Leveraged Financing

Ian Giddy

1
 Four Applications of Valuation

™ Business restructuring: breakup value of public

companies
™ Financial restructuring: before and after
™ Mergers and acquisitions
™ Valuing a private company

2
 What Does Value Mean? Public vs. Private

™ Public Company Valuation

‰ maximum share price
™ Private Company Valuation
‰ maximize after-tax personal income
‰ build personal wealth
‰ protect wealth from taxes

3
 “Enhance Shareholder Value?”

Depends on Corporate Life Cycle

BUSINESS

Start-Up Growth Early Maturity Late Maturity

Creation Growth Preservation Transfer

PERSONAL

4
 Managing Value

™ Maximize corporate expenses

™ Shift income to low-tax bracket family
‰ tradeoff payroll taxes if employed
‰ better to make family S-corp holders or limited partners
™ Own assets privately, lease to company
™ Lever company to finance new investments
™ Multiple corporations:
‰ distribute income and value
‰ lower tax bracket

5
Uses of Private Company Valuation
™ Estate planning
™ Merger & acquisition
™ IPO
™ ESOP
™ Phantom stock options
™ Stock repurchase (buy/sell agreements)
‰ First right of refusal
‰ Shareholder disputes
™ Private equity investments

6
 Private Valuation Concepts

™ Corporate value
¾ Value of company if acquired whole

™ Controlling interest premium

™ Marketability (illiquidity) discount
™ Minority interest discount
¾ “Swing vote”: a minority share that effectively controls the
company

7
 Private Companies: Typical Valuation Methods

™ Book value
™ Market comparables
¾ earnings multiples
ƒ weighted averages of recent earnings
ƒ earnings adjusted for recurring operations
ƒ earnings normalized for related party transactions

™ Prices of prior arm’s-length stock sales

™ Discounted cash flow/VC method/LBO

8
Marketability Discounts

™ No market for shares versus public company

™ Lacks liquidity unless:
‰ do an IPO
‰ sell or merge the business
‰ sell shares to company or other shareholders
™ Flotation costs must be incurred to sell
™ Typical range: 15-35%

9
Minority Interest Discounts
™ Cannot influence dividends
‰ insecure income stream
™ Shareholders have no control
‰ can be squeezed-out
‰ no influence on Board of Directors
™ Typical discount range: 35-50%
‰ degree of discount affected by buy/sell agreements,
preemptive rights, appraisal rights, employment agreements,
etc
‰ as specified in shareholders’ agreement

10
Relationships Between Discounts

Issue 1 Issue 2
Controlling Interest
Private Company?
or Minority Interest?

Marketability
Control Minority
Discount

15-35%
Control Minority
Premium Discount
20-25% 35-50%
11
M&A and Leverage

Takeover?
Company
has
unused Leveraged buyout?
debt
capacity
Leveraged
recapitalization?

12
 Private Pitfalls

™ Methods: same
™ Problems:
™ No market price
™ No history of reported information
™ Data provided can be distorted

13
Private Pitfalls

™ Revenue overstated?
™ Costs understated? Overstated?
™ New costs that will be incurred?
™ Intangible value?

14
LBO: A Temporary Capital Structure

Stage 1: Pre-LBO
Stage 2: LBO
financing

Stage 3: LBO
refinancing
Stage 4: Debt
paydown
COST
OF
CAPITAL

DEBT
RATIO

15
12-Step Method

™ Evaluating cost of deal

™ Estimating borrowing capacity
™ Estimating cash costs of funding
™ Estimating growth rates of sales, expenses, etc
™ Projecting cash flows (FCFF and FCFE)
™ Projecting debt amortization
™ Calculating terminal value of FCFE and FCFF
™ Estimating costs of capital to find PV
™ Making sense of the deal

16
Cost of the Deal

Estimating cost of deal

Shares 10
Price $ 45
Premium 15%
Equity cost $ 518
Debt cost $ 55
Fees 5% $ 29
Capex & restructuring 10% $ 57
Total cost of deal $ 658

lbocapacity.xls on giddy.org
17
Borrowing Capacity

Estimating borrowing capacity

Given:
EBIT $ 95
Min EBIT int coverage ratio 1.3
Interest capacity $ 73 From table
Interest rate 16.00%
Debt capacity $ 457

lbocapacity.xls on giddy.org
18
Capital Structure

Preliminary capital structure

Debt $ 457
Missing $ 177
Mgt equity $ 25
Total financing $ 658

lbocapacity.xls on giddy.org
19
LBO Financing

NEWCO

Senior
Cost of debt $457 What securities?
purchasing What returns?
Mezzanine
the What investors?
business
Equity $25

20
Cash Flows and Debt Repayment

Cash Flows and debt repayment

1 2 3 4 5
NOI 95 5% $ 99.75 105 110 115 121
Principal $ 457
Interest 16% 73 55 51 46 40
Tax 35% 9 17 21 24 28
Add depr of 57 11.4 11.4 11.4 11.4 11.4
Less capex 10% $ 10.0 $ 10.5 $ 11.0 $ 11.5 $ 12.1
Cash avail to repay debt 19 33 39 45 52
Remaining debt 438 405 366 321 269

lbocapacity.xls on giddy.org
21
Exit

Company gets bloated or slack IPO or sale of

and stock price falls company

LBO financing lined up

Rates of return LBO offer made

IPO @ NOIx 6 727
VCs 87.6% $ (177)LBO completed
0 0 0 0 637
Managers 12.4% $ (25) 0 0 0 0 90
$ (202)

IRR 29%
Restructuring
ƒ Efficiencies
ƒ Divestitures
ƒ Financial

? years 3-9 months 5-7 years

22
Case Study

Photronics

Flexics

23
 Flexics
™ Using what you have learned about M&A valuation,
private company valuation and leverage capacity,
estimate a range of values for the company
™ What should Flexics’ owners do?
™ What should the LBO team offer?
™ What should Photronics offer?

24