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Harrington Corporation

Professor Kevin Rock

Background
The Harrington Corporation is the leading producer of commercial desk calendars in the US at the time of the case
Founded by Joshua Harrington in 1920 Headquartered in Boston Currently owned by Thaddeus Baring, a descendant of the founder

Thaddeus Baring is contemplating retirement


The stress and strain of the calendar business is taking a toll on his health Every year another calendar: Its relentless!
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Background
The prospect of Barings retirement is a source of concern to the CFO, Paul Brooks
Baring intends to divest the business and relinquish control Baring is already soliciting offers in the $10M range and finding some interest among corporate buyers

Notwithstanding Barings assurances that the current management team would be protected in the event of a change of control, Brooks is skeptical the new owner would leave everything as is
Two CFOs?
Twice the trouble and half the effectiveness of one CFO
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Background
Brooks is not optimistic of duplicating his current situation at another employer
Current responsibilities include
Shareholder reporting: one individual Capital budgeting: major capital expenditure program just completed
Harrington facilities the most modern in the industry, excellently maintained

Financial forecasting and planning: level production; 98% re-order rate for product Working capital management: pay cash for all orders when due Debt issuance: two unutilized $1M lines of credit Equity issuance and dividend policy: as Owner decides
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Background
Brooks is not optimistic continued
Brooks currently enjoys a compensation package of $45,000 per year plus 2.5% of pre-tax profits
For a total of $80,000 in the most recent year, 1970 Equivalent to $463,724 in 2011 dollars

The prospect of an extended search and possible relocation does not appeal, particularly given Brooks employment history
Graduated from a leading school of business administration Worked five years in the venture capital area of a large Boston bank Started own management consulting firm before joining Harrington
Which means out of work for two years Had to step over the laundry basket every day on way to the office
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Background
Having surveyed his opportunities, Brooks gathers the management team together and proposes making a bid
Team members include Kim Darby (marketing), Keith Jackson (manufacturing), and Waldo Sloane (controller)
Have a combined 90 years experience in the business

Baring is amenable to a bid from management and willing to delay further solicitations of interest provided that
Proposal received in six weeks Meets Barings price of $10M, $8M of which is in cash
No more than $2M of seller financing
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Economics of the Transaction


The managers are unanimous that Barings retirement presents a unique buying opportunity Among Harrington Corporations favorable attributes:
High barriers to entry, due to economies of scale in production
To match Harringtons costs, an entrant would have to match its investment in high speed printing presses, leading to overcapacity and a debilitating price war

Virtually recession-proof product


Desk calendars disproportionately favored by those who work at desks; i.e., in the service rather than manufacturing sector
The service sector is historically less susceptible to economic downturns

A desk calendar is an inexpensive but essential part of office routine, virtually immune from budget cutting
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Economics of the Transaction


Favorable attributes continued
High customer re-order rate (98%)
Harrington desk calendars are competitively priced; company supplies its own stands Want to order another calendar? Better shop around hard and buy a stand yourself
Plus, better do it in August when your Purchasing Department is sending out the requisition forms ; Purchasing wants it done early to take advantage of Harringtons discount

Multiple expansion opportunities


Personalized appointment books, day planners, desktop accessories All vetoed by Baring, because dilute profitability and returns
Though returns still higher than cost of capital
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Economics of the Transaction


Favorable attributes continued
Minimal capital expenditures on core business until 1975
Recently renovated plant in Puerto Rico; permanently exempt from U.S. taxation and from Puerto Rican taxation until 1982

Unutilized debt capacity


$2.88M cash as of December 31, 1970 $2M undrawn working capital lines $0M long term debt and trade financing Excellent receivables collection experience

Eminently realizable cost savings


Barings salary of $200K per year Management bonuses of $140K per year, if need be
Combined savings of $272K after tax (20%). At a 10 multiple, worth $2.7M
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Economics of the Transaction


Favorable attributes continued
Insider deal; Brooks enjoys favor of Owner
Brooks increasingly responsible for general management of business as Baring disengages

Insider price
Granted right of first offer
exclusive right to enter into good faith negotiation with seller before seller entertains other bids

And nearly granted right of first refusal


Baring seems to be suggesting the company is theirs if only the management team can meet the $10M price

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Financing
Although the economics look good, the financing does not
Brooks and fellow team members only have $250K of capital

Brooks is tasked with raising more money


Over next three weeks, Brooks obtains a tentative commitment for an unsecured loan, in the amount of $3M
The loan would be provided by a New York City bank, rather than Brooks former employer in Boston

Brooks also reaches an understanding with Baring to accept a five year subordinate note in lieu of $2M in cash
The note would carry a below market rate of 4%, in order to minimize strain on the companys cash flow; as a result, the principal amount of the note would exceed $2M ($3M to be precise) In return for these concessions, Baring insists the management team personally endorse the note, making them and their families potentially liable for the entire amount
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Financing
With three weeks to go, Brooks is still short $4.75M
Turns to his old venture capital contacts His venture sources are willing to fund the remaining $4.75M in the form of a 20 year debenture but at a steep price
Want the debt to include an equity kicker stock warrants, to be exact exercisable into common stock at $1 per share
The same price paid by Brooks and the other members of the management team in acquiring their own stock

Also want an 8% 9% coupon plus the ability to exercise the warrants in kind (by surrender of equivalent principal amount) rather than in cash

All-in-all, the venture investors are looking for a return of 20% - 25% over their estimated holding period of six years (to 1976)
With considerably more downside protection than the management team

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Financing
Brooks finds an alternative funding source for part of the shortfall in Harringtons two, unutilized working capital lines
Rate of 6.25% instead of 20% - 25% Availability up to $2M

By drawing on the lines for seasonal working capital needs, some of Decembers estimated cash balance of $2.881M can be remitted to Baring just before closing
Reducing the purchase price to the management group on a dollar for dollar basis

The size of the remittance depends critically on the timing of


The compensating balance requirements The net working capital positions
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Financing
For the forthcoming year, 1971, the non-financial working capital accounts are expected to be 5% higher than 1970 (Ex. 4) Thus, the forecast quarterly and peak net working capital positions are
Non Financial WCAP (Quarterly + Peak) 12/31/1970 accounts receivable 1,270 inventories 294 current liabilities (633) non financial net working capital 931 change in non-financial WCAP Initial Cash Position begin cash 2,881 cash left behind (Baring) (1,750) remaining cash 1,131 3/31/1971 385 1,160 (652) 894 (37) 6/30/1971 317 2,015 (706) 1,626 733 8/31/1971 3,205 877 (638) 3,443 1,817 9/30/1971 12/31/1971 3,236 1,334 276 309 (616) (665) 2,896 978 (547) (1,918)

Preliminarily, Brooks assumes a $1.75M disbursement at close


Reducing the venture funding requirement to a nice, round $3M
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Financing
Assuming the term loan is paid monthly and the compensating balance requirements apply monthly as well, Brooks arrives at a preliminary estimate of a $1.851M shortfall in August, the peak borrowing month
The shortfall can easily be covered by drawing on the $2M working capital line
Non Financial WCAP (Quarterly + Peak) 12/31/1970 3/31/1971 6/30/1971 8/31/1971 9/30/1971 12/31/1971 accounts receivable (Exhibit 4, 5% growth) 1,270 385 317 3,205 3,236 1,334 inventories 294 1,160 2,015 877 276 309 current liabilities (633) (652) (706) (638) (616) (665) non financial net working capital 931 894 1,626 3,443 2,896 978 change in non-financial WCAP (37) 733 1,817 (547) (1,918) Cash Position forecast cash (Exhibit 4, 5% growth) 2,881 2,833 2,151 402 1,076 3,025 cash left behind (Baring) (1,750) (1,750) (1,750) (1,750) (1,750) (1,750) remaining cash 1,131 1,083 401 (1,348) (674) 1,275 Bank Term Loan Loan outstanding (monthly payments) $ 3,000 $ 2,819 $ 2,638 $ 2,517 $ 2,457 $ 2,276 compensating balance (20% term loan) 600 564 528 503 491 455 Balance surplus (deficiency) 531 519 (126) (1,851) (1,165) 820

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Financing
A more refined estimate, based on a forecast of all the monthly inflows and outflows, shows a slightly smaller August draw of $1.832M
Cash Flow (Quarterly and August Peak) 12/31/70 3/31/71 Cash flow from operations (post interest) 216 less investment in non-financial WCAP (37) assumes Jan 1 close; less capx 15 operating flows not less repayment of bank loan 181 seasonalized cash flow, after invest and debt service 57 plus begin cash 1,131 less comp balance req't (20% loan) (564) equals excess (deficiency) 624 plus seasonal draw (max highlighted) 0 equals end cash (begin + cflow +draw) 1,188 change in cash 57 change in WCAP begin seasonal loan end seasonal loan Bank term loan (monthly payments) minimum balance (20% term loan) 0 0 2,819 $ 564 0 53 2,638 $ 528 53 1832 2,517 $ 503 1832 1267 2,457 $ 491 1267 0 2,276 455 6/30/71 6/30 - 8/31 8/31 - 9/30 12/31/71 216 144 72 216 733 1817 (547) (1,918) 15 10 5 15 181 121 60 181 (713) (1804) 554 1938 1,188 528 503 491 (528) (503) (491) (455) (53) (1779) 566 1,974 53 1779 (566) (1267) 528 503 491 1,162 (660) (24) (12) 671 Total 47

31 78

3,000 $

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Financing
Since the anticipated August draw is still $168K under the borrowing limit, Brooks is tempted to increase the upfront payment to Baring a comparable amount, from $1.75 to $1.918M Brooks soon realizes , however, even a small increase could cause trouble with the working capital covenant on the term loan Compensating balances are classified as current or non-current according to the loan itself
Since the term loan is non-current, so are the balances In the March quarter, the net working capital is $894K, exclusive of cash Therefore, adding the $624K of cash not held as compensating balances (the excess in the preceding slide) gives working capital of $1.518M, which is too close to the covenant, $1.5M, to permit any change

Brooks has squeezed all the cash out of the firm he prudently can
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Financing
The proposed financing package is, therefore,
Financing for Harrington Buyout Cash left in company Term loan Venture capital debenture plus warrants Baring subordinated note Management equity Total $ $000's 1,750 3,000 3,000 2,000 250 10,000

The main question is whether it satisfies the managements and V.C.s objectives
V.C.s need a 20% - 25% return to 1976 (exit) Management needs to retain control (>50%), in the event the warrants are exercised
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Valuation
Seek to value the management equity using the APV method to value the firm APV seems a sensible approach because the debt schedule is fixed in dollar terms until the anticipated exit date, 12/31/1976
Flows to capital is a less preferred alternative because the methodology assumes a constant proportional capital structure
Meaning the debt is fixed as a constant percentage of firm value; not true of Harrington until after 1976
Unlevered equity flows EBIT tax rate EBIAT plus non cash charges less increase in working capital less capital expenditures equals unlevered equity flows $ 1971 1,516 $ 15.6% 1,280 120 78 60 1,262 $ 1972 1973 1,636 $ 1,717 $ 17.3% 18.4% 1,353 1,401 130 142 82 86 67 71 1,334 $ 1,386 $ 1974 1975 1,804 $ 1,894 $ 20.5% 22.1% 1,434 1,475 150 155 90 95 75 233 1,419 $ 1,303 $ 1976 1,988 22.5% 1,541 170 100 300 1,311

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Valuation
Need an unlevered cost of equity to discount the unlevered cash flows
But case written before CAPM no beta! - what to do? Use Gordon growth model: Pstock = d.p.s./(keg)
Where d.p.s. is dividend per share and g is the growth rate (in dividends or sales)

Flipping the Gordon model around, ke=g+(d.p.s./ Pstock ); the term in the parentheses is known as the dividend yield Applying the model to the comparables in Exhibit 5 gives an unlevered cost of equity of ku,e=11.6% (rounded to 11.5%)
good method of estimating equity costs in developing economies, such as China
Comparables Kane Granger Linden-Johns Average Gordon Growth Model dividend yield + rev growth '66-'70 = cost of equity -riskless rate 8.7% 1.9% 10.6% 5.25% 3.7% 12.5% 16.2% 5.25% 5.5% 9.2% 14.7% 5.25% 6.0% 7.9% 13.8% MRP 8.80% 8.80% 8.80% =beta 0.61 1.24 1.07 % equity = unlev'd 71.5% 0.44 79.6% 0.99 70.3% 0.75 73.8% 0.73 Est'd unlev'd ke

11.6%

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Valuation
For the terminal value, want to estimate WACC in 1976
Using a capital structure typical of firms in the industry, namely 75% equity and 25% debt (see preceding slide)
Harrington is expected to be a typical firm at that time; management and V.C.s expected to cash out

At a 7.25% rate, equivalent to the current bank term loan, the WACC is about the same as the unlevered ke
WACC calculation target equity unlevered beta ke pre tax cost of debt tax rate (1976) kd WACC 75% 0.70 13% 7.25% 22.5% 6% 11.5%

The result is not too surprising, as the tax shields are small and the bank rate is high
P + 2% is no bargain for the most senior debt in a relatively stable company
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Valuation
Estimating a growth rate for the post 1976 cash flows is challenging
Surge in capital expenditures in 1975 and 1976 Incremental increases in tax rate every year, notwithstanding Puerto Rican operations totally tax exempt until 1982 (shifting production to US?)

Assuming the trends in capex and tax continue, growth in cash flow should be restrained, even though sales increasing at 5%/yr
1%? 2%? Split the difference and say g=1.5% per year Therefore, a rough terminal value estimate is
Same as FCFcap of course

$1,311 $13,111 WACC g 10%


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FCFeu ,1976

Note the terminal value includes the PVITS from 1977 onward

Valuation
One way to check the terminal value is to compare it to the initial value It better be the case that Harrington can be sold at the same multiple of EBIAT in 1976 that management paid in 1970
Management is supposed to be getting a good price from the Owner

After deducting the excess cash of $1.75M which is not part of the deal, the investors are paying $8.25M for the company
Or a multiple of 8.39 times 1970s EBIAT of $983K

In 1976, Harringtons EBIAT forecast is $1.541M (slide 19) Thus, its estimated value at that time is $12.993M
Virtually identical to the $13.111M from the perpetuity method, the number used henceforth below
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Valuation
Ignoring, for the moment, the interest tax shields to 1976, the firm/enterprise value of Harrington is
Valuation, excluding PVITS ('71-'76) EBIT tax rate EBIAT plus non cash charges less increase in working capital less capital expenditures plus terminal value equals unlevered equity flows + TV unlevered cost of equity firm value & enterprise value $ 1971 1,516 $ 15.6% 1,280 120 78 60 1,262 $ 11.5% 12,384 1972 1973 1974 1975 1976 1,636 $ 1,717 $ 1,804 $ 1,894 $ 1,988 17.3% 18.4% 20.5% 22.1% 22.5% 1,353 1,401 1,434 1,475 1,541 130 142 150 155 170 82 86 90 95 100 67 71 75 233 300 13,111 1,334 $ 1,386 $ 1,419 $ 1,303 $ 14,422

$ $

Based on an acquisition price of $8.25M net, the equity investors are getting a very good deal an NPV of over $4M
But who exactly are the equity investors? Management? VCs? Both?
Need to come back to this question

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PVITS
The missing interest tax shields are unlikely to add significant value because of the low tax rate in the 1971-76 period An approximation to their present value can be obtained by discounting the shields by the unlevered cost of equity
PVITS 1971-76, simple method interest expense times tax rate equals interest tax shield PV at unlevered cost of equity (=11.5%) $ $ $398.30 1971 1972 1973 1974 1975 1976 637 $ 585 $ 523 $ 454 $ 400 $ 400 15.6% 17.3% 18.4% 20.5% 22.1% 22.5% 99 $ 101 $ 96 $ 93 $ 88 $ 90

To do the PVITS calculation the right way, however, it is necessary to discount the shields separately for each layer of debt
At each debt layers yield to maturity
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PVITS
Here are the results of the so-called accurate method
PVITS 1971 to 1976 ($ 000's) Bank loan: average balance $ interest at 7.25% tax shield Present value at 7.25% $ Seasonal loan: interest (plug) $ tax shield Present value at 6.25% $ VC debt average balance $ interest at 9.00% tax shield Present value at 11% (est'd stripped yield) $ Baring note average balance interest at 4.00% tax shield Present value at 13.4% (IRR) $ Total PVITS $ 3,000 $ 270 42 217 $3,000 120 19 67 413.9 3,000 $ 270 47 3,000 $ 270 50 3,000 $ 270 55 3,000 $ 270 60 3,000 270 61 56 $ 9 52 61 $ 11 64 $ 12 59 $ 12 32 $ 7 65 15 1971 2,638 $ 191 30 78 1972 1,851 $ 134 23 1973 945 $ 69 13 1974 233 $ 17 3 1975 700 $ 51 11 1976 900 65 15

$3,000 120 21

$3,000 120 22

$2,704 108 22

$1,192 48 11

$0 0 0

Theory says the accurate method results in a higher PVITS


And so it does here, but the difference is small 4%
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PVITS
Note the assumed yield to maturity on the VC debt is 11%
Lower than the 13.4% yield on the Baring note because Baring has the more subordinated claim Higher than the 6.25% yield on the 10 year Treasury bond (not in case) because the VC debt is illiquid and non-investment grade (junk)
B-rated spreads to long Treasuries are normally 4% - 5%; here 4.75%

As a straight debt security, the VC bond is only worth $2.746M, assuming an annual coupon of 9% and callable at par on 12/31/76
VC debt, price to call (12/31/1976) interest & principal repayment assumed yield present value (price) 12/31/71 270 11% $2,746 12/31/72 270 12/31/73 270 12/31/74 270 12/31/75 270 12/31/76 3270

So, why would the VCs pay $3M?


The difference of $254K is the price of the equity kicker (warrant)
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The VC Debt plus Warrants


How do the VCs know what the warrant is worth?
An equity warrant is the same as a stock option, except the exercise price is paid to the company, not a third party Formula for valuing options (Black Scholes) not published until 1973!

First, the VCs compare their deal to managements


Upfront cost of the warrant is the essentially the same as managements stock: $254K versus $250K, same number of shares VCs, however, have an additional $250K outlay upon exercise
But thats not for six years; can earn VC-like returns in the interim 20% And dont forget: half of that outlay goes back to VCs as 50% owners Thus, net cost of exercise only $125K; $42K on a PV basis (20% rate)
Even less if take into account VCs can put the debt back at par as exercise consideration

Bottom line: The VCs pay less than a $42K premium relative to management for an approximately equal stake in the company
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The VC Debt plus Warrants


Second, the VCs compare their deal to previous deals
See if they earn a 20% - 25% holding period return, using the base case forecast and a 50% equity position

Here is the equity value in 1976, when the VCs expect to exit
Terminal value of equity (12/31/1976) Terminal value of firm less bank term loan less seasonal less sub debt less Baring plus proceeds upon exercise of warrants equals equity value VC stake (50%) management stake (50%) $ 13,110 (399) 0 (3,000) 0 250 9,961 4,981 4,981

$ $ $

The estimate assumes the VCs exercise the warrants in cash


Again, if the debt is trading below par at that point, it would be better for the VCs to use $250K of bonds at face value in lieu of money
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The VC Debt plus Warrants


Based on the terminal equity estimate, the VCs returns are
VC cash and percentage returns interest principal less exercise cost ($250K) terminal equity stake initial investment Total $ IRR: 1970 $ 1971 270 $ 1972 270 $ 1973 270 $ 1974 270 $ 1975 270 $ 1976 270 2,750 4,981

(3,000) (3,000) $ 23.5%

270 $

270 $

270 $

270 $

270 $ 8,001

Note the VCs meet their hurdle rate of 20%


The calculated return of 23.5% is in the approximate middle of the required range of 20% - 25%

Therefore, have a workable deal management has a positive NPV opportunity and the VCs meet their return objective without exceeding 50% ownership
But can management do better?
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Management
How well is management doing in the transaction as currently structured?
Put in $250K Equity worth $4.981M in 1976 Receive no dividends in the meantime

Therefore, management is looking at an expected return of 64.6% per year Is a 64.6% annual return enough? Hard to say, highly risky position
Last to get out Restricted compensation Unlimited downside
have pledged house, car, and even little Thaddeus the cat
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Management
Perhaps a different perspective might help; here is the NPV of the entire transaction
Harrington Enterprise Value and NPV simple APV accurate APV Present value, unlevered equity flows $ 12,384 $ 12,384 interest tax shields 398 414 Total value, levered firm and enterprise $ less purchase price NPV $ 12,782 $ (8,250) 4,532 $ 12,798 (8,250) 4,548

There is $4.548M of value in Harrington over and above the companys price; who are the rightful owners of this NPV?
The equity investors, clearly Thats management Plus the warrant holders
As the transaction is currently structured, the warrant holders are entitled to a half share in the upside ($2.27M), once they have paid the exercise price
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Management
Want to have one more look at the valuation
Check the pricing of the debt as well as the equity

Suppose all the principal payments scheduled up to 12/31/76 are rolled over with interest until the exit date
Like carrying a balance on a credit card until you get paid

The accumulated principal and interest is $13.85M


Harrington buyout debt Term loan Venture capital debt Baring subordinated note Total estimated value at 12/31/70 $ $000's 3,000 3,000 2,000 8,000 yield 7.25% 9.00% 13.40% 1976 acc'd princ'l & int $ 4,566 5,031 4,253 $ 13,850

Consider what the equity is worth at that time, as a function of the firm value, VF
For simplicity, assume the warrants expire at 12/31/76 and have a zero exercise price
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Management
The value of the equity on that date is max[VF$13.85M, 0]
The equity equals the value of the firm less the debt
As long as that difference is positive; else, zero

The equity value at exit is the same as the payoff of a call option
the underlying asset is the firm, whose initial value is $12.798M (pg. 32) the exercise price is $13.85M ; the exercise date is 6 years; the 6 year riskless rate is 6.25% (equal to the 10 year Treasury note, pg. 27) the volatility of the firm is assumed to be 30%, indicative of a safe business the equity value includes the warrants, which are either converted to stock on that date or thrown away

Putting these parameters into the Black-Scholes model values the option and therefore, the equity plus warrants at $5.08M
Go to http://www.xleverywhere.com/samples/bs/bs.htm and try it!
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Management
The implied equity & warrant value of $5.08M is virtually identical to the original estimate
The difference of $44K looks a lot like the exercise cost of the warrants, which was ignored for simplicity in the option analysis The cost adds to value because it is a deferred payment for equity
Value of equity plus warrants at 12/31/1970 Price paid for management equity $ Price paid for warrants NPV shared by mgnt. and wt. holders (pg. 32) Total $ $000's 250 254 4,548 5,052

Therefore, if the firm is properly priced and the equity & warrants are properly priced, then the debt is properly priced
Here, debt refers to the aggregate debt, stripped of the warrants
Cannot really comment, however, on the accuracy of the pricing of any particular debt instrument, just the totality
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Management
This analysis confirms management and the VCs get basically the same deal as far as their equity interests are concerned
Both pay about $250K for a 50% interest

That doesnt sound fair


Management doing all the work; even betting the cat VCs need to give up some of their equity percentage

How far down can VCs go and still clear their hurdle? 35.2%
in which case, managements return increases to 72% and justice is done
VC cash and percentage returns interest principal less exercise cost ($250K) terminal equity stake (35.2%) initial investment Total $ IRR: 1970 $ 1971 270 $ 1972 270 $ 1973 270 $ 1974 270 $ 1975 270 $ 1976 270 2,750 3,516

(3,000) (3,000) $ 20.0%

270 $

270 $

270 $

270 $

270 $ 6,536

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What happened
Harrington Corporation is actually Keith Clark Calendar In 1967, John Keith Pete Clark decided to retire after 28 years and sold his company to four men
James ONeill, Jay Negin, Robert Nevin, and Samuel Negin
ONeill became President, Jay Negin CFO, Robert Nevin Vice President, and Samuel Negin Treasurer

In the mid 1970s, these individuals sold the company to Lewis Cullman for $13M cash
Very close to the assumed terminal value of $13.11M used above Thus, the management team realized a better than 64.6% annual return
No information on the VC share, so how much better than 64.6% is not known

But thats not the end of the story its more like the beginning
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What happened
In Lewis Cullmans autobiography, he described the Keith Clark Calendar business as about as good as it gets
Agrees with our assessment!

Over the next 22 years, Cullman expanded the company until it had a 90% market share, while remaining sole owner In 1999, he sold the company to Mead Paper for $550M He and his wife, Dorothy, then embarked on a career of philanthropy, giving away $233M to a variety of educational institutions and medical centers You can read about it in his book
http://www.lewiscullman.com/pages/cullman_bio.html

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