1. 1 Caught in the Middle De-risking 2 Contract Terms you Normally Ignore Presented by: Eric Bartsch Stoel Rives, LLP June 12, 2014 Minneapolis, MN

2. 2 Why Contract Terms Matter Acme, Inc.Quarter Typical Quarter Growing Business - Long Term Contracts Sales1 mm units x $3/unit 3,000,000 COGS1 mm units x $2/unit 2,000,000 Gross Margin 1,000,000 SG&A 800,000 EBITDA 200,000 Taxes30% 60,000 Net Income 140,000 Stock MarketYear Simplified Valuation Analysis Annualized Net Income 560,000 P/E Ratio 17 Implied Return (1/PE)5.88% Market Capitalization 9,520,000 Earnings per Share (EPS)$0.56/sh Shares Outstanding 1,000,000 Price Per Share $ 9.52

3. 3 Problem: 5¢ Unit Charge Acme, Inc.Quarter $0.05/Unit Charge Growing Business - Long Term Contracts Sales1 mm units x $3/unit 3,000,000 COGS1 mm units x $2.05/unit 2,050,000 Gross Margin 950,000 SG&A 800,000 EBITDA 150,000 Taxes30% 45,000 Net Income 105,000 Stock MarketYear Simplified Valuation Analysis Annualized Net Income 420,000 P/E Ratio 17 Implied Return (1/PE)5.88% Market Capitalization 7,140,000 Earnings per Share (EPS)$0.42/sh Shares Outstanding 1,000,000 Price Per Share $ 7.14 25% Drop!

4. 4 Amplification Effect Gross Margin w/out Charge: 4,000,000 Gross Margin w/Charge: 3,800,000 Drop in Gross Margin: 200,0005% Drop in Net Income:140,00025% Stock Price w/out Charge: 9.52 Stock Price w/Charge: 7.14 Drop in Stock Value: $ 2.3825% What Causes Amplification? 1.Larger SG&A as % of GM amplifies loss translation 2.1:1 Translation if Stable PE 3.More amplification if PE changes

5. 5 Effect on Value – PE & EPS Net Income Falls PE Stable or Declines EPS Declines Both Doubles Downward Trend Net Income Increases PE Stable or Increases EPS Increases Both Doubles Upward Trend

6. 6 Example -TGT 27% Drop Target Corp.Aug-13May-14 Earnings Guidance EPS:$3.85 - 4.15/sh$3.60-3.90/sh $4.00/sh Avg.$3.75/sh Avg. Net Income 2,532,000,000 2,373,750,000 P/E Ratio (ttm/forward tm) 18.8 14.6 Implied Investor ROI5.32%6.85% Market Capitalization 47,550,960,000 34,656,750,000 Shares Outstanding 633,000,000 Price Per Share $ 75.12 $ 55.00 6% Drop

7. 7 Double Amplification Earnings/SHChange in PE 13-Aug $ 4.0018.8 14-May $ 3.7514.6 Difference $ 0.25 4.20 Original ROI5.32% Multiply Change in PE by Share Impact Value Loss $ 4.70 4.20 $ 4.70 x Starting Price75.12 19.74Impact on Sh Value Ending Price55 Difference20.12

8. 8 Risk Term #1: Shipping UCC 2-503: Tender of Delivery Requires Seller to put and hold conforming goods at the buyer’s disposition and give the buyer any notification reasonably necessary to enable him to take delivery.

9. 9 Seller Ships UCC 2-504: Where the seller is required or authorized to send the goods to the buyer...then, unless otherwise agreed, he must: (a) put the goods in the possession of a carrier and [contract for their transport to buyer].

10. 10 FOB: Dock or Destination UCC 2-319: FOB is a delivery term. “Shipping Point” means default 2-504. “Destination” means tender at Buyer. Buyer Seller Buyer’s

11. 11 Economic Consequence Gasoline Costs Jan-98 – Jan-09 “f.o.b Buyer’s Montreal Warehouse” Margin w/out Charge: 4,000,000 Margin w/Charge: 3,800,000 Drop in Gross Margin: 200,0005% Drop in Net Income: 140,00025% Stock Price b/4 Charge: 9.52 Stock Price w/Charge: 7.14 Drop in Stock Value: $ 2.3825% 5 cent/case fuel surcharge

12. 12 Better Language UCC presumes that tender and title change is at place of shipment (2-503, 2- 504, 2-401 (Passing of Title)) De-Risking Language I use:

13. 13 Sale of Goods – Trade Credit A “sale” consists in the passing of title from the seller to the buyer for a price. Title can pass before you get the cash. When that happens, you have extended a loan called trade credit.

14. 14 Trade Credit Time between shipment and payment is the credit period. –“Credit period” is when the seller becomes a lender to the buyer. –Unsecured trade credit riskiest form of debt. –Credit period = No goods & no cash. –If 33% Gross Margin, risk $66 to earn $33 –Or, need 3 sales to recoup loss of one

15. 15 Risk #2: Credit Limit Quarter Sales: $3,000,000 Big Customer:10% Sales Big Customer: $ 300,00033% Margin Credit Policy: $ 100,000Per Month Stop Shipping Aged Past 60 Days Current0 - 3030 - 6060 - 90 $ - $ 100,000 $300,000 at risk

16. 16 Bankruptcy Big Customer, Inc.

17. 17 No Security Interest Trade Credit is Unsecured Debt File a Claim as an Unsecured Creditor If no likelihood of being paid, write off COGS, or $200,000. Budget Net Income: $ 560,000 Write-Down: $ (200,000) Actual Net Income: $ 360,000-36%

18. 18 Financial Consequence Bankruptcy by one big customer threatens systemic risk. Risk forces down P/E; increases investor’s demand for a higher return FASB requires bad debt write-down plus examination of your allowance accrual for bad debt

19. 19 PMSI Solution Take a Lien in Big Customer’s Inventory May need to negotiate with Lender UCC 9-103: “A security interest in goods is a purchase-money security interest...to the extent that the goods are purchase money collateral with respect to the security interest.”

20. 20 Purchase Money Collateral Seller Buyer Promise to Pay & Credit Agr. Goods Secretary of State UCC - 1 Lender PMSI Notice

21. 21 UCC-1 Perfection A security interest must both attach and be perfected. –Attachment happens with a signed Credit Application & goods received by Debtor. –Perfection happens with the filing of a UCC-1 and mailing of Pre-Lien Notice before ship The UCC-1 must be filed in the state where the corp. debtor is organized.

22. 22 PMSI Pre-Lien Notice Re:Inventory of ___________ (the “Debtor”) Dear Sir or Madam: We note your financing statement first filed on ____ __, 20____, with the office of the _________________ against the Debtor (the “Financing Statement”). Based upon the contents of the Financing Statement, it appears that you may assert a security interest in the Debtor’s inventory. Please be advised that we have or expect to acquire a purchase-money security interest in the following property: All inventory acquired by Debtor from [Seller] (“Secured Party”), including all proceeds thereof, pursuant to the terms of that certain Credit Application between the Debtor and Secured Party. Sincerely, [Seller Entity] By:___________________________________

23. 23 Credit Agreement

24. 24 UCC - 1

25. 25 Conclusion eabartsch@stoel.com