Southwest Ventures is considering an investment is an Austin, Texas-based start

Question

Southwest Ventures is considering an investment is an Austin, Texas-based start firm called Creed and Company. Creed and Company is involved in organic gardening and has developed a complete line of organic products for sale to the public that ranges from composted soils to organic pesticides. The company has been around for almost 20 years and has developed a very good reputation in the Austin business community, as well as with the many organic gardeners who live in the area.

Last year, Creed generated earnings before interest, taxes, and depreciation (EBITDA) of $4 million. The company needs to raise $5.8 million to finance the acquisition of a similar company called Organic and More that operates in both the Houston and Dallas markets. The acquisition would make it possible for Creed to market its private-label products to a much broader customer base in the major metropolitan areas of Texas. Moreover, Organic and More earned EBITDA of $1 million in 2009.

The owners of Creed view the acquisition and its funding as a critical element of their business strategy, but they are concerned about how much of the company they will have to give up to a venture capitalist in order to raise the needed funds. Creed hired an experienced financial consultant, in whom they have a great deal of trust, to evaluate the prospects of raising the needed funds. The consultant estimated that the company would be valued at a multiple of five times EBITDA in five years and that Creed would grow the combined EBIDTAs of the two companies at a rate of 20% per year over the next five years if the acquisition of Organic and More is completed.

Neither Creed nor its acquisition target, Organic and More, uses debt financing at present. However, the VC has offered to provide the acquisition financing in the form of convertible debt that pays interest at a rate of 8% per year and is due and payable in five years.

a) What enterprise value do you estimate for Creed (including the planned acquisition) in five years?

b) If the VC offers to finance the needed funds using convertible debt that pays 8% per year and converts to a share of the company sufficient to provide a 25% rate of return on his investment over the next five years, how much of the firm's equity will he demand?

Explanation / Answer

Answer to Question a. Need to Calculate - Enterprise Value(including the Planned Acquisition) in Five Years Amount in $ a. EBDITA of Creed (Given in the Question)            40,00,000 b. EBDITA of Organic (To get acquired)            10,00,000 Total EBDITA of Merged Organisation as a whole            50,00,000 Growth in Five Years - Estimated EBDITA after 5 Years ((5000000)*((1.02)^5))         1,24,41,600 EBDITA Growth Rate = 20% Enterprise Value = Estimated EBDITA * EBDITA Multiple         6,22,08,000 EBDITA Multiple = 5times Less : Debt (No Information abou debt so treated as zero)                            -   Equity Value after 5 Years =         6,22,08,000 Answer to Question b. Year 5 Coversion Value Company Needs to Raise - Funding Needed            58,00,000 (1+0.25)^5 - Year 5 Conversion Value - Organic estimated Rate of Return = 25%                  3.0518 Year 5 Coversion Value = 5800000*3.0518         1,77,00,195 Organic's Share = Year 5 Conversion Value/Total Equity Value 28.45% (17700195/62208000) Answer to Question c. If Creed is able to grow at 30% Organic's Share Need to Calculate - Enterprise Value(including the Planned Acquisition) in Five Years Amount in $ a. EBDITA of Creed (Given in the Question)            40,00,000 b. EBDITA of Organic (To get acquired)            10,00,000 Total EBDITA of Merged Organisation as a whole            50,00,000 Growth in Five Years - Estimated EBDITA after 5 Years ((5000000)*((1.03)^5))         1,85,64,650 EBDITA Growth Rate = 30% Enterprise Value = Estimated EBDITA * EBDITA Multiple         9,28,23,250 EBDITA Multiple = 5times Less : Debt (No Information abou debt so treated as zero)                            -   Equity Value after 5 Years =         9,28,23,250 Year 5 Coversion Value Company Needs to Raise - Funding Needed            58,00,000 (1+0.25)^5 - Year 5 Conversion Value - Organic estimated Rate of Return = 25%                  3.0518 Year 5 Coversion Value = 5800000*3.0518         1,77,00,195 Organic's Share = Year 5 Conversion Value/Total Equity Value 19.07% (17700195/92823250)

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