Gary and Iris are to finance the purchase of Visual Scientific. In order to make this possible, there are some debt sources and some equity sources available. Before making any decisions on the financing, one must decide whether the R&D is to be completed in one year or three and the lens should be manufactured in-house or outsource. Apparently one must try to complete the R&D in one year if at all possible and outsource the production. In order to structure the financing of the purchase using all equity or a combination of debt and equity, I made an assumption that the $2 million purchase price was agreed upon.
First of all, the proforma income statement for VSI and estimate the free cash flows for Gary & Iris and for Cowboy Ventures was constructed. All equity option for Gary & Iris is 80, for Cowboy Ventures is 1 820. This makes 1 900 altogether, so with $100 in excess cash the sum would be $2,000.
According to theoretical knowledge, the cash flow available to pay dividends for each year cannot be negative. In my case it was 56,80%. Thus, the R&D was delayed, the salaries to the owners were lowered, G&A was cut, more was borrow, and shares were sold to Cowboy Ventures. Iris had developed a new substance from which to make the lens. It would be not that costly and would create a better lens than existing technology. That is how Gary and Iris began developing a business plan to explore and capitalize on the opportunity.
If it is assumed that the dividends payable will be equal to cash flow available to pay dividends, the percentage ownership that is needed to be given to Cowboy Ventures for any capital should be reduced. In practice, the additional alternatives in this situation are to repay the high cost loans faster (possible if the terms of the loan allows early repayments), put the funds aside to earn interest if it will be needed in a future year when the company has a deficit (the interest income becomes more than the income statement), or buy out the venture capitalists.
Figure out what percentage of the company you will need to give Cowboy Ventures for the capital you get from them. Initially, you may assume that Cowboy Ventures will exit at the end of seven years.
The financing arrangements can be optimized by minimizing what the suppliers are paid of capital in order to keep as much as possible of the company for Gary & Iris. For instance:
Taxable income (428) 711 875 1 383 3 001 5 870 5 800
Corp. income tax (50%) (214) 356 438 692 1 501 2 935 2 900
VSLI’s equipment had been replaced not too long ago but rapid depreciation had decreased its book value to $100,000. Gary and Iris were convinced that it was worth $500,000. Because of the custom nature of its work, VSLI kept large stocks of highquality optical glass on hand. Much of this had been purchased a year or two ago on particularly favorable terms. The raw material inventory with $200,000 in book value was worth $500,000.
Cowboy ventures firm found the venture beneficial and pledged to give Gary and Iris up to $3.5 million in equity investment. However, the company required from the management team to put up all of their liquid assets which Gary and Iris estimated to be $80,000 (about $40,000 each). The cost of capital for the equity funding will be 60% before-tax if any debt is used to finance the buyout and 50% before-tax if the buyout is made entirely with equity.
All excess cash will be paid out. You want to do this for planning purpose since it pays back Cowboy's 60% cost of equity faster. Dividends payable range from 306 to 2910.
This takeover should be financed together as Gary and Iris thought that running out the numbers would help them get a feel for the important issues and trade-offs. Since Gary, who was making $100K per year, and Iris, making $80K per year, both were willing to each take a 50% salary cut until the business was self-sufficient in terms of cash. The implantable lens technology needed an additional $1 million in R&D before the product could enter the market. Without a major influx of venture capital, Gary and Iris thought it would take three years to generate enough cash flow to complete the R&D that is necessary for profit. This would delay VSLI’s entry into the market, lower their market share when they did enter and reduce the market in the early years since VSLI would not be out developing the market.
Visual Scientific could manufacture the implantable lens in-house or outsource. If they manufactured in-house, they would need additional capital for equipment and working capital. If they outsourced, VSLI’s COGS could rise to 40% from 20% of sales and they would still need additional capital to finance accounts receivable and finished goods inventory.
Gary and Iris should have the same ownership since there have the same obligations and share the same benefits. Gary is convinced that the new implantable lens technology has great potential and is the key to VSLI’s future. Moreover, he has a great deal of respect for Iris’s engineering and management abilities. Thus, he decided that she should be part of the management buyout team.