1. 1 Harvesting Harvesting Frank Moyes Leeds College of Business University of Colorado Boulder, Colorado

2. 2 Harvesting This Week’s Agenda  Feasibility Plan Presentations  Harvest strategy

3. 3 Harvesting Harvesting  Definition: “Method for achieving terminal after-tax cash flows on investment.” Bygrave  Why do you harvest?  Investors require rate of return. For high growth ventures, won’t come from dividends.  Entrepreneur wants a new challenge  Become part of the problem  “I can’t stand it any more.”

4. 4 Harvesting Lifestyle Business  Perfect life style business  Independence, autonomy & control  Make sufficient income for your requirements  Good at it & enjoy  Quiet desperation  Don’t see an alternative  Marginal income  Not good at it, family destroyed, alcoholic

5. 5 Harvesting When Should Entrepreneur Step Aside?  Do you have the skills to continue?  When does it stop being exciting and fun?  Examples  John Walker of AutoDesk founder return to full time programming  Steve Jobs of Apple, replaced by John Scully of PepsiCo, stayed on as Chairman. Later left to start NEXT. Scully left after 5 years, followed by a succession of CEO’s

6. 6 Harvesting You Are Ready When  Company generating earnings  No longer working 80 hours per week (or the thought of continuing is daunting)  Your company has value, but is not liquid  Becoming cautious - represents your entire net worth  Founding team interests are changing  You are becoming bored  Your family is becoming restless  Company is at a stage where it must make a transition Stolze: Start-up

7. 7 Harvesting Harvesting Alternatives  Increase the free cash flows  Leveraged buy-out  Employees – ESOP’s  Sell entire business  Initial public offering

8. 8 Harvesting Increase Free Cash Flows  Cash cow  Pros  Not necessary to exit the business  Retain ownership  Don’t need to find buyer  Cons  Tax implications  Sustainable competitive advantage  Takes time

9. 9 Harvesting Management Buy-out (MBO)?  Pros  Management understands business & are motivated  Founder knows & trusts  Management likely to maintain culture & retain employees  Bankers understand & willing to fund equity and/or debt  Cons  Management must put up large amounts and/or  Founder willing to accept installment payments  High amount of debt effects cash flows  Risk of default

10. 10 Harvesting Leveraged Buy-out ( LBO)?  Pros  Managers from large companies looking to become entrepreneurs  Bring experience and new perspective  Credibility with lenders  Cons  Founder doesn’t know new owners  May not maintain culture and retain employees  Final payment depends on earn-out (may be required in order to agree on valuation)

11. 11 Harvesting Employee Stock Ownership Plan (ESOP)  Leveraged ESOP  Company guarantees debt of ESOP  ESOP borrows money from a lender to buy owner’s stock. Held in trust.  Company make tax-deductible contribution to trust to repay loan.  Pros  Tax advantages  If ESOP owns > 30%, then owner can avoid capital gain tax by purchasing stocks or bonds of another US company  If ESOP owns> 50%, then lender is taxed on only 50% of income; therefore can offer lower interest rate.  Dividends are tax deductible, i.e. like interest  Employees own share of company  Suitable for companies in industries where acquisition is not likely, e.g. construction  Cons  Owner may not want employees to control company  Must disclose information such as exec salaries

12. 12 Harvesting Sale or Merging Entire Business  Company needs to finance growth  Company at a transitions stage  Founder wants  Diversify investment  Change for personal reasons  Another challenge

13. 13 Harvesting Sale or Merge Issues I  Owners naiveté  Expectations towards value  Selling your soul  Founder negotiating deal  Deal structure  Valuation  Cash or shares - risk of holding shares  Tax implications  Earn out

14. 14 Harvesting Earn-Outs I  Final purchase price depends on how the company performs in the years subsequent to the purchase  Buyer:  Wants company to perform well  Doesn’t want to buy a cat in a bag  Management to be motivated to make a success  Seller:  Believes the business is worth more  Willing to take a risk to increase amount receives

15. 15 Harvesting Earn-outs II  Inherent conflicts  Buyer wants to pay lowest price  Seller wants to receive highest price  Works when Buyer and Seller interests are aligned  Buyer can manipulate earnings to reduce final purchase price  Accounting policies  Inter-company transactions

16. 16 Harvesting Sale or Merge Issues II  Can take a long time (up to 18 months)  Deal may fall through  Devastation  Impact on employees  Loss of momentum  What do I do now?  Continue in management? – become a manager, decision making, culture  Sail your boat

17. 17 Harvesting Valuing the Company for Harvest  Multiple of  Earnings  Net Income  EBITDA  Cash flow  Revenues  Net Assets  Present Value of Free Cash Flows  Importance of intangibles

18. 18 Harvesting Intangibles  Inventory undervalued  Replacement value of assets is high  Company has been run to minimize income taxes  Carmel art gallery  Operating permit – moratorium on art gallery licenses  20 years in business  Established wealthy client and art buyer from all over world  10 year lease in prime location with heavy traffic  Well trained sales people who understand the customers’ needs  Excusive rights to 6 famous local artists FastTrac

19. 19 Harvesting How Find a Buyer?  Investors, Board of Directors  Accountants, bankers, attorneys  Investment banker – Lehman formula  Brokers - fee is based on sale price  Founder’s industry contacts  Be proactive – identify potential buyers early

20. 20 Harvesting Preparing Your Company for Sale  Window of opportunity  Record of growth and profitability  Luck  Strong management team & Board of Directors & Advisors  Clean ownership structure  Minority shareholders  Avoid legal hassles  Ready for due diligence process  Audited financials by a top firm  Management controls & information systems  Representations and warranties  What tell employees?

21. Consider Going Public Choose Underwriter Prepare Prospectus Road Show Pricing Meeting Consequence IPO Process Company Has All the Power Investment Banker Gains Power Market & Investment Banker In Control Market Takes Over Teaching Notes, CML (B) & (C) Harvard College 1985

22. 22 Harvesting Initial Public Offering What Are the Cons?  Not suitable for most companies: size, history, management  Timing is everything – hot issues  Difficult for founders to sell shares – lock up period  Cost is high: legal fees, underwriters  Time required from management before, during, and after – 6 to 18 months  Roadshows  Underwriters, lawyers, accountants  Disillusionment  Price of shares may fall below offer price. Market “under values”  Shareholder suits  Disclosure requirements – Sorbaine  Pressure for short term profits

23. 23 Harvesting Initial Public Offering What Are the Pros?  Pressure for short term profits  Liquidity  Alternative to venture capital  Higher valuation  Flavor of the month  Company more visible  Easier to hire employees  Credibility with bankers, suppliers, customers  Impact on competition, funding  More fun for top management, if going well  If decide to merge with a larger company, will get higher valuation

24. 24 Harvesting Harvesting Conclusions  Should plan for harvesting? It may not happen.  Don’t take actions that preclude selling to the highest bidder, e.g. strategic alliances  A company with an exit strategy is easier to manage  Motivating force  Set high standards  Required actions help run the business