ofthe company and would be almost impossible toreplace in the short term. The fiercely competitiveenvironment had made development engineersfor voice portals highly in demand.

MARKET CONDITIONS

The marketplace for voice portals in mid-2000appeared turbulent and unstructured. Becausethe market was still in its infancy, the industry’sboundaries were still undefined. Many playersfrom very different industries were clashingfor dominance in the voice portal space. Majorplayers included the pure voice portals, Internetportal/new economy media companies, telecomcarriers and the speech recognition companies.

Voice Portals

Tellme Networks

Tellme Networks (Tellme) offered servicessimilar to Quack’s at 1800 555 TELL. First tomarket alongside Quack, as of June 2000,Tellme’s service required online registration. ByJuly 2000, this was expected to change afterTellme completed its systems testing. In June2000, Tellme was tied with Quack for dominanceof the public voice portal market.

Tellme had impressive financial backing;Benchmark Capital, Kleiner Perkins Caufield &Byers and The Barksdale Group were all earlyinvestors in the firm. These were leading and well-known venture capital firms in the United States.The company had been started by expatriates ofMicrosoft and Netscape. Parts of both the Internet

Explorer and Netscape Navigator design teamscame together in the creation of Tellme. The high-profile management team and financiers of thecompany gave Tellme a prominent position in themedia. Moreover, Tellme undertook an aggressivebranding campaign, making it the best-knownbrand in voice portals as of 2000.

Tellme was also the best funded of the voiceportals. With $188 million in venture funding,Tellme’s “war chest” scared many competitors inthe industry. In May 2000, for example, Tellmeraised another $50 million (at an estimated valu-ation of $600 million) from AT&T. The invest-ment was in the form of telephone access andminutes, essentially erasing Tellme’s telephonycosts for the next 10 years. Although still focusedon its public voice portal, this funding deal indi-cated Tellme’s receptiveness to working withtelecom companies. It also gave credibility to thevoice portal business.

BeVocal Inc.

BeVocal Inc. offered products and servicesfor the voice application market. It ran a freeconsumer voice portal (1800 4B VOCAL), offeredprivate label work for telecom companies andenabled existing Web sites with voice features.Although trailing Quack in the consumer voiceportal area, BeVocal had more experience in sell-ing voice technology to businesses. In May 2000,BeVocal also raised $45 million from Mayfieldfund, U.S. Venture Partners, Technology CrossoverVentures and Trans Cosmos USA. For descriptionsof other voice portals see Exhibit 4.

Internet Portal/New Economy Media Companies

Lycos

Founded in 1995, Lycos was a leadingWeb media company and owner of the LycosNetwork, one of the most-visited hubs onthe Internet, reaching nearly one out of everytwo U.S. Web users. The Lycos Network wascomposed of Lycos.com, Tripod, WhoWhere,Angelfire, MailCity, HotBot, HotWired, Wired


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Company

AudiopointFairfax, Va.www.myaudiopoint.com

BeVocalSanta Clara, Calif.www.bevocal.com

HeyAnitaLos Angeleswww.heyanita.com

InternetSpeechSan Jose, Calif.www.internetspeech.com

Talk2.comSalt Lake Citywww.talk2.com

Tellme NetworksMountain View, Calif.www.tellme.com

TelSurf NetworksWestlake Village, Calif.www.888telsurf.com

Service

Launched a consumer voiceportal in April. Also offersvoice-access technology andhosting services to telecom,Internet and media companies.

Launched a consumer voiceportal in June. Also offersvoice-access hosting to Websites and other companies.

Expects to launch a consumervoice portal this fall. Offers anASP option, hosting andlicensing voice technologyto telecoms and others.

Its NetEcho consumer voiceportal lets callers hear info,listen to any Web site orcheck Web-based e-mail.Recently launched technologyfor dot-coms to voice-enabletheir Web sites.

Built technology slatedto launch in the fall forcompanies to providephone-based voice accessto info on a corporate intranet,including e-mail and otherdata behind a firewall. Isdeveloping private-label voiceportals for wireless carriers.

Launched a consumer voiceportal in late July with news,sports, restaurant lists andmore, from content providerssuch as CNN, ESPN andInfoUSA. Also offers open-source based voice-accessdevelopment services.

Expected to launch aconsumer voice portal. Willalso private-label the portal towireless carriers, ISPs, portalsand others.

Fees

The consumer service isfree. Audiopoint chargessetup and monthly fees;shares transactionrevenue.

Consumer service is free.Charges setup fees forhosting, monthly fees forserver capacity andtransaction fees.

Voice hosting includesone-time setup fee and7 to 12 cents per minute;licensing includes feesper line or port.

Plans to chargeconsumers $29.95 amonth for approximatelysix hours of use;software licenses includean undisclosed one-timefee and royalties.

Prices not yetdetermined.

The consumer serviceis free. Tellme chargesbusiness customersper-minute or per-lineusage fees, and willeventually collecttransaction fees.

The company’s consumervoice portal will be freewith ads, or 6 cents aminute without; prices forTelSurf’s private-label voiceportal haven’t been set.

Customers

Won’t disclose thenumber of customers forconsumer voice portalor for private-label andhosting.

In pilot tests withunnamed wirelesscarriers, retailers,financial services andtravel companies.

Has partnerships withKorea Telecom and SKTelecom to createconsumer voice portalsin Korea.

It’s testing its consumervoice portal with200 customers; alsonegotiating with severalunnamed Fortune500 companies.

Talk2 is testing itsenterprise services withseveral unnamedcorporate customers andthree wireless carriers.

Handled more than1.5 million calls to itsconsumer voice portalsince starting tests inApril. First businesscustomer is Zagat.

TelSurf is testing itsprivate-label voice portalwith undisclosedcustomers in the U.S.and Latin America.

Exhibit 4 Competition

Source: www.thestandard.com

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News, Webmonkey, Suck.com, Sonique, Quote,Gamesville and Lycos Zone. Lycos, Inc. was aglobal Internet leader with a major presencethroughout the United States, Europe, Asia andLatin America.

On May 22, 2000, through an agreement withQuack, Lycos became the first Internet portal tooffer voice services. The agreement gave much-needed exposure to Quack and its services, butwas rumored to be financially unattractive. Itwas believed that Quack had accepted a “stan-dard Internet deal.” Quack received a percentageof advertising revenue and a fee based on theusage of the voice portal. In this scenario, Quackassumed all the cost risk.

Yahoo

Yahoo was a global Internet media companythat offered a branded network of comprehensiveinformation, communication and shopping ser-vices to millions of users daily. The first onlinenavigational guide to the Web, www.yahoo.comwas a leading guide in terms of traffic, advertis-ing, household and business user reach, and wasone of the most recognized brands associatedwith the Internet.

Yahoo did not offer any voice or phone accessservices. However, Yahoo’s strong brand, largeuser base and skill at packaging and running aconsumer portal might be leveraged for profit inthe voice portal market. Moreover, with a marketcapitalization of $70.95 billion in June 2000,Yahoo had the financial resources to enter newmarkets.

AOL

AOL America Online was a world leader ininteractive services, Web brands, Internet tech-nologies and electronic commerce services. Thecompany operated two worldwide Internet ser-vices (America Online and Compuserve) severalleading Internet brands including ICQ, AOLInstant Messenger and Digital City, the NetscapeNetcenter and AOL.com portals, and NetscapeCommunicator and Navigator browsers. After

merging with the Time Warner media companyin June 2000, extensive content and cable prop-erties were added to its portfolio.

In the voice portal space, AOL ran AOLMoviePhone, the nation’s largest movie listingguide and ticketing service. MoviePhone wasoperated through touch pad entries but wasrumoured to be investigating voice technologiesto reduce costs and increase functionality.Moreover, as the largest subscription fee-basedInternet service providers, AOL presented anattractive and valuable user base for the voiceportal market. AOL was also financially power-ful. With a share price of $53.75 per share andmarket capitalization of $238.7 billion, AOL alsohad the financial resources to enter new markets.

Speech RecognitionTechnology Companies

Speechworks International, Inc.

Speechworks International, Inc. was a leadingprovider of over-the-telephone automated speechrecognition solutions (products and services).Speechworks provided the voice recognition“back-end” software for the Quack technology.

Speechworks’ focused on businesses that wereaiming to harness the value of voice recognitiontechnology. Speechworks built custom solutionsfor businesses that were generally focused onone application. This was different from Quack’svoice solution which was a multi-applicationplatform that dealt with the higher complexity oftasks at the same time. Quack did not competewith Speechworks or its competitors.

Speechworks had built the voice applicationsfor E*trade, Amtrak, Apple Computer, MapQuest.com, United Airlines, MCI WorldCom andNortel Networks.

Nuance Communications Inc.

Nuance Communications Inc. developed, mar-keted and supported a voice interface softwareplatform that made the information and servicesof enterprises, telecommunications networksand the Internet accessible from any telephone.


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The software platform consisted of softwareservers that ran on industry-standard hardwareand performed speech recognition, natural lan-guage understanding and voice authentication.Nuance was Speechworks’ major competitor andprovided the back-end technology to bothBeVocal and Tellme.

Nuance also focused on selling to businesses.Its technology enabled the voice applicationsof Charles Schwab & Co., Fidelity Investments,American Airlines, Sears and telecommunicationscarriers such as British Telecommunications.

Both speech recognition companies hadstrong core competencies in voice recognitiontechnology. In the B2B voice portal industry,they were dominant players but neither wasexpected to enter the consumer voice portalindustry. Although Nuance and Speechworksoffered a different product and service fromQuack, these companies’ long list of blue chipclients might make entrance to the B2B voiceportal market more difficult.

Telecommunication Carriers

AT&T Corporation

AT&T Corporation provided voice, data andvideo communications services to large and smallbusinesses, consumers and government entities.AT&T and its subsidiaries provided domesticand international long distance, regional, localand wireless communications services, cabletelevision and Internet communications services.AT&T also provided billing, directory and callingcard services to support its communications busi-ness. AT&T’s primary lines of business werebusiness services, consumer services, broadbandservices and wireless services.

AT&T had already showed an interest in voiceportals when it invested $50 million in TellmeNetworks. The investment was made in the formof an undisclosed amount of telecom access andminutes. It was also rumored that AT&T wouldgive Tellme control of directory assistance on itsnetworks. This would give unparalleled exposure

to Tellme’s voice portal. Every caller lookingfor directory assistance would reach the Tellmeportal.

Verizon Communications

Verizon Communications, the newly createdname for the June 30, 2000, merger between BellAtlantic and GTE, was one of the world’s lead-ing providers of communications services. With95 million access lines and 25 million wirelesscustomers, Verizon companies were the largestproviders of wireline and wireless communica-tions in the United States. Verizon’s global pres-ence extended to 40 countries in the Americas,Europe, Asia and the Pacific.

Among the largest telecom carriers, Verizondid not offer voice portal services. However, with120 million customers in the United States,Verizon was an attractive potential customer whocould greatly leverage voice portal technologyacross its user base.

Over all, analysts were unsure who woulddominate this emerging marketplace. AlthoughQuack had been first to market, Tellme had suchstrong media and financial backing that no clearmarket leader existed. Moreover, the existingInternet portals had such strong brands and largeuser bases that their entrance into the marketcould destroy the fledgling voice portals.Aggravating this confusion were the telecomcarriers, who could lock out both the Internet andpure voice portals from the market if they choseto switch the dial tone of all phones to their ownprivate voice portals. And finally, many peoplebelieved that there did not necessarily need to beone winner in the voice portal market. Mergers,acquisitions or alliances could take place chang-ing the competitive landscape and further com-plicate a prediction of market leadership.

JUNE 2000

In June 2000, Quack executives faced manymajor decisions that could reshape the company


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and dictate the future of the firm. Withoutanother round of financing, Quack’s current burnrate would allow the company to survive justthree more months.

The company was still grappling with theissue of a B2C or B2B focus. A new revenuemodel would need to be found for the consumerportal . . . and selling voice portals to businesseswould be a difficult shift. Quack had limitedexperience selling to businesses. The companyhad been founded to deliver voice portals to con-sumers, but Quack executives now wonderedwhether or not public voice portals could ever beprofitable.

Tied to this strategic issue was the issue offinancing. As soon as a strategic direction waschosen, additional funding would be needed tokeep Quack alive. Concerned after Quack’sunsuccessful search for second round financing,the original Canadian investors in Quack hadfound an alternative offer in Canada. Led byCaisse de Depot, the largest labor-sponsored fundin Canada, a group of Canadian investors hadoffered a second round of financing to Quack at alow valuation with a high dilution of shares.

News of Quack’s financial worries spreadacross Silicon Valley. Tellme approached Quackexecutives to gauge the company’s receptivenessto being acquired. Although not a formal offer,Tellme was theorizing that there would be a sim-ilar acquisition situation as the WebMD mergerwith Healtheon. They believed that there was notroom for two players in the public voice portalmarket, but perhaps there was room for one well-funded company. Quack’s management now hadanother financing option. However, Tellme wasstill focused on the consumer portal market andQuack’s management could not foresee this busi-ness being profitable. Thus, Quack executivesthought that merging with Tellme would not cre-ate a new revenue model to make the conceptmore sustainable.

The proposed merger would be paid formostly with Tellme stock issued to Quack’s

current management and investors. Tellme’sshares were not publicly traded, and a lock-upperiod would exist during which Quack’s man-agement and investors would not be able to selltheir stock. Quack’s investors would have to waitto sell their shares in Tellme. For this reason, thesustained profitability of a merged Tellme/Quackwas a concern for Quack management.

Alex Quilici slumped into his chair as heconsidered his decisions. Perhaps he had otheroptions. Alliances or mergers with other compa-nies that could lower Quack’s costs or createnew revenue streams might be more attractivethan the Tellme offer. There was also the optionof continuing operations without funding.Whether operating in the B2B space, B2C spaceor both, if one venture deal was being offered,new offers would be available in the future. Thisassumed that Quack continued its leadership andinnovation in its market. These funding offerswould also presumably be at a higher valuationand lower dilution than the Caisse de Depot deal.

In the interim, there were alternative financingoptions to extend the life of the company. Oneexample was a phenomenon developed inCalifornia called “Silicon Valley Financing.”Although computer companies scrutinized smallpersonal computer purchases, multimillion-dollarpurchases would be given to companies on credit.This credit allowed companies three months topay. After running out of funding, Quack couldcontinue to purchase all of its needed hardwarewithout paying for three months. Many “cashstrapped” technology companies used this tactic.Although a short-term solution, an extra threemonths of operations could be financed this way.However, would an extra three months reallysolve Quack’s problems?

NOTE

1. All funds are in U.S. currency.


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In February 1999, the corporate offices ofPharma Technologies Inc. (PTI) were housed inthe biosciences complex at a major medicalresearch University in Canada. In spite of thecramped conditions, the excitement at the fledg-ling company was palpable. PTI had recentlyobtained a patent for a revolutionary approach tothe treatment of sexual dysfunction. This tech-nology would form the basis for a new oral ther-apy to treat male erectile dysfunction (MED).Drs. Mitchell Abram, Justin Hall and JeffreyBlair, the University scientists responsible for thediscovery, believed their approach would equalor surpass Pfizer’s widely acclaimed Viagra™ asthe preferred treatment for this condition.

Blair Glickman, who had joined the companyin June 1998 as president, shared their convictionand saw great potential to leverage their propri-etary technology into other new businesses:

We are consumed right now by short-term mile-stones, but when I think of what PTI will be in thefuture, I don’t want us to be defined narrowly as acompany focused on the sexual dysfunction mar-ket. I hope that PTI will be in a position to apply itsknowledge of peripheral vascular disorders to otherareas, like congestive heart failure, renal failure,and even male pattern baldness. I envision PTI asestablishing a series of comprehensive partneringagreements around our platform technologies.

Although everyone in the company wasenthused about the future potential, they werealso fully aware of the pressures for day-to-day results. The $2 million representing thefirst tranche of PTI’s financing would run outin about nine months. In order to access thesecond tranche of $3 million, Glickman and histeam had to ensure that the company achieved

the rigorous technical and business milestonesset out by its investors.

The path of progress was both slow and wind-ing. While PTI had obtained a “method of use”patent giving it exclusive rights to use Factor Xfor the treatment of sexual dysfunction, it did notactually own any of these compounds. Therefore,a critical technical milestone for PTI was to com-plete the technologically sophisticated and time-consuming studies associated with screeningvarious compounds for use in PTI’s oral therapy.On the business side, this also meant negotiatingan agreement with the owner of the compoundfor subsequent co-development of the product.The PTI management team felt that there wouldbe considerable interest in their technology. Thecombination of PTI’s method of use patent withthe right compound could result in a drug capa-ble of generating sales in the billions of dollars.

Glickman faced a short window of opportu-nity: competing technologies were already inexistence and new alternatives were under devel-opment, most by major pharmaceutical firms.PTI needed to make substantive progress whilethe sexual dysfunction market was still attrac-tive and before all of their existing capital wasdepleted. In addition, the company had a varietyof other exciting technologies that were in vari-ous stages of the patent application process. Thequestion facing Glickman was how to proceedand which issues should receive highest priority.

THE CONDITION OF SEXUAL DYSFUNCTION

Sexual dysfunction is the inability or unwill-ingness to engage in sexual intercourse. Inmen, this condition is easily diagnosed as male


PHARMA TECHNOLOGIES INC.

Prepared by John Herbert under the supervisionof Professors Charlene Nicholls-Nixon and Rod White

Copyright © 2004 Ivey Management Services Version: (A) 2004-09-21

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erectile dysfunction (MED), the clinical inabilityto obtain and hold an erection sufficient forintercourse.

In addition to being strongly related to age,sexual dysfunction in men was also associatedwith the patient’s physiological/organic, neuro-genic and psychogenic condition. Physiologi-cal or organic conditions such as hypertension,diabetes and excess cigarette/alcohol consump-tion were the most common causes of MED.Neurogenic conditions such as multiple sclerosisand spinal cord injuries were also related toMED. Finally, the cause could be psychogenic innature due to stress, anxiety or conflict.

In October 1998, it was estimated by Cowen& Company, a privately held research firm, thatthere were approximately 10 million to 20 mil-lion MED suffers in the United States. Femalesexual disorders (FSD) were more complex andmore difficult to diagnose. However, the FSDmarket was believed to be equal in size.

In February 1999, the Journal of the AmericanMedical Association published a report on“Sexual Dysfunction in the United States.” Thereport cited studies’ indicating that sexual dys-function was highly prevalent, ranging from10 per cent to 52 per cent of men and 25 per centto 63 per cent of women. The report also citedprior studies, which had showed that 34.8 percent of men aged 40 to 70 years suffered frommoderate to complete erectile dysfunction. TheNational Institutes of Health Consensus Paneldescribed erectile dysfunction as an importantpublic health problem.

THE MARKET FOR

TREATMENT OF SEXUAL DYSFUNCTION

The market for treatment of sexual dysfunctionwas believed to hold considerable potential.Cowen and Company’s 1998 report on the out-look for therapeutic categories suggested that theworldwide MED market was valued in excess of$1 billion in 1998, with approximately five percent to eight per cent of the roughly 55 millionsufferers undergoing treatment. This market was

forecast to grow to almost $8 billion by 2002. Itwas believed that this growth in the MED marketwould occur as the number of sufferers grew to80 million and as the percentage seeking treat-ment increased to over 20 per cent due to moreefficacious and convenient treatments as well associal acceptance.

The MED market was traditionally dominatedby injectable and topical therapies. This changedin 1998 with the entry of Pfizer’s Viagra™, thefirst breakthrough medication in the oral market.At $10 per pill, and prescriptions ranging from10 to 50 pills, Viagra™ captured 36,000 pre-scriptions in the first week it was on the market.

According to Cowen and Company, oraltherapies would grow to represent an estimated90 per cent of the MED market. This methodof therapy, useful in mild to moderate cases ofMED, was usually administered first regardlessof the severity of the MED due to its ease of use.It was expected that oral therapies would con-tinue to dominate in the future with an estimatedmarket share of 93 per cent by 2002.

The report also observed that more invasivetreatments for MED, such as injectable andtopical therapies, had lost market share to oraltherapy and represented only nine per cent ofthe MED market in 1998. These therapies wereprojected to continue being used only in themore severe cases of sexual dysfunction andwere expected to retain approximately six percent of the MED market in 2002.

Finally, the market for implants and surgerywas estimated at only one per cent and was notexpected to change, since this form of therapywas reserved for patients with no other treatmentoptions.

COMPETITION IN THE

MARKET FOR ORAL THERAPIES

Cowen & Company’s report, “TherapeuticCategories Outlook,” predicted an increasinglycompetitive market for oral therapies. In 1998,Pfizer’s Viagra™ was the sole player in the oralMED market capturing sales of $850 million.


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Viagra™, a drug initially developed to treathypertension, was projected to continue todominate even as new competitors entered theoral market. It was expected to capture at least75 per cent of a much larger oral MED market in2002, producing sales of over $5 billion.

It was anticipated that Schering-Plough/Zonagen would enter the oral market in 1999with a product called Vasomax™, which wasadministered sublingually. This product workeddifferently than Viagra™ using a compoundcalled phentolamine to enhance blood flow inthe penis. Vasomax™ was in the late stages ofphase III clinical testing. Although it appeared tobe less effective than Viagra™, Vasomax™ hadfewer side effects. As a result, it was predicted thatVasomax™ could capture approximately 15 percent of the oral market by 2002.

Takeda Abbott Pharmaceuticals’ (TAP) alsohad a product in Phase III of clinical testing.TAP’s product, based on a compound calledapomorphineSL, was expected to enter the marketin 2000. This method of treatment worked inthe central nervous system, but had not yet beenproven to be as effective as Viagra™. TAP’sapomorphineSL-based product was predicted tocapture approximately 11 per cent of the oralmarket by 2002.

The Cowen report observed that severalother companies, such as Merck and BristolMyers Squibb, also had oral products with com-positions similar to Viagra™ in Phases I and II ofclinical testing. These competitors were expectedto enter the MED market within three to fouryears.

THE REGULATORY APPROVAL PROCESS

Prior to marketing a drug for the treatment ofdisease, such as MED, companies were requiredto obtain approval from each of the countries inwhich they planned to release the drug. In theUnited States, approval was granted by the Foodand Drug Administration (FDA). In Canada, theprocess was governed by the Health ProtectionBranch of the Department of Health. Because

of the difference in market size, approval inthe United States was critical to the commercialsuccess of PTI’s oral therapy for MED.

The first step in receiving regulatory approvalin the United States involved pre-clinical testingof the drug’s compounds first in vitro (in cell cul-tures) and then in vivo (in live animals hosts)to assess the toxicological and pharmacokineticproperties of the compound. Once this stage oftesting was completed, the company would filewith the FDA for Investigational New Drug(IND) status. This approval would give thecompany clearance to proceed with clinical test-ing on humans; a three-phase process, which cantake several years and cost in excess of a $100million to complete. After a drug completesall three phases of clinical trials, it is grantedNew Drug Approval (NDA) by the FDA. At thispoint, the company can begin manufacturing andmarketing the drug.

Generally speaking, it can take as many as10 years and cost as much as US$500 millionfor a compound to move through the develop-ment process from patenting to NDA approval.Only five in 5,000 compounds that enter pre-clinical testing are approved for human testing.Of those, only one in five is approved for sale.Because of the long time frame for regulatoryapproval, patents (which are usually granted atthe beginning of the development process andhave a 20-year life span) often have only a fewyears of protection remaining by the time thedrug is actually made commercially available.

The long lead times for drug development,coupled with the comparatively short life spanof patent protection following FDA approval,places considerable pressures on firms engagedin drug development to expedite the develop-ment process.

COMPANY BACKGROUND

In February of 1999, PTI occupied approxi-mately 1,200 square feet of space, comprised ofa single administrative office, a research lab andan office/lab combined space. PTI employed a


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total of four people: Terri Vaughn, executiveassistant; Blair Glickman, president; Dr. JeffreyBlair, vice-president operations/business devel-opment; Jake Randall (manager—research pro-grams). PTI also paid, on a contract basis, forthe services provided by John Ross, the com-pany’s part-time chief executive officer (CEO),and Drs. Hall and Abram, the principal scientistsand founders of PTI. Hall served as the com-pany’s vice-president of clinical affairs, whileAbram acted as vice-president of research anddevelopment (R&D).

Drs. Hall and Abram had been involved in acreative research partnership long before theyformed Pharma Technologies Inc. Both men heldfaculty appointments. In his role as Professor ofUrology and member of the Human SexualityGroup at a major Canadian hospital, Dr. Hall wasinvolved in more than 20 Phase II, III and IVclinical trials involving disease states related tosexual dysfunction and reproduction. Dr. Abramheld a full professorship in cardiovascular phar-macology. Both Abram and Hall had publishedover 70 peer-reviewed papers or book chapterseach. They had also been recipients of numerousresearch grants and career merit awards.

Hall and Abram, who had worked togetherin other research and development projects forthe treatment of MED, had an idea for a productbased on a very novel technology. They tooktheir concept to a major pharmaceutical firm, butit did not go forward. So they kept their concept“secret” and continued developing the tech-nology independently. The thesis work ofDr. Jeffrey Blair, a PhD student of Mike Abram,provided the basis for the initial technology plat-form around which Pharma Technologies Inc.was formed. Blair received his PhD in 1997 incardiovascular pharmacology and had receivedresearch traineeship awards from organizationssuch as: the Heart and Stroke Foundation ofCanada, the Canadian Hypertension Society andPfizer/Medical Research Council of Canada.

In early 1996, Drs. Blair, Hall and Abrambegan working with the University’s incubatorfacility to obtain patent protection for theirtechnology. It was through this facility that they

met Glickman. Glickman, who was working asvice-president of commercial development, hadbeen involved in the formation, financing andgrowth of a number of technology-based start-upventures. His expertise included business devel-opment, patenting and licensing.

Blair, Hall and Abram were anxious toproceed with the development of their oral ther-apy for MED, but they needed a business infra-structure. With the help of Glickman and othersat the incubator, PTI was formed in March 1997.Hall commented that, although the threefounders were reluctant to accept venture capitalfinancing, they were anxious to proceed. So inexchange for an option on future equity, theyobtained $250,000 in seed capital from a venturefund specializing in medical research.

During the period between early 1996 andlate 1997, the incubator filed a total of six patentapplications, based on PTI’s technology, withthe U.S. Patent and Trademark Office (USPTO)of the U.S. Department of Commerce. TheUniversity, the registered assignee of thesepatents, subsequently granted PTI an exclusiveworldwide license to use the technologies.

In November 1998, PTI obtained seed capitalto proceed with technology development fromtwo well-known Canadian venture capital (VC)funds. Together, they provided funding of $5million in two tranches: $2 million at the time ofsigning; $3 million upon satisfactory comple-tion of technical milestones and the signing of apartnership agreement with a pharmaceuticalcompany for co-development of the technology.

Credibility with the financial and businesscommunity was an issue for PTI. At age 36,Glickman had considerable experience in thehigh-technology arena, but lacked the “grayhairs” expected by prospective commercial part-ners and investors. For this reason, the boardappointed John Ross as part time CEO inNovember 1998. Ross was a well-known andwell-respected figure in the Canadian biotech-nology industry. He had served as CEO of amajor Canadian biotechnology company andprior to that, held an executive position at amulti-national pharmaceutical firm.


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Prior to the second tranche of financingdescribed above, approximately two-thirds ofPTI’s common shares were held by the fourprincipals, Abram, Hall, Blair and Glickman. TheUniversity incubator, the PTI Trust and the initialoutside investor held the remaining one-third com-mon shares. The subsequent two VC investors heldconvertible preferred shares in equal proportions.

The board of directors was composed offive members: Ross; Glickman; Dr. Hall andone representative each from company’s majorinvestors. John Malcom, the president of theincubator, Hall and Blair also attended the com-pany’s board meetings. Blair kept the minutes.

PLANS FOR TECHNOLOGY DEVELOPMENT

PTI’s product development programs werebased upon a significant portfolio of intellectualproperty. In the area of sexual dysfunction PTIhad established two strategic product develop-ment programs, PTI Oral Therapy and PTI LocalTherapy, each targeting a distinct segment ofthe MED market. In addition, the company hada number of interesting research initiatives atearlier stages of technical development.

PTI Oral Therapy

While PTI was actively pursuing a varietyof initiatives, oral therapy represented thecompany’s most promising technology and wasclearly the immediate focus of attention. Asdescribed below, the PTI technology differedfrom Pfizer’s Viagra™ product in several impor-tant ways, which the PTI management teambelieved would provide the basis for a competi-tive advantage.

The Underlying Technology

Male Erectile Dysfunction (MED), the clini-cal inability to obtain and hold an erection suffi-cient for intercourse, occurs when blood vesselsto the penis become constricted, thereby prevent-ing the level of blood flow required to achieve an

erection. Scientists had believed for years thatthese blood vessels became constricted in men,over time, due to reduced levels of nitric oxide, amolecule that is released by the blood vesselsand causes them to remain open.

Pfizer’s Viagra™ was the first therapy toattempt to solve this problem and had been verywell accepted in the marketplace. Viagra™worked through the use of a phosphodiesterase(PDE) inhibitor, which prevented the breakdownof nitric oxide, thereby keeping the requiredblood vessels open. Research by scientists at PTIhad revealed that the breakdown of nitric oxidein these patients was only the symptom and notthe real problem causing MED.

Nitric oxide is expressed by endothelial cellsinto the smooth muscle cells of the blood vesselsin the penis. PTI scientists discovered an inverserelationship between levels of nitric oxide and theamount of Factor X, a small protein released fromthe lining of the blood vessels. As the amountof Factor X is increased, levels of nitric oxidedecrease, causing the smooth muscle cells to con-tract, thereby constricting the vasculature and sub-stantially blocking blood flow to the penis. PTIscientists believed that the solution to the underly-ing problem of MED would be to reduce the levelsof Factor X expressed into the smooth muscle, asopposed to increasing the local levels of nitricoxide. This approach would offer three distinctadvantages over the market leader Viagra™.

First, while Viagra™ increased the level ofnitric oxide throughout the body, the PTI methoddecreased the levels of Factor X only where itwas over expressed in the penis, thereby reducingthe likelihood of side effects (known or unknown)in patients. Second, because Viagra™ operatedby manipulating the levels of nitric oxide in thebody, it could not be taken by patients usingnitrate therapy to manage cardiovascular disease.In contrast, because the PTI method did not affectnitric oxide levels, it would provide a safe alter-native for these patients. Finally, because thePTI method addressed the underlying physiologyof MED, it had the potential to prevent the pro-gression of sexual dysfunction rather than justtemporarily treating the symptoms.


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Although the oral therapy was being developedinitially as an acute treatment, PTI scientistsbelieved that ongoing research would demonstrateits use as a chronic treatment which, when admin-istered in at-risk patient populations, could preventthe onset or progression of sexual dysfunction andeffectively reverse the disease process.

In April 1998, the University received U.S.patent approval for the use of Factor X in appli-cations related to the treatment of sexual dys-function. In turn, the University gave PTI theexclusive worldwide license for the technology.The company was still waiting for approval of aworldwide Patent Cooperation Treaty. This wasthe first step in the process for patent approval inapproximately 90 other countries. Companiestypically narrowed this field to a smaller subsetof countries (approximately 18) in which theythen pursued the lengthy and expensive processof obtaining full patent protection.

Development Milestonesfor the Oral Therapy

The development of a product using the PTImethod of treatment required the identification ofa compound to antagonize the action of Factor X.A research scientist at a Europen pharmaceuticalcompany first discovered the scientific potential of‘Factor X’ for this purpose in 1983. Researchers atthe company produced the first usable compoundas a result of their search for alternative therapiesfor cardiovascular disease. By 1999, at least 10major pharmaceutical firms were pursuing clinicaltesting of Factor X for treatment of a variety ofillnesses, such as congestive heart failure, hyper-tension and acute renal failure. While PTI’smethod of use patent gave the company exclusiverights to pursue the development of a treatmentfor sexual dysfunction by manipulating Factor Xlevels, PTI did not possess a Factor X compound.

The management team at PTI believed that theycould greatly shorten the development timeline fortheir oral therapy and reduce the associated costsby partnering with a firm that possessed a FactorX compound. Firms with Factor X had taken thesecompounds through various stages of pre-clinical

testing, to assess their toxicological and pharma-cokinetic properties. This testing provided valu-able information about how long the compoundwould remain in the body after it was adminis-tered, the efficacy of the compound at differentdosage levels, etc. PTI scientists believed that theywould face less of a hurdle in taking their productthrough the regulatory approval process if theycould access a compound that had already suc-cessfully passed the first one or two stages of clin-ical testing in the treatment of a different disease.

Therefore, rather than developing an FactorX compound internally, PTI’s strategy was toapproach these firms to determine if their mole-cules had potential for use in the treatment ofsexual dysfunction. Subsequently, the companyformed non-binding materials transfer agree-ments with five of these firms, involving a totalof 16 different compounds. There was no finan-cial consideration associated with the signing ofthese agreements.

Following the signing of the agreements, PTIinitiated a rigorous three-step screening process,involving the use of laboratory rats, to assess theefficacy of the various Factor X in the treatmentof sexual dysfunction. The screening processserved as a “funnel” for evaluating the com-pounds: All of the compounds would be evalu-ated at Step 1, but their performance in that stageof screening would determine whether or not theyproceeded to Step 2. Similarly, only a subset ofthe compounds that passed the hurdles in Step 2would move on to Step 3. PTI planned to rank thecompounds based on the results of the first twosteps. The third step would be conducted after apartnership agreement had been signed with theowner of one of the top-ranked compounds.

Solid scientific results were critical, sincePTI would rely upon the data from these experi-ments to prove to any prospective partners thatits method of treatment would be effective.

Development Timeline

PTI’s investors required the completion of fivemilestone activities as a condition to releasing thesecond tranche of financing: 1. Completion of


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pre-clinical efficacy studies on a target list ofcompounds. 2. Identification of two potential leaddevelopment candidate compounds. 3. Communi-cate results of pre-clinical studies to compoundowners. 4. Finalize the selection of a lead devel-opment candidate compound. 5. Negotiate acollaborative agreement for the development ofthe lead compound candidate. PTI had allocated$360,000 of its operating budget to the achieve-ment of these business milestones.

The PTI management team expected to makeprogress across several of the milestones simulta-neously. For example, the company’s projectionscalled for the completion of the screening processand the ranking of the compounds by April 1999.During this time, the PTI management teamwould also be assessing the attractiveness of eachof the potential partners from a business perspec-tive and seeking to identify a champion for theproject within each firm. Over the next fourmonths, they would conduct initial meetings withthe proposed partners to disclose the screeningresults and to discuss collaboration. An addi-tional four months would be needed to negotiatean agreement, with finalization of the partnershipagreement targeted for November 1999. Once thepartnership was formed, the PTI managementteam believed that an oral product could be on themarket within two to three years.

While the oral therapy was the primary focusof PTI’s business development efforts, the com-pany was also pursuing a program for local ther-apy and developing a novel delivery device. Bothof these initiatives were also believed to havesignificant potential.

PTI Local Therapy

The local therapy involved the development ofan injectable and/or topical product that enabledthe administration of two compounds that hadalready been approved and were available on themarket. The injectables currently available onthe market used a high level of a drug calledFactor Y, which caused pain and discomfort inpatients. PTI’s local therapy program repre-sented advancement over the current products by

combining Factor Y with a second therapeuticagent that reduced pain and improved efficacy.

PTI had the following milestones in the localtherapy program over the next 11 months:

• Select a supplier of components.• Fix components of the final product.• Obtain IND approval to conduct clinical trials.• Find a manufacturing partner for assembly,

packaging and sterilization as well as a distrib-ution partner.

PTI had reserved $215,000 of its operatingbudget for the completion of these milestonesduring the next year. Subsequently, Glickmanplanned to form a collaborative agreement with apartner in order to complete a one-year Phase IIstudy. He expected that PTI would be required tocontribute approximately $1 million toward thecost of this study.

In early 1999, PTI received notice that theexaminer for the patent pertaining to the local ther-apy had raised several broad concerns/objectionsthat would need to be addressed before the com-pany could proceed with product development.Glickman was confident that the issues raised bythe examiner could be resolved fairly quickly.

Delivery Device

Creams and suppositories had been poorlyreceived in the MED market due to low efficacyand lack of comfort. PTI was working to developa drug delivery device that did not involve a creamor suppository. This device could eventually belicensed for therapies beyond sexual dysfunction.

PTI had the following milestones for the pro-ject over the next 14 months:

• Identify formulation to be used.• Contract out development of a prototype.

Of the PTI operating budget, $472,000 hadbeen allocated for the completion of these mile-stones. This would be followed by five monthsof manufacturing trials and IND approval forclinical studies in collaboration with a partner.PTI expected to be required to contribute anadditional $50,000.


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Other Research Initiatives

In addition to PTI’s oral and local therapyprograms, the company was also pursuing anumber of other research initiatives. PTI scien-tists had discovered a method of identifying avascular condition that would help aid in thediagnosis of MED and FSD. A provisional patenthad been filed with the U.S. FDA in May 1998.PTI was also investigating other novel methodsfor the diagnosis and treatment of MED andFSD. The company intended to file a provisionalpatent application for this technology with theFDA in the summer of 1998. Finally, PTI hadbeen experimenting with a technology that couldbe used in the treatment of vascular conditions,such as premature aging of the skin.

PRESENT SITUATION AT PTI

Although PTI had sufficient capital for the nextfew months, Glickman knew that the company’scash requirements were accelerating and thatthere was significant pressure to achieve resultsin order to access the next tranche of financingfrom their investors.

Glickman projected that the first tranche of$2 million would be exhausted by November1999. At present, PTI’s burn rate for its baselineoperation was around $50,000 per month. Thiscovered payroll, consulting fees, administrationand overhead expenses. Over the next few monthsthough, the company needed additional cash topay for contract research associated with the con-tinued development of the oral therapy product.Specifically, PTI was committed to expendituresin the neighborhood of $360,000 over the next sixmonths to advance the milestones on this project.There was an additional liability of $200,000 forresearch being performed off-site to advancespecified milestones contained in their mostrecent financing agreement.

In order to access the second payment of$3 million, Glickman needed to have a commit-ment from a corporate partner. PTI’s main chal-lenge was to complete its screening process so

that it would be possible to identify a suitablepartnership candidate. Timing was critical. Apartnership agreement had to be reached andresults obtained before competing therapiesentered the market, before the company’s moneyran out, and before PTI’s patent was challenged.

Achieving Key Scientific Milestones

In late January 1999, Jake Randall, a PhDcandidate in pharmacology, had been hired asthe manager of research programs. By February,Randall had completed Step 1 of the screeningprocess on 12 of the 16 compounds. Two com-pounds had failed to make it through Step 1 and 10compounds had been advanced to Step 2. Whileit was taking longer than anticipated to test themolecules, Randall’s mandate was clear: he had tofinish the screening of the Factor X compounds byApril so that the company would be in a positionto complete negotiations for co-development ofthe product by the November deadline.

Forming a Partnership Agreement forCo-development of the Oral Therapy

One of the key issues surrounding partnerselection was whether PTI should proceed withtechnology development vis-à-vis out-licensingor in-licensing. Integrated pharmcos would bemore likely to push PTI to out-license its tech-nology, while smaller firms would be more will-ing to allow PTI to in-license their technology.

Under an out-licensing agreement, the targetfirm would obtain a license for PTI’s oral therapytechnology. The responsibility for the clinicalresearch program would reside with the partnerfirm, with the possibility that a portion of it wouldbe contracted back to PTI. From Glickman’s per-spective, this was less appealing because it meantthat PTI would be giving up control and revenue-generating potential. However, partnering with anestablished and integrated pharmaceutical com-pany offered the potential for PTI to leverage itschance of future success by obtaining support tolaunch all of its research initiatives, rather thanbeing restricted to only two or three.


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Under an in-licensing agreement, the targetfirm would grant PTI a license to use its FactorX compound as the basis for developing an oraltherapy. PTI’s scientists would perform theresearch required to take the product throughcompletion of Phase II clinical trials. The finalstages of clinical testing, production, distributionand marketing would then be licensed to a thirdparty. All three partners would then share in theproceeds from the sale of the end-product.

There was also the possibility of a collabora-tive agreement between PTI and a small pharmcoto jointly take the product through Phase II clini-cal testing. The advantage to this approach wasthat PTI could retain some control over the devel-opment process, although to a lesser extent thanwould be possible with an in-licensing agreement.The final stages of clinical testing and commer-cialization would either be turned back to the part-ner or licensed to a third party for completion.

The resources and capabilities to be offeredby a partner varied considerably across the firmsbeing considered by PTI, depending on their sizeand commitment to the sexual dysfunction mar-ket. To the extent that the target firm did not havean established position in the market, Glickmanand his colleagues would have to work harder topersuade the firm of the huge market potentialfor their oral therapy. Moreover, they would haveto be able to demonstrate the benefit of partner-ing with PTI, in terms of the reduced costs ofproduct development (PTI had already done the

pre-clinical research) and the shorter time framefor regulatory approval associated with using aproven Factor X compound.

The size and resource position of potentialpartners would also affect the ability of the end-product to achieve market penetration. Hall noted:

It is more than the compound that matters. It’s allabout timing. We are concerned about our oraltherapy being the only drug in its class; the onlytreatment operating on the principle of Factor Xreduction. In contrast, there will be three drugs inthe same class as Viagra™. I am concerned that ifour product is the only one in its class, it will notget noticed. A single drug could also be out-marketed by Viagra™. We need a top 20 companyin order to make sure that our product can competeeffectively. Alternatively, there is space for morethan one Factor X drug to compete. Another thingwe could do is arrange non-exclusive licenses toavoid being the only one in our class.

Blair saw the decision differently. He wasconcerned that the search for a large, establishedplayer would lengthen the time frame for productdevelopment:

In a large company, it takes a long time to figure outwhom you have to talk to; find the right people withdecision-making authority. You need to be assuredof proper diligence and movement, or your deal willget lost. It might make sense to look at an interme-diate company to co-develop the technology, ratherthan going right away to a multinational company.


ALPES S.A.: A JOINT VENTURE PROPOSAL (A)

Prepared by David T.A. Wesley under the supervisionof Professors Henry W. Lane and Dennis Shaughnessy

Copyright © 2006, Northeastern University, College of Business Administration Version: (A) 2006-02-07

As Dennis Shaughnessy, senior vice-president(VP) for Corporate Development and generalcounsel for Charles River Laboratories (CRL),

prepared his presentation to the company’s boardof directors,1 he wondered how the board wouldreact to his request to invest up to $2 million in a

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Mexican joint venture (JV) to create a state-of-the-art specific pathogen-free (SPF) egg farm.

Shaughnessy believed that the productionand pre-incubation of SPF eggs for interna-tional agricultural vaccine companies in Mexicorepresented a long-term growth opportunity forCRL. The proposed joint venture with ALPES,a family-owned company that provided animalhealth products and services, would allow bothcompanies to more aggressively exploit thisopportunity and offered attractive financialreturns for both partners.

Shaughnessy knew that to win over theboard, he would also need to win over the supportof company chief executive officer (CEO) JimFoster. Without it, the JV would never come tofruition. But Foster viewed the proposed jointventure as a potential distraction for SpecificAntigen-Free Avian Services (SPAFAS) as itcontinued to expand rapidly in the United States.He also worried about the risks of investing in acountry like Mexico, with an unstable currencyand an uncertain market. He was especially con-cerned about the plan to partner with a small,family-owned company that was not making anew investment of their own, but rather relyingsolely on CRL’s capital to fund the project.Finally, after nearly 50 years in business, CRL hadnever successfully conducted business in Mexico.

CHARLES RIVER LABORATORIES

Founded in 1947 by Henry Foster, Charles RiverLaboratories was the global market leader in thecommercial production and supply of laboratoryanimal models for use in discovery research andthe development and testing of new pharmaceuti-cals. Foster took his company public in 1968, rais-ing $3 million. In 1981, Foster sold the companyto Bausch and Lomb (B&L) for $110 million.

Henry Foster continued as CEO under B&Luntil his son Jim succeeded him in 1992. JimFoster was eager to expand the company but,at the time, B&L had been experiencing itsown challenges, and was reluctant to investthe needed capital. Nevertheless, Charles River

Laboratories remained one of B&L’s mostprofitable divisions, at times contributing morethan 10 per cent of B&L’s corporate net income.

The company’s strategic growth objectivewas to grow its existing businesses by between12 per cent and 15 per cent annually and itsentire business by 20 per cent. This plan left a“strategic growth gap” of five per cent to eightper cent each year. Charles River Laboratoriesthen pursued technology platform acquisitions,joint ventures, technology licensing and strategicpartnerships to fill the gap.

Charles River Laboratories served customersin more than 15 countries worldwide. Thesewere primarily large pharmaceutical compa-nies that, together with biotechnology firms,accounted more than 75 per cent of Charles RiverLaboratories’ sales. The remaining customersincluded animal health, medical device anddiagnostic companies, as well as hospitals, aca-demic institutions and government agencies. As aresult of its leadership position in the industry,CRL had not lost any of its 20 largest customersin more than 10 years. The company’s largestcustomer accounted for less than three per cent oftotal revenues.

Specific Antigen-FreeEggs and Avian Services

CRL’s entry into avian services traced itsbeginning to Shaughnessy’s visit to Merck’sNew Jersey headquarters to discuss the pharma-ceutical company’s use of CRL animal models.Over lunch, one Merck executive offhandedlyremarked that they had to do something about“that old chicken farm.”

Shaughnessy was puzzled. “Why on earthdoes Merck own a chicken farm?” he asked.

“Well, we have been developing poultryspecies to help us better understand genetics,”replied the Merck executive.

Now, of course, we’re doing our genetic workin mice, but we still have these chicken farms.Currently, we’re using the farms to produceSPF eggs that we use to make those few human


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vaccines left that haven’t converted over to newertechnology for their production, and what remainsof our agricultural vaccine operations.

Contaminated poultry posed a serious risk tohuman health. The U.S. Department of Agricultureestimated that such bacteria caused more thanfour million illnesses and up to 3,000 deaths eachyear.2 For that reason, poultry had to be vaccinatedagainst pathogens that were harmful to humans,including salmonella and campylobacter.

Material for vaccines used to inoculate poultrywas produced when a target virus was injected intofertilized eggs. As the eggs matured, they becamenatural bioreactors in which isolated pathogensexpanded geometrically. Specific pathogen-freeeggs were raised in controlled environments thatwere free from common bacteria, viruses andother contaminants. These “biosecure” environ-ments3 were important for the production of poul-try vaccines, since contaminated chicken eggsoften contained antibodies that killed the targetvirus. Contaminated eggs also posed the risk ofintroducing unwanted pathogens into the vaccine.

Shaughnessy was intrigued. He wonderedaloud, “Well, we raise lots of mice as you know.Maybe we would be good at raising chickens.”“Then why don’t you buy it?” replied one Merckexecutive, who had for some time been seeking abuyer for SPAFAS. Shaughnessy agreed to meetwith the head of SPAFAS to further discuss thematter.

Charles River Laboratories eventually agreedto acquire SPAFAS from Merck for $6 millionin cash, an amount roughly equal to the busi-ness’s annual revenues. During the due diligenceprocess, Shaughnessy learned that some humanvaccines were still produced in eggs.

Companies that produced influenza vaccinesalone consumed more than 100 million eggsannually, although nearly all of these were notSPF eggs, but rather standard farm-grade eggs.4

Shaughnessy recalled:

When we bought SPAFAS, our grand schemewas the conversion of production of inactivatedhuman vaccines like flu vaccine, from commercial

eggs to SPF eggs. That will dramatically increasedemand for SPF eggs, and the business will growdynamically.

Convincing human vaccine producers toswitch to SPF eggs proved to be a Herculeantask. At a cost of pennies per egg, farm-gradeeggs were significantly cheaper than SPF eggs,which could cost as much as a dollar per egg.Shaughnessy quickly realized that convincingCRL’s traditional vaccine customers would bemore difficult and time consuming than firstimagined. In the meantime, opportunities forgrowth were limited to agricultural applications,principally avian vaccines sold to the integratedpoultry companies. As a consequence, potentialmarketing synergies between SPAFAS andCharles River Laboratories were less than antic-ipated. With projected annual poultry industrygrowth set at a lethargic three per cent,Shaughnessy wondered if SPAFAS could hope toachieve CRL’s aggressive growth objectives.

One consolation was that demand for SPFeggs had exceeded available supply by betweenfive per cent and 10 per cent worldwide.Accordingly, in fewer than four years followingthe acquisition, SPAFAS more than doubled itsannual revenues while improving its operatingmargin to nearly 20 per cent. In order to supportthis growth, CRL continuously invested capitalin expanding domestic SPF egg productioncapacity. Recently, the board of directors hadapproved a significant capital investment inSPAFAS for increased production in the UnitedStates. Meanwhile, the company’s two maincompetitors failed to respond to rising demandby adding new capacity of their own, allowingSPAFAS to continue to increase its market share.

Based on recent projections, SPAFAS wasexpected to attain revenues of $25 millionwithin the next two to three years. However,projections of this kind were based on growthwithin the existing business, and did not accountfor opportunities to expand internationally. InShaughnessy’s estimation, accessing interna-tional markets could further improve revenues toas much as $50 million within four to five years.


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SPAFAS International

The pharmaceutical industry, currently ser-viced by CRL, conducted approximately 80 percent of worldwide research and development inthe United States and Europe; Japan accountedfor most of the remainder. In contrast, poultryvaccines were developed globally, and includedlarge facilities located in low-cost areas, such asIndia, China and Brazil.

When CRL acquired SPAFAS, the companyhad franchise operations in Mexico, India andBrazil. Franchisees produced SPF eggs from breedstock provided by Merck’s SPAFAS operation at acost of as much as $10 per egg.5 This arrangementallowed them to use the SPAFAS brand name,resulting in confusion among some customers whowere sometimes unaware of lower standards ofcleanliness outside of the United States. Althougha customer may have believed the product to beequal to the U.S. standard, “the facilities were seenas unacceptable to those accustomed to U.S. facil-ities,” observed Shaughnessy. And while the costper egg was high, relatively few were needed tostock a facility. As such, international franchisefees did not contribute significantly to SPAFASrevenue or growth.

Growth Objectives

Unable to convince human vaccine producersto use SPF eggs, Shaughnessy hoped to grow thecompany through the purchase of SPAFAS fran-chises in Brazil, Mexico and India from theircurrent owners. Once purchased, SPAFAS couldintegrate its worldwide operations and consoli-date the revenues.

Since franchisees were typically large poultryintegrators,6 the value of the SPF egg businesswas relatively small (typically less than fiveper cent of revenues). Furthermore, agriculturalcompanies appeared less suited to manage abiotech operation and rarely devoted the fundsneeded to make SPF operations internationallycompetitive. In their current state, Shaughnessythought the owners of these companies wouldbe eager to sell the franchises in order to

concentrate on their core poultry businesses—provided they were offered a fair price.

Shaughnessy was surprised by the Brazilianfranchisee’s reaction, which was one of distrust.Instead of selling the franchise, the Brazilianfranchisee eventually decided to sever ties withSPAFAS and continue the operation indepen-dently. The Indian reaction was far less acrimo-nious, but still failed to result in an agreement,although India remained a SPAFAS franchisee.

ALPES

Finally, Shaughnessy turned his attention tothe Mexican franchisee, ALPES S.A.7 Foundedin 1974 as a member of the IDISA group ofcompanies, ALPES was the sole producer ofSPF eggs in Mexico. The company was ownedby the Romero family, which also owned a largepoultry operation known as Grupo Romero.

In the early 1950s, Socorro Romero8 estab-lished a medium-sized poultry farm in the highdesert of Tehuacán, east of Mexico City. Shortlyafterward, she was joined by one of her twobrothers. Together they created the venture thatwould eventually be known as Grupo Romero.

Grupo Romero was officially founded in1963 by Socorro Romero to produce boilerchickens for the Mexican market. In the early1970s, Socorro asked her brother Miguel,9 whohad recently completed a Ph.D. in chemistryat Harvard University and had begun workingfor a U.S.-owned company in Mexico City, tohelp improve the company’s feed formulation.The idea was to reduce the company’s depen-dence on third-party suppliers. Nutrition wasthe most expensive variable cost item in poultryfarming, and by vertically integrating feed pro-duction, Grupo Romero could both reduce costsand increase reliability.

Realizing that a wider need existed for animalhealth services, Miguel Romero decided to starthis own company, which later became known asGrupo IDISA. IDISA soon began offering ser-vices throughout Mexico and Latin America.


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Although by this time poultry vaccines couldbe purchased from various international animalhealth firms, no one provided vaccines that werespecifically suited to Latin American farmers.In 1972, Miguel Romero contacted poultry vac-cine researchers at Cornell University in Ithaca,New York, who agreed to coordinate a vaccinedevelopment project with the UniversidadNacional Autónoma de México (UNAM). Afterseveral contaminations at the Mexico Cityresearch site, however, both parties agreed toabandon the project.

Refusing to admit defeat, Miguel Romerodecided to continue the research on his own.In 1974, he founded ALPES as the SPF eggsubsidiary of IDISA (see Exhibit 1). He turnedto SPAFAS, which at the time was a relativelysmall family business in Connecticut, for techni-cal assistance. SPAFAS sold ALPES breedingstock and provided technical advice on creatinga biosecure environment within which SPFchickens could be raised. All knowledge transferand technical support was provided informallythrough a “handshake” agreement between thetwo family-owned companies.

Alejandro Romero described the early busi-ness affiliation between ALPES and SPAFAS as

an “open relationship” in which both partiesbenefited from the honest exchange and sharing ofinformation and product innovations.10 Finally,ALPES became the exclusive Mexican distribu-tor for imported SPAFAS eggs and embryos.

By 1978, ALPES had its own well-establishedproduction facilities. As a result of the readilyavailable supply of SPF eggs and embryos, inter-national vaccine manufacturers began to estab-lish operations in Mexico.

All forms of cooperation between ALPES andSPAFAS were conducted through informal “hand-shake” agreements between the original owners.Although Merck maintained this arrangementwhen it acquired SPAFAS in 1986, the Romerofamily was wary of the new management, withwhom it had no relationship. The Romerossought to formalize a deal, eventually establishingALPES as a franchise of SPAFAS, with exclusiv-ity within Mexico and Central America.

Alejandro Romero joined Grupo IDISA in1989 after completing his master’s degree inchemical engineering at the University of BritishColumbia in Canada.11 Knowing that IDISAcould not depend on his father’s leadership for-ever, he pushed for structural changes such asa professional management staff and the use of


IDISA GroupIndustrial Research &

Development

IASAAnimal Nutrition

IDISAAdministrative

Services

IMSABreeding Stock

Nutex

LaboratoryServices

ALPESSPF Eggs

Romero GroupVarious companies

producing eggs, poultryand swine

Exhibit 1 IDISA Group of Companies

Source: Company files.

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external auditors and consultants. When MiguelRomero passed away in 1997, Alejandro becameCEO and chairman of Grupo IDISA.

IDISA had annual revenues of approxi-mately $2.9 million compared to Grupo Romerorevenues of approximately $200 million. Theboard of directors included Alejandro Romero’smother, aunt and sister, a veterinarian witha master’s degree from Cornell University.

To comply with Mexican law, the companyheld formal board meetings once a year (ALPESMission and Organizational Vision Statementsare provided in Exhibit 2).

Market Conditions

In 1994, the North American Free TradeAgreement (NAFTA) came into effect, facilitating


DEFINITION and MISSION

IDISA, which stands for Vital Research and Development and Animal Health,1 is a world-class group of compa-nies dedicated to providing optimal solutions to the needs of the health, farming and industrial sectors, throughdifferentiated products and services, based on research and development.

AIM

To unite material, financial and technological resources and, through human intervention, to transform them intogoods and services that generate wealth, in a wider sense, as a combined set of economic and socialbenefits for workers and investors.

VISION

We envision IDISA as a group of companies:

1. with a high level of synergy derived through integration;

2. that leads the domestic market in each of its specialized functions, while increasing its internationalmarket presence;

3. offering vital solutions that meet the needs of its clients, while providing products and services thatoptimize the relationship between costs and benefits;

4. generating leading edge, innovative and differentiated technologies, products and services;

5. committed to the continuous improvement and quality of its products and services;

6. that consolidates existing business and develops new lines of business;

7. committed to satisfying its shareholders with an optimal return on investment, to suppliers with fair treat-ment and to the communities in which it operates through the generation of employment and environ-mental responsibility;

8. that motivates and rewards employee achievements and performance, permits and encourages their per-sonal development, and offers opportunities for growth and advancement consistent with their capacityand career path; and

9. with an institutional structure that is flexible and facilitates decision making in an adaptable, efficient andeffective manner.

Exhibit 2 Organization of Group IDISA


1. As translated from the Spanish acronym for Investigación y Desarrollo Integral y Salud Animal.

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the free flow of goods and services, which resultedin a number of changes that had a direct impact onALPES. Fearing increased competition fromimports, Alejandro Romero sought to mitigate theeffect by establishing exclusivity contracts withsuppliers, customers and potential competitors.

While some business left Mexico as feared,the overall effect of NAFTA proved positive.Vaccine producers increased production inMexico, from which they supplied the UnitedStates and Canada, while competition fromimports failed to materialize. ALPES hastilydoubled its production to meet rising demand.

ALPES was the major supplier of SPF eggs toMexico’s two largest animal vaccine producers,InterVet and Anchor. Netherlands-based InterVetwas one of the world’s largest poultry vaccinemanufacturers with more than $1 billion in rev-enues and operations in 55 countries. InterVetpurchased approximately 80 per cent of the SPFeggs produced by ALPES. Anchor, the Mexicansubsidiary of Boehringer Ingelheim of Germany,accounted for most of ALPES’ remaining sales.Both companies had recently invested severalmillion dollars in new plants near Mexico City tomeet growing demand for animal vaccines inEurope and Asia.12 InterVet projected a doublingof its need for SPF eggs to four million unitswithin one year. Eventually, changes in Europeanand Asian vaccine regulations could result in afurther increase in overall demand for SPF eggs inMexico to more than 10 million units per year. Tomeet this growing demand, both InterVet andAnchor had begun importing SPF eggs from theUnited States, primarily from SPAFAS.

European countries had very strict qualitystandards that had to be met before vaccinescould be imported. For ALPES, meeting thosestandards proved particularly challenging.13 Notonly did the company need to improve its facili-ties to meet international standards, but risinglevels of poultry production in the surroundingarea had significantly increased the likelihood ofcontamination. One ALPES customer produceda large lot of vaccine before contaminants werediscovered. When the entire lot had to berecalled, the customer’s reputation suffered.

Capital Investment Needs

On his first visit to Charles River Laboratories,Alejandro Romero met Jim Foster, DennisShaughnessy and several other senior managersfor the first time. His task was to present theALPES business case and discuss opportunitiesin Mexico under NAFTA. Specifically, the headof InterVet in Mexico, who was both a long-timefriend and customer of the Romeros, had beenpressing Alejandro Romero to expand productionin order to meet InterVet’s growing demand forSPF eggs. Both agreed that any new facilitywould need to have considerably greater produc-tion capacity as well as superior sanitary stan-dards, including sealed and quarantined animalhousing, a laboratory and service buildings,where eggs could be pre-incubated prior to beingshipped to customers. IDISA was unwilling toinvest these funds itself because of “high borrow-ing costs in Mexico” and the “relatively smallcontribution to the total returns of GrupoRomero.” Romero hoped that Foster would agreeto either loan ALPES the money needed toexpand its facilities, or make a minority equityinvestment that would still leave control of thebusiness in the hands of the Romeros.

Loaning ALPES the funds was dismissed out-right. As a growth-oriented firm, Charles RiverLaboratories was simply not in the business oflending money. The idea of becoming a minorityshareholder was also looked upon unfavorably asit would limit participation in the business andprevent CRL from fully consolidating the com-pany’s revenues in its income statement.

Shaughnessy explained that CRL was primar-ily interested in acquisitions. If the Romeroswould be willing to sell ALPES outright, CRLwould certainly be interested. He also expressedconcern about the real rates of return for the exist-ing business under its current management, whichhad been between negative 25 per cent and nega-tive 28 per cent for each of the last three years.

Romero explained that the poor rates of returnhad been a consequence of unforeseen contam-inations, which had both reduced revenues andincreased costs.14 A new facility would greatly


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reduce the risk of contamination. Shaughnessy andFoster appeared skeptical that new facilities alonewould reduce the contamination risk, given thatstrict compliance with biosecurity principles hadnot been part of the ALPES work environment.

Ultimately, ALPES was not for sale, explainedRomero. “We want to continue this business,” headded. “Especially now, we see great opportunitiesthat we want to take part in.” His bottom line posi-tion was that if CRL were unwilling to invest inALPES, IDISA would seek other investors.

The company had already entertained the optionof partnering with SPAFAS’s primary competitor,Lohmann-Tierzucht International of Germany.Lohmann-Tierzucht was the SPF eggs subsidiaryof the PHW Group, a large international animal

health company with more than 30 subsidiariesworldwide, including SPAFAS’s primary com-petitor in the United States. Shortly after CRLacquired SPAFAS, the Romeros began discus-sions with Lohmann-Tierzucht in order to ensurean uninterrupted supply of breed stock. Morerecently, ALPES began using Lohmann geneticlines in its SPF egg production.

As a compromise between the two positions,Alejandro Romero suggested that both partiesconsider a joint venture. If Charles RiverLaboratories contributed the funds needed fora new facility, IDISA would contribute buildings,land and other assets currently owned by ALPES(see Exhibit 3). Both parties agreed to considerthe matter.


CURRENT ASSETSCash And Cash Equivalents 56,703 Accounts Receivable 282,628 Inventory 92,613 Birds 390,674

TOTAL CURRENT ASSETS 822,618

PROPERTY PLANT AND EQUIPMENT 112,003 OTHER ASSETS 16,249 TOTAL ASSETS 950,870

LIABILITIES AND STOCKHOLDERS’ EQUITYCURRENT LIABILITIES

Trade Accounts Payable 92,397 TOTAL CURRENT LIABILITIES 92,397

LIABILITIESIncome Taxes Payable 8,346 Accrued Liabilities 88,912

TOTAL ACCRUED LIABILITIES 97,258

SHAREHOLDERS’ EQUITYCapital Stock 541,681 Retained Earnings 1,040,207 Revaluation Deficit (1,025,286)Accumulated Income 204,613

TOTAL STOCKHOLDERS’ EQUITY 761,215TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY 950,870

Exhibit 3 Aves Libres de Patógenos Específicos, SA Balance Sheet (in US$)


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Alejandro Romero returned to Mexico todiscuss the joint venture opportunity withfamily members. The one concern that wasraised was the effect a joint venture would haveon the decision-making process of the company,from a family-oriented process to one that wasmore institutional. Even so, everyone recogni-zed that the change was necessary if ALPES andIDISA, and even Grupo Romero, were to con-tinue to mature into world-class internationalcompanies. Alejandro Romero called Shaugh-nessy to express his family’s willingness to enterinto formal negotiations.

First Encounters With Mexico

Shaughnessy made three visits to Mexico,each time accompanied by one or two seniormanagers from SPAFAS, before presenting hisfindings to CRL’s management and board ofdirectors. The first was an official meeting withmembers of the Romero family, which, outsideof Alejandro Romero’s visit to the United Statesearlier in the year, was the first of its kindbetween the Romeros and anyone from CharlesRiver Laboratories.

Several weeks later, Shaughnessy made asecond trip that included a tour of ALPES’sfacilities in Tehuacán. As he left Mexico City,he was unprepared for the isolation and povertythat he would encounter in the Mexican country-side, both of which left a strong and lastingimpression upon him. And while Grupo IDISA’sheadquarters was a modern facility in the centerof Tehuacán, a maquiladora15 city with morethan 300,000 inhabitants, the company’s poultryfarms appeared to him to be below standards.

On his third visit, Shaughnessy had dinner atthe Romero estate in Tehuacán. He recalled:

We had a six-hour Mexican dinner with theentire Romero family, and we talked about books,education, philosophy and all the things thatpeople think about when they reflect on their lives,family and society. Out of that came the storiesof who they are. For example, before that visit,I didn’t know that they had already been in negoti-ations with Merck for a long time to do some sort

of joint venture. And I didn’t know that Alejandro’sfather had been a federal deputy in Mexico and hadbeen instrumental in several campaigns to clean upgovernment corruption.

The Romeros seemed to be very high-qualitypeople, as did their siblings and other familymembers. We discussed what it is like to be aprominent and successful Mexican. That carriedover to their views on business. These were clearlybusiness people with great personal integrity andcommitment, the type of people that could be thefoundation for a strong business partnership.

Those views seemed a stark contrast to whatShaughnessy was accustomed to in the UnitedStates, where quarterly earnings targets oftenappeared to drive company strategy. AlejandroRomero explained:

For us as a company, success comes from three fac-tors. One is hard work, another is people, and theother is honesty or trust. You have to have thosefactors in hand and then profit comes as a conse-quence. Profit is really not a final objective. It is aconsequence of doing things right and doing theright things.

After these visits, Shaughnessy became lessconcerned about the potential impact of the ruralpoverty surrounding the ALPES operations. Healso became convinced of the integrity and com-petence of his Mexican counterparts.

Before returning to the United States,Shaughnessy notified the Romeros that he wouldrecommend the joint venture to the Charles RiverLaboratories board of directors. He warned themhowever that neither the board of directors northe CEO had the same level of knowledge of theRomeros family and its businesses. Without thatfirst-hand knowledge, their support might not beeasily won.

THE JOINT VENTURE PROPOSAL

Shaughnessy presented the following terms of thejoint venture to the Charles River Laboratoriesboard of directors:


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SPAFAS would invest $2 million in cash into a newjoint venture company to be located near MexicoCity, in exchange for 50 per cent of its equity. Ourpartner, ALPES, would contribute its existing SPFand commercial egg (for vaccines) assets to thejoint venture company for its 50 per cent equityinterest. Profits would be shared equally.

The $2 million cash investment would be usedto increase the SPF egg production capacity of thejoint venture ($1.5 million), establish a pre-incuba-tion facility ($250,000), and compensate ALPESfor associated goodwill and management services($250,000).

The existing ALPES business, which would becontributed to the joint venture, represents nearly$2 million in sales and an estimated 15 per centoperating margin. The $2 million in-kind contribu-tion value assessed to this business, when con-sidered in the acquisition context, reflects favorablepurchase price multiples in the range of l ×Revenues and 6 × EBIT.

As shown below in the Financial Summary, thejoint venture will produce $3 million in sales nextyear, more than doubling by year four, with oper-ating margins forecast to be in excess of 30 percent (see Exhibit 4).


Year 1 Year 2 Year 3 Year 4 Year 5 Total

Sales 2,941,028 4,916,477 5,837,466 6,686,183 7,562,987 27,944,141

Cost 2,097,306 2,951,721 3,347,327 3,712,698 4,093,262 16,202,314

Cost germ egg 288,830 617,171 781,550 932,897 1,088,253 3,708,701

Gross margin 554,892 1,347,585 1,708,589 2,040,588 2,381,472 8,033,126

Packaging, Shipping, Delivery 243,475 292,622 307,253 322,616 338,747 1,504,713

Distribution margin 311,417 1,054,963 1,401,336 1,717,972 2,042,725 6,528,413

G&A 225,455 271,805 285,395 299,665 314,646 1,396,966

Total Cost before tax 2,855,066 4,133,319 4,721,525 5,267,876 5,834,908 22,812,694and finance

Finance Cost 709 745 782 821 962 4,019

Operating Income 85,253 782,413 1,115,159 1,417,486 1,727,117 5,127,428

Tax 4,175 5,495 5,770 6,058 6,361 27,859

Total Cost 2,859,950 4,139,559 4,728,077 5,274,755 5,842,231 22,844,572

Operating Net Income 81,078 776,918 1,109,389 1,411,428 1,720,756 5,099,569

Assumptions

Unit price/egg ALPES I1 $0.54 $0.57 $0.60 $0.63 $0.66

Unit price/embryo ALPES I $0.68 $0.71 $0.75 $0.79 $0.83

Unit price/egg ALPES II2 $0.11 $0.12 $0.12 $0.13 $0.13

Unit price/embryo ALPES II $0.16 $0.17 $0.18 $0.19 $0.19

Inflation 5.00% 5.00% 5.00% 5.00% 5.00%

Exchange Rate $7.50 $7.50 $7.50 $7.50 $7.50

Exhibit 4 Pro Forma Income Statement (Proposed Joint Venture) (in US$) (Continued)

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Market opportunities notwithstanding, severalboard members raised objections. First, somewere concerned by the complex organizationalstructure of Grupo IDISA, which consisted offive legally independent companies that were allowned by the same family. Others were equallyconcerned with the large number of inter-com-pany transactions between ALPES, IDISA andother Romero companies. And finally, some ofthe directors were concerned about the lack oftransparency of a company that only held boardmeetings once a year and did not appear to have

strategic plans, operating budgets, meetingminutes or other formal corporate documentsthat are routine for U.S. public companies. Somemembers of the board wondered if they couldmake an informed decision about a business thatthey knew so little about.

Some members of the board were especiallyconcerned about media reports that often por-trayed Mexico as a country plagued withendemic corruption and economic instability.The directors from Bausch and Lomb recalled anearlier “unpleasant experience” with a Mexican


Year 1 Year 2 Year 3 Year 4 Year 5 Total

Cost germ egg ALPES I $0.10 $0.10 $0.11 $0.11 $0.12

Prod Cost/Egg ALPES I $0.38 $0.40 $0.42 $0.44 $0.46 (OLD FARM)

Prod Cost/Embryo ALPES I $0.49 $0.45 $0.47 $0.49 $0.52(NEW FARM)

Prod Cost/Egg ALPES II $0.09 $0.10 $0.10 $0.11 $0.11

Prod Cost/Embryo ALPES II $0.16 $0.16 $0.17 $0.18 $0.19

# Egg sold (ALPES I) 1,732,398 1,732,398 1,732,398 1,732,398 1,732,398

# Embryo sold (NEW FARM) 1,038,465 3,632,946 4,683,974 5,525,636 6,301,817

# Egg ALPES II sold 2,952,630 2,952,630 2,952,630 2,962,630 2,952,630

# Embryo ALPES II sold 6,091,089 5,947,948 5,308,544 4,737,875 4,228,554

# Total house 5 10 11 12 12

# Years depreciation building 20 20 20 20 20

# Years depreciation equipment 7 7 7 7 7

# Years depreciation vehicles 5 5 5 5 5

Exhibit 4 (Continued)


1. ALPES I eggs were SPF eggs used primarily in the production of live vaccines (flocks tested negative for 28 avian pathogens).

2. ALPES II eggs were clean, commercial fertile eggs used for the production of inactivated vaccines (flocks tested negative foreight pathogens).

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optics distributor who had defrauded thecompany. Both the CEO and the board of direc-tors wanted assurances that the Romeros could betrusted and that the joint venture would serve thestrategic interests of Charles River Laboratories,not just those of ALPES and Grupo IDISA.

NOTES

1. Charles River was a wholly owned subsidiaryof Bausch & Lomb (B&L). As a result, its board waslargely controlled by senior management of B&L.

2. Caroline Smith DeWaal, “Playing Chicken:The Human Cost of Inadequate Regulation of thePoultry Industry,” Center for Science in the PublicInterest, Washington, D.C., March 1996.

3. Biosecurity involved unique animal housingwith pressure-filtered air. The integrity of these facili-ties was maintained through decontamination and con-trol procedures for both animals and humans toprevent the entry of unwanted pathogens.

4. “Dirty” eggs contained pathogens that couldbe harmful to other poultry. Many experts believedthat human beings were immune to poultry diseases.However, in 1997, Hong Kong experienced the firstknown cases of avian flu in human beings. Since then,avian flu outbreaks in humans have been reported inEurope, the United States and Asia. More recently, sci-entists have linked the Spanish Flu of 1918 thatclaimed up to 50 million lives to avian flu, “1918Killer Flu Secrets Revealed,” BBC News UK Edition,February 5, 2004.

5. Breed stock eggs were used to restockhatcheries with hens that had specific genetic profiles.While the eggs were more expensive, the numberneeded to restock hatcheries was relatively small.

6. A poultry integrator carries out differentaspects of poultry production through its various farmsand related businesses. These include growing, breed-ing, care, transport, processing and marketing of eggs,boiler chickens and other end-use poultry products.

7. ALPES (Aves libres de patógenos específi-cos) was a Spanish acronym equivalent to SPAFAS.

8. Aunt of Alejandro Romero, CEO of ALPES.9. Alejandro Romero’s father.

10. For example, some innovations in buildingdesign and construction, such as the use of cementrather than wood, were later adopted by SPAFAS asmore effective in the prevention and elimination ofpotentially harmful contaminants.

11. Alejandro Romero also held degrees in engi-neering and business administration (MBA) fromMexican universities.

12. More than two-thirds of Mexico’s vaccineproduction was exported.

13. Poultry vaccines made from “dirty” eggs werepermitted in Mexico and Central America, but theywere strictly prohibited in the United States, Europeand Japan.

14. ALPES had to decontaminate the farm andrestock its facilities several times in the past threeyears.

15. Known officially as the in-bond industry,maquiladoras were export-oriented factories that oper-ated under special trade rules established by theMexican government. International companies oftenestablished maquiladora factories in order to producelower cost goods destined for the U.S. market. UnderNAFTA, most products manufactured in Mexico couldenter the U.S. free of duties.


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STRATEGIC RATIONALE Should a Firm Build a Strategic Alliance?

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