FINANCE 394.4

FINANCIAL MANAGEMENT OF THE SMALL FIRM

Course Introduction

This course is one of the five rigorous case courses that are part of the entrepreneurship core specialization:

  1. Opportunity Identification and Analysis
  2. Gathering Resources, Launch and Deals
  3. Entrepreneurial Growth and Renewal
  4. Financial Management of the Small Firm (The combined Small Business Finance and Entrepreneurial Harvest classes)
  5. Entrepreneurial Management

This Financial Management of the Small Firm course explores financial analysis, managing growth, raising capital and exit strategies for owners of businesses. Financial decisions should create increases in the owner’s net worth but without a public stock price, private companies do not have feedback about their financial decision-making. Like a farmer who plants the seed, waters and fertilizes the crop to increase his yield, and eventually harvests the fruits of their labor, a business owner must eventually decide how they will exit the business they have created. But unlike the farmer who has defined seasons, standard procedures for harvesting and commodity prices for their products which can be hedged, the business owner must decide:

When is the appropriate time to sell?

Why should I sell the business?

How much is the business worth?

What valuation models should be employed?

What exit strategies are available?

Which method should be used – merger, asset sell, IPO, ESOP or other?

What are the accounting, tax and legal issues?

How do I find the right buyer – financial buyer or strategic buyer?

Should I use an intermediary?

How do I protect confidential information given to potential buyers?

How do I protect my customers and employees?

How do I negotiate the best price?

It is not uncommon to see businesses that were launched before there was ever a clear picture that there was an opportunity. Therefore, it should not be surprising that many small businesses start without “the end in mind” and thus have not considered succession plans or exit strategies. Many business owners are good at the operations aspects to the business but have little experience in the finance and accounting aspects.

Most of the cases will require you to render a valuation (or value range) of the firm. The cases in their course generally deal with privately held companies with no secondary market for their debt or equity. This lack of liquidity and marketability generally decreases the value of private firms relative to public companies. Adjustments will also have to be made if the interest being valued is a minority or majority interest. Since many private firms manage the company to minimize taxes rather than maximize profits, earnings normalization may have to be made for excessive salaries, excess cash, and non-recurring income or expenses. Therefore, the many assumptions will have to be made in your analysis and will probably lead you to the conclusion that valuation is as much art and science.

COURSE GOALS

The goals of the course are to help students become better managers and decision-makers by engaging in fact-based analysis and a thorough understanding of the levers that create value. The case method revolves around student-centered learning and will force you to use frameworks that you can use for a lifetime to identify problems, creatively develop alternative solutions, filter your quantitative analysis into a point of view and concisely deliver your recommendations into a practical solution. This course will specifically focus on skill that will help students maximize the sales value of a business. At the completion of the course, students should be able to

Evaluate the timing of the sale, either for personal, competitive or contextual reasons.

Calculate the intrinsic value of the firm as well as the current market value, which are often different

Determine the type of transaction that would maximize value – such as a sale to a strategic or financial buyer, IPO, merger, etc.

Create a negotiating strategy to realize the maximum value by determining how much the company is worth to the seller and buyer.

COURSE STRUCTURE

The first part of the course stems from the Small Business Finance class and will deal with legal forms of organization, financial statement analysis, working capital analysis, sources of capital and capital structure policy. A combination of lecture and cases will be used with a multiple choice pop-quiz to test your understanding of the tactical financial tools and analysis. This course has preserved the best part of the Small Business class by giving students the option to form teams of 4 students in their section and find a company to analyze (a note on the company requirements follows in this package). Professor Nolen must receive written notice of your exercising this option within the first month of the start of the class. The team will work throughout the semester on performing a financial analysis including industry benchmarking, researching the industry and competitive landscape, creating a SWOT analysis, making financial projections, and valuing the equity of the company. A final written report will be turned in at the end of the semester in lieu of an analysis of a Harvard valuation case. The due date of the report is the same as the final exams of the students who do not elect to do the consulting project and all team members will receive the same grade (assuming the other team members do not report a person as not contributing to the team) based on the quality of their analysis.

The second part of the course stems from the Entrepreneurial Harvest classand is entirely case based dealing with valuation of private companies and exit strategies. The coursecould have been laid out based on the method of valuation – having cases in which the student must decide which valuation model best fit the situation. But in most of our cases, a combination of valuation models will be used – a cost approach, market approach, income approach, excess earnings approach, or discounted cash flow approach based on the case facts. The course could be laid out based on the exit strategy being employed – thus having cases on leveraged buyouts, mergers, sale of assets, pooling of interest, rollups, IPO, bankruptcy (involuntary exit), leveraged recapitalizations, ESOPs and other special situations. Our cases will indeed deal with these various methods for harvesting. But the most natural way to design the course is to simulate how an owner would consider selling their business:

  1. Why and when should I harvest the investment?
  2. How much is the business worth – to me and to someone else?
  3. Which method or exit strategy should I use?
  4. How do I negotiate the best price?

There will be some heavy reading requirements and lectures at the front end of the class to familiarize the students with the various valuation models. We will then start our case discussions. Initially, I am more concerned about the process of having a rigorous class discussion than the value being rendered. To that end, the first case has no numbers and is as much an ethics case as it is a negotiations case. The second case is positioned because it short, not too complex, but with enough data that you can perform a cost analysis, comparable market analysis and a DCF analysis. The Frank Spence case will lead us to drill down into pricing firm unique risk, the appropriate discount rate and terminal value assumptions, growth assumptions, and other factors affecting the value of the firm. Then we will have a series of cases about when and why a business owner might decide to exit followed by cases in which determining the value is the primary objective. The next section will provide cases in which different exit strategies are being employed and choices between exit strategies must be made. The final section will discuss negotiating for the best price, including a case involving an exchange of stock between two small public companies. The final case is a comprehensive case over two case class days with A-F versions of the case. The midterm case and the final exam cases will test what you have learned throughout the semester.

Why and When?

Timing is critical to maximizing the value of the firm. Changes in economic conditions, industry consolidation, capital availability, new technologies, supplier power, customer power, key personnel can substantially alter the value of the firm. Changes in the owner’s goals, age, health or motivation may not coincide with market conditions that would maximize value. Most small business owners are too caught up in running their business and have poor succession plans or exit strategies. Breakup of partnerships may trigger the execution of a buy/sell agreement.

Usually it is time to sell when someone else can do more with the company resources than you can and thus it is worth more to them than to you or the company’s competitive position is deteriorating. If the company is sold too soon, it may not be able to cash in on future growth while selling too late, when the business is already in decline, may find no buyers or poor valuations. The ideal time to sell is when a company is losing its competitive advantage, but no one has noticed. A good sell signal is when the business owner believes that future cash flows will be lower than most people expect.

Helpful questions to ask during this “why and when” section of the course are:

  • What are the owner’s goals and reason for harvesting?
  • Is the owner burned out, becoming too tired, too rich, or too bored to continue trying to create value in the firm?
  • Have there been internal changes in the firm, such as the loss of key personnel, expiration of patents, deterioration of financial condition, or changes in costs such that you can no longer remain competitive
  • Has there been a significant change in the external environment, such as a change in customer demographics or customer needs, new entrants into the market, cheaper substitute products, more intense competitive rivalry, new technology, barriers to distribution channels, or changes in social context?
  • Is the company more valuable to someone else?
  • Has the market reached a peak in valuations relative to historical norms where price is greater than indicated intrinsic value?

HOW MUCH?

Virtually every case will require that you perform some type of valuation of the firm. Valuation is about convergent validity – getting as many valuation points as possible, throwing out outliers, and then narrowing the range of realistic values. If the case has sufficient data, you should attempt to perform a cost approach, market approach, and DCF approach. Which models you use and which method you rely on for rendering your valuation number will depend on the circumstances of the case. You should attempt to build a spreadsheet that allows you to enter inputs, which will then do the mechanical calculations of valuation. This will assist you in your daily case analysis but especially when you are given time constraints on the final exam. It also allows you to identify the assumptions you made in arriving at the value.

The valuation approaches we will use will include the use of market and transaction comparables, liquidation value, the “venture capital method”, firm free cash flow, APV, equity cash flow and capital cash flow models. Discussions will center around: which firms were the best comparables?; what discount rate was used and how was it calculated?; what are the expected future cash flows?; what normalization of historical data were made and why?; and what terminal value assumptions were made?.

Useful questions for this section include:

  • What data do I have available? How reliable is the source? What motive do they have?
  • Which valuation model(s) fit the data best?
  • What are the strengths and weaknesses of each model?
  • Which variables or assumptions produce the greatest sensitivity in value?
  • Does the valuation rendered make common sense?

WHICH METHOD?

The cases in this section will require you to consider the method of completing the transaction. Many of the cases may require you to choice between a merger vs. An IPO or a strategic buyer vs. a financial buyer. You should consider whether the sale should: be an asset sale or stock sale; the terms of the sale as well as the tax implications of the sale; the effects on employees, customers and vendors; and the effects of the transaction of future growth.

The cases will cover such exit methods as: (1) the sale of the assets or stock of the company; (2) an Initial Public Offering; (3) a merger (4) a rollup (5) leveraged buyout or recapitalization; (6) an employee stock ownership plan (7) earnouts; and (8) bankruptcy.

Key questions for this section of cases include:

  • Which method best fits the goals of the buyer and the seller?
  • Which strategy would maximize the value of the firm?
  • What are the implications of the transaction on the risk of the firm, the seller and the buyer?
  • What are the tax ramifications and how can the transaction be structured to minimize the tax?

NEGOTIATION TACTICS

Most valuation situations will occur between a willing buyer and seller, but may involve asymmetric information. Since the transaction is a single game, it may become a win-lose scenario. Different negotiation tactics will be discusses including positional bargaining and interest-based bargaining as well as assessing each person’s BATNAs.

Key questions for this section include:

  • Can a sale be created that “makes the pie bigger”?
  • Can I identify and be able to provide what the buyer and seller value most?
  • What are each parties best alternative to a negotiated agreement?
  • What is the business worth to the seller and to the buyer and have each set their minimum or maximum value?
  • What are the pressures on the buyer and seller to close?
  • Has the seller determined ways to decrease the pressures on him/her and increase the pressures on the buyer?

DISSCUSSION FORMAT

Students will be “cold called” to open each class. The student should take the point of view of the protagonist in the case. A good opening would begin by taking a firm stand on the solution to the problem and defending it with logic and numerical analysis. Openings should include: (1) defining the problem; (2) answering the questions; (3) developing strategic alternatives; (4) presenting a solution; and (5) providing an action plan for implementation. An opening can take anywhere from five to fifteen minutes. Since one’s analysis is filtered through each student’s different personality and life experiences, what seems like a logical solution to one person may not fit with the way others in the class view the situation. This is where the discussion begins and you are encouraged to support or challenge the assumptions and conclusions your fellow classmates are making. There generally are no right or wrong answers, or better put, there might be many good answers. Much of the discussion will center around the question “why?” and good arguments will be supported with good facts, logic and analysis. Simply restating case facts like “the company’s revenues were $100 million and profits were $5 million” is not of value and uses precious airtime. We can assume everyone has read the case and a discussion of sales and profit trends and explanations or solutions for these trends moves the class forward in our discussion. By the same token, just throwing out an answer such as “I believe the company is worth $10 million” is of little use without first telling which method you used, what adjustments and assumptions you made, and why you believe this to be a reasonable value.

You may also be cold called to provide a summary of lessons learned from the case. Your class participation grade will be based on quantity and quality of discussion, with quality being far more important. Openings and closings have a disproportionate weighting and since there are more students than openings and closings, you must remain fully engaged and participate in each case discussion.

Since we will be discussing complex financial models, you should be prepared to come to the front of the class with your model to discuss your inputs and outputs. This means that you should have a printout of your model and make a copy of it on a transparency for use on the overhead or bring your notebook computer to be hooked up to the LCD projector.

As your instructor, my role is to serve as a moderator of the discussion. Do not look to me for “the answer”. Address your questions and answers to your fellow students, not to me. Hold up your hand and wait to be called on – do not blurt out a response. I monitor the participation throughout the semester and if you are not called on when you have your hand up, do not get discouraged as I may have reasons for directing the discussion to other students. You will be given feed back on your mid—term exam as well as updated on your participation performance throughout the semester. If you are falling behind, expect an e-mail reminding you that discussion is 40% of your grade.