The information and data used in this report are extracted from the given case study , no primary data. In order to present the questions, the main body of this report has been divided into four parts. The first part aims for first question including the background of business, different methods I used to identify the valuation of business. The second part is about the business financing acquisition and structure, the third part I give my suggestion on business management after transaction and you should find the answer for question Q.3 and Q.4 in this part. And last part is about my overall recommendation and conclusion.
Finding
Background
Record Master (RM) was a leading provider of record and information management services to the health-care industry. It got 13 franchisees but 4 of them failed vote to demanding furture investment. For this main reason, the owners of 4 franchises decided to sell their business. Those four franchisees generated nearly 50% of sale and profit of RM, by 1993 it achieved revenues of $6,957,758 and operating income $1,166,912.
Kent Dauten had been a general partner at Madison Dearborn Partners and had worked there and at its predecessor. Dauten's had an investment experience of more than 15 years. It ranged across industries and stages of investment (LBO, Turnaround).
Dauten wanted to buy a business where he can apply his previous experience & increase the value of the business by his management skills & later on sale it when it's value is on its peak (Buy Low Sell High). This was second time that he was interested in RM. Six years ago he wanted to buy RM but did not bought it, but now had a great chance as could have realised the lost opportunity in the last six years.
Financial forecasts
RM had sales growth of 73%, 44%, 39% & 40% in 1990, 1991, 1992 and 1993, respectively which equals a 49% compound annual growth rate. However in 1990 the growth rate was 73% which is much different with other years. If possible, I recommend potential buyers should check historic papers to find out the reasons. Due to continue growing in information management of health care industry and also RM has got new market and products plan, in the next 5 years financial forecast I am going to use average historic growth rate to work out some items and use cash flow method with 15% expected EBITDA growth rate+ constant in the table below.
Table 2 Income and expense of RM forecast 1994-1997
Forecast income/expense items
1994
1st quarter*4
1995
1996
1997
Revenues
$8,029,572
-
-
-
Less: Cost of goods sold
5,076,224
-
-
-
=Gross margin
2,953,348
-
-
-
Less: G&A expenses
1,139,812
-
-
-
=Operating income
1,813,536
2,085,566
2,398,401
2,758,161
Adjustments
Depreciation
369,544
424,976
488,721
562,030
EBITDA
2,183,080
2,510,542
2,887,122
3,320,191
Less: Taxes/ interest
9,258
10,646
12,243
14,080
Less: investments in property and equipment
542,691
624,095
717,708
825,365
1,631,133
1,875,800
2,157,170
2,480,745
Reconstructed balance sheet
Table 3 Reconstructed RM's balance sheet 1993
Balance sheet items
Recorded
Assets
Accounts receivable
1,278,000
Cash and equivalents
289,000
Other (including cash)
75,000
Total current assets
1,642,000
Fixed assets (gross)
1,923,000
Accumulated depreciation
964,000
Fixed assets(net depreciation)
959,000
Total assets
2,602,000
Liabilities and equity
Account payable
127,000
Accrued expenses
196,000
Current portion of long-term debt
99,000
Deferred income
225,000
Total current liabilities
676,000
Long-term debt
95,000
Deferred rent
41,000
Net worth
$1,790,000
Business valuation approaches and methods
asset -based valuation result
Under this approach of business valuation I use the Capitalized Excess Earnings method which is used to work out: 1) the fair market value of the business net tangible assets and 2) business goodwill.
RM's net tangible assets figures come from the restructured balance sheet. It's goodwill is calculated by capitalizing 'excess earnings' which are the difference between net cash flow and a fair return on the net tangible assets. In this report I use discount rate instead of fair rate of return. The equity discount rate is worked by the build up procedure as below:
The discount rate =Rf+Pi+Pc (Note: Rf is the risk-free rate of return; Pi is the industry- specific premium and Pc is the risk premium specific to the subject business) as there is not relative information given hence historical US stock market return is used-15%, and this is used to calculate the business goodwill),
And then, value of net tangible assets is $1,790,000, value of business goodwill is $10,431,786
Business value: $12,221,786
income- based valuation result
Income-based valuation is based on the business forecast earning, discounted future potential earnings used to reflect the business risk. Table 2 in this report provides the net cash flow in next 4 years.
As there is no cost of capital is given, so even if we assume that it is unlikely to be any higher than 15% and this discount rate will be used.
Using average next 4 years cash flow figures $2,036,212 discounted by 15%
The residual business value is $13,574,747
market-based valuation result
Revenues
EBITDA
EBITDA%
Revenue growth rate
Revenue/employee
Earning Multiple
Revenue Multiple
Purchase price
Berkins
18.3m
4m
22%
17%
10.5times
2.3times
$42m
Bell+Howell
35.1m
8.1m
23%
76k/employee
7.5times
1.7times
$60m
RM
6.9m
1.5m
22%
49%
29k/employee
(10.5+7.5)/2=9times
(2.3+1.7)/2=2times
Ajustment
-5%
-5%
-5%
Case gave us other two business (Berkins Records Mangement and Bell+Howell Records Mangement) in the same industry as RM. Below I calculate Earnings Multiple and Revenue
Multiple by using the figures come from those two companies.
And then, the business value of RM as the average of those selling price estimates.
Business value is
7mX2timesX0.85=11.9m (revenue multiple)
and 1.5mX9timesX0.85(adjustment)=11.5m (earning multiple)
conclusion of business value
I used 3 methods above to provide the estimate RM's business value. In my opinion to understand case each of those methods used in this report is equally relevant. Therefore, I apply equal weight to each result and calculate indicated business value in the table below:
Valuation method
approach
value
weight
Weighted value
Capitalized Excess Earnings
Asset
$12.22m
25%
$3.06m
Discounted cash flow
income
$13.57m
25%
$3.39m
Comparative of earnings multiple
Market
$11.5m
25%
$2.88m
comparative of revenue multiple
Market
$11.9m
25%
$2.98m
Indicated business value
$12.31m
The minimum price that Dauten should pay for buying the 4 franchises of Record Master's is $11.5million + any premium of $1.5 m Maximum. The price of the Record Master's has been valued by two methods.
Income Approach (Comparable Approach) done in week 9.
Discounted Cash Flow Method.
Both the method has few short coming as did not have complete information.
Income Approach (Comparable Approach).
Particulars
Amount
Net Income (Pg 23 of Case)
1,122,216.00
Add: Depreciation.
368,104.00
Provision for Local Taxes.
37,174.00
Total
1,527,494.00
Less : Miscellaneous Income
529.00
EBITDA
1,526,965.00
The EBITDA of Record Master's Franchises is $ 1,526,965.
By Comparable P/E the Value of Record Master's = 1526965 * 7.4 = $11.3million
Value of Record Master's 4 Franchises by Comparable P/E is $11.3 m
There is some deficiency in this model due to lack of Information.
Assumptions: Assume multiple of 7.4 as it were most recent out of the two.
There is example of the 2 acquisition of a firm in the case study at pg 25. These companies are also dealing in the record management. This example gives out the following multiple:
Bekins Record Management (12/1985) has a multiple of 10.5 times.
Bell + Howell Record Management (12/88) has a multiple of 7.4 times.
Discounted Cash Flow Method
Particulars
1994
1995
1996
1997
NPBT
1669861.92
2003834.30
2304409.45
2650070.87
Add : Depreciation
584451.67
701342.01
806543.31
927524.80
Less : Capital Expenditure
200000.00
200000.00
200000.00
200000.00
Less : Increase in WC
834960.96
1001917.15
1152204.72
1325035.43
Less : Tax
500958.58
601150.29
691322.83
795021.26
Net cash Flow
718424.06
902108.87
1067424.20
1257538.98
NPV
2555007.03
NPV = $ 2.5m * 5 (multiple) = $12.5 m
As it is a mere forecast & things could go wrong as no one can predict the future, so the value that should be $11.5m for 4 Franchises of Record Master's & Negotiable on the higher side.
Assumptions Made for Calculating DCF are:
Sales (1994 /95) 20% arguments are mentioned below for both all the years
Sales (1996 /97) 15%
Depreciation + Amortization 7% of Sales/Revenue
This is on the higher side as we can see in the case study that the highest % to Revenue is 6 % & they are into service Industry so do have that much of Fixed assets.
Changes in Working Capital 10% of Sales/Revenue.
This is accordance to the Historic data given in the case study.
Capital Expenditure $ 0.2m for each year till 4 years. As already discussed the Company is into Service Industry.
Discount Rate : 18%
This firm is a small to medium size firm & is under the network of Record's Master's who has the right to cancel the membership with a 30 day notice, so it is risky.
Tax Rate: 30 %.
Ignored the Interest.
There are few non financial assumptions that are made for valuing 4 franchises of Record Master's are stated below:
Dautens Goal & Acquisition Criteria: 4 franchises of Record Master's fit perfectly with the Goals & the Acquisition Criteria which was mentioned by Dauten. This for me was the first step in the valuing Record Masters 4 franchises. If the below mentioned conditions were not meet then it would have been of no use to value Record Master's as Kent Dauten would have not shown interest in the business.
Achieve profitability of 10% to 15 % which was possible in the case of Record Masters.
Managing a company as a CEO & Chairman was possible if Dauten buys the franchises as this franchise was more like Sole Trader. The Network provided administrative help to the franchisees but did not control their strategic decisions or day-to-day operations.
Purchase price of $5 - $ 15million: The value of the 4 franchises approximately $12.5m
Minimum $1 million EBIT (no turnarounds): Actual EBIT was more than $ 1 Million
Leading and Protected Niche Market Position (under $1-$200 million): RML
Currently provides service to 46% of the hospitals, comprising 49% of the beds within their overall service area. The business is the market leader in each of the four cities.
Close Geographical Proximity or Easy Travel Access : The four locations of Record Masters that comprise the Business enjoy a dominant market position within their respective territories
Growth Potential Internally or Add-on Acquisitions: Growth potential was there as in this case we have just valued the 4 franchises out of 13, so there was a possibility of Add - on Acquisitions.
Potential Personal Contribution (prior experience, profit plans, etc.): Kent dauten had 15 years of extensive experience leading transactions in the healthcare industry.
The assumption that there is growth potential in the business (Sales) has been made on the following grounds. The below mentioned assumptions are the ''How ''factor of the growth in sales.
RML had sales growth of 73%, 44%, 39%, and 40% in 1990, 1991, 1992 and 1993 respectively, which equals a 49% compound annual growth rate. The Business could continue sales growth through increased market penetration (current hospital penetration is 47%) and new service initiatives, so the growth rate assumed in this valuation of 20 % is possible & sustainable in long run.
New Orleans : There is a huge scope in increasing the sales of this franchise as according to pg 11 of case study New Material Processing is only at 6.62 % of the Revenues, where as this figure is minimum 17.6 % in 3 franchises. Record Management Services are comprises on 41.64 % of Revenues which is more than 65 % in other 3 franchises.
Philadelphia: In this franchise there is huge scope of growth as the market penetration is on 32 %, where as it is more than 55 % & Bed penetration is at 31 % which is minimum at 65% in other 3 franchises & also there is a scope for growth in other part of the Revenue as it at zero currently. According to summary table on pg 11 of the case study.
Competitor advantage: Competitors are only able to service records that are several years older than those which Record Masters now serves due to the sheer volume of retrieval and refile service activity on newer files. These companies are not viewed as a significant competitive threat. This means that Record Master's have upper hand. It is also because of the Services Given by them.
Guaranteed one - hour "STAT" delivery
Record Masters is the record tracking performed for clients through customized and proprietary software.
Hospitals require a level of confidentiality that is higher at Record Master's than that normally associated with general business records.
New services: To increase Sales Record Master's could increase its spending per client or increase its client base. Increase in client base is not possible as Record Master's is into health care service Industry, so increasing client base is not sustainable in long run. So Record Master's should get into New Services which would enable the same client in spending more. Below Mentioned are few services which it could get into :
Integrate digital radiology media.
Navigate the transition to electronic health records.
Ensure compliance, even across multiple locations.
Minimize demands on IT staff.
Establish an effective model for records and data management cost control.
Temporary Staff as they were well trained.
Copy/Release of Information service to all other locations: It was a service where the earning where running at 15% before taxes. It constitutes 25 % of Medical records recall. 2/3 of storage & retrieval revenues.
Billing Services for hospital.
Imaging service that converts paper files to CD-ROM or optical disk for a large physician group practice as it's expensive.
Hospital file room purges.
How should the acquisition be financed? Recommend the amount and type of financing required, & provide a full justification for your recommendation?
Valuing the company is just the 50% of the work done, as the balance 50% depends on the financing part. The information provided in the case study is not very precise or full; as there is no clue about the Kent dautens financial condition (can he finance this acquisition on his own). There has to be a portion of the money which needs to come for the buyer's side. In this case kent Dauten top most priority is having voting control in his hands, for this he need to have at least 51% of the share of the company. The below mentioned are few methods for raising funds for a unlisted company. Every method has advantages & disadvantages. Kent dauten has 15 years of work experience in the venture capital, so he could use his network or contact form his past to get the things started. The owners of the 4 franchises are selling the franchises because the businesses represent a major portion of the net worth of the sellers. The owners have a desire to realize these holdings as are not happy with the networks expansion plan. This also should be taken into consideration.
The three main ways of financing takeovers: cash, issue of ordinary shares and fixed-interest securities (loan stock, convertibles and preference shares). The first two methods predominate, although their relative importance varies over time. The share exchange is favoured when the stock market is high and rising, while cash offers are used more when interest rates are relatively low or falling, given that many cash offers are themselves financed by the acquirer's borrowing. Increasingly, however, bidders offer their targets a choice of cash or shares, or even a three-way choice between straight cash, cash with shares, or shares alone.
Cash Method: The amount is certain, there being no exposure to the risk of adverse movement in share price during the course of the bid. The targeted shareholders are more easily able to adjust their portfolios than if they received shares, which involve dealing costs when sold. Because no new shares are issued, there is no dilution of earnings or change in the balance of control of the bidder (unless, in the case of borrowed capital, creditors insist on restrictive covenants). Moreover, if the return expected on the assets of the target exceeds the cost of borrowing, the EPS of the bidder may increase, although perceptions of increased financial risk may mitigate this apparent benefit. A disadvantage from the recipient's viewpoint is possible liability to Capital Gains Tax (CGT).
Share Offer: Any liability to CGT is delayed with a share offer, and the cash flow cost to the bidder is zero, apart from the administration costs involved. However, equity is more costly to service than debt, especially for a company with taxable capacity, and an issue of new shares may interfere with the firm's gearing ratio. There could be an adverse impact on the balance of control if a major slice of the equity of the bidder came to be held by institutions looking for an opportunity to sell their holdings. The overhanging threat of a substantial share sale may depress the share price of the bidder. The supply of equity to an unquoted company depends partly on its size and partly on its stage of development. Most new companies find it virtually impossible to raise equity finance except of a 'personal' nature, i.e. from supportive friends and relatives. Some venture capitalists (see below) will provide start-up finance for highly promising activities, but most invariably look for a track record on the part of the entrepreneur(s). Until this is established, such companies need to rely on additional supplies of personal finance and retained earnings for further equity.
Other methods: The use of other financing instruments is comparatively rare. When fixed-interest securities are used, they are usually offered as alternatives to cash and/or ordinary shares. Convertibles have some appeal because any diluting effect is delayed and the interest cost on the security, which qualifies for tax relief, can usually be pitched below the going market rate on loan stock, due to the expectation of capital gain on conversion. Preference share financing in general is comparatively rare, owing to the lack of tax deductibility of preferred dividends and to limited voting rights. Having established some sort of record of operating success and potential, further avenues open up. Among these are the following.
Business angels : A business angel is a private equity investor with spare funds to invest who wishes to gamble on the future prospects of young companies, often start-ups, managed by entrepreneurs lacking a track record but possessing a good idea plus enthusiasm.
Government-backed schemes
Venture Capital Trusts (VCTs) are a form of investment trust set up specifically to provide equity capital to small and growing companies.
Venture capital (VC) is funding mainly for the development of existing companies with sound management and high growth potential, but sometimes for especially attractive start-ups.
Private placing (or 'placement'): Private placing is a means whereby well-established companies can widen their shareholder base without going for a Stock Exchange listing. It is arranged through a stockbroker or issuing house, which buys the shares and then 'places' them with (i.e. sells them to) selected clients.
What Strategies could Dauten adopt to increase the value of the business?
Some companies went to failure due to poor business management. Business management is most important factors in daily running business. Especially for new owners who just completed company transaction. Dauten has rich experiences on investment and most likely he would sell RM when its value is on its peak time, if he would like to buy it. This is the way he makes money. Business growth can be happened by either organically such as through internal growth or external growth such as through take-over or merger with other business. In order to increase the value of business, the followings should be concerned, some of them include integral and external growth expect:
Increase sales
From historic financial statement we can see that RM has good performance. However RM already has over ten years history, due to business cycles, there would be decrease in growth in future if less efficient corporate strategy & implementation. In order to gain more profit, there are two ways should be applied- increasing sales and decreasing cost.
Increasing sales: Increase in sales is an art more than science. Many factors are involved in it. Kent Dauten can increase its customer base or increase the customer spending. Increase in Customer base is costly affair in long run & is not sustainable as it puts pressure on the resources, resulting lower profitability & defeating the whole purpose of increase in sales. On the other hand increase in customer spending is costly in short run as need to launch new services but is profitable in long run.
Ansoff's matrix growth strategies: By considering ways to grow via existing products and new product, and in existing markets and new markets, there are few possible product-market combinations which can be used for RM
Market Penetration- Even RM was leader in its industry and customer exit barrier's relative high but still RM need to improve its sales in current market. This strategy is the least risky as it leverages many of the firm's existing resources and capabilities. It seems like there is still growth trend in RM industry as older people group was getting big and more health information demand RM products and services.
Market development options : RM (4 franchisees) has almost 50% of sales and profit of whole 13, those 4 franchisees have natural experiences on segments market, thereafter it is very good chance with Dantan's future investment to expand market to other cities (less chance of failure).
Product development strategy: It can leverage its strengths by developing a new product targeted to its existing customers. New technology and automation not only bring opportunities to the company itself but also to its competitors. RM should concern on this section and also need to contribute its R&D as technology was its core competitive advantage. Below Mentioned are few services which it could get into:
Integrate digital radiology media.
Navigate the transition to electronic health records.
Ensure compliance, even across multiple locations.
Minimize demands on IT staff.
Establish an effective model for records and data management cost control.
Temporary Staff as they were well trained.
Copy/Release of Information service to all other locations: It was a service where the earning where running at 15% before taxes. It constitutes 25 % of Medical records recall. 2/3 of storage & retrieval revenues.
Billing Services for hospital.
Imaging service that converts paper files to CD-ROM or optical disk for a large physician group practice as it's expensive.
Hospital file room purges.
Motivating the current Workforce of RM:
The owners & workforce of the business have exhibited the entrepreneurial drive and skills necessary to bring RM to its current performance and are poised to continue growing. They showed their willing of working with a new owner in memorandum. However, prevoius owners' skills would be important factors for fate of company's future. Dauten should make sure prevoiuse owners & workforce would still work efficently in future.Dauten should think about build new skilled employees in certain time.
Growth Rate:
There are two things you can do to maximize the growth rate of your cash flows.
The first, a broad category, is to manage your business efficiently and effectively. Every action taken that increases sales more than expenses, or decreases sales less than it decreases expenses, increases net income and, hence, the growth rate of net income.
The second thing to do to maximize the growth rate is to stop playing tax games of pocketing cash income and not reporting it, and charging personal expenses to the business. This will report more income, pay more taxes, and have less personal cash flow for those three to five years, but by "going legit," This should be able to sell the business for many times the additional taxes you will pay.
This will able to increase the cash flows, the more valuable business will be. Usually, though not always, this will depend on the ability to produce and manage high growth in the past. As with the other variables, there is a trade-off. Fast growth means sales will be higher, which requires more net working capital. Thus, fast growth increases net income, which adds to cash flow but also requires more net working capital, which decreases cash flow. The worst combination is fast growth in sales, which decreases cash flow through its effect on net working capital, combined with a declining profit margin, which decreases net income and cash flow. This occurs when the business owner is managing growth poorly.
Management of Fixed Assets:
Maximizing value through management of fixed asset purchasing is a matter of spending wisely for Property, Plant & Equipment and balancing the costs of buying too much with the costs of buying too little. It is a good idea to begin by comparing your Return on Assets with industry statistics to see where the company stands up against your competition. If your ROA is lower than your industry, it means that others are using fewer assets to make the same income, or they're making more income with the same assets-or some combination of the two. Sweating out the asset adds to value by reducing the Retention Ratio, thus increasing the Payout Ratio. This does not necessarily mean that spending more money on equipment each time you buy, but buying less often, will increase the business value. As in almost all decisions, usually there is a trade-off. Perhaps using that old computer instead of buying something faster is costing more in lost income than gaining by increasing the Payout Ratio. If so, the value will decrease by stretching out capital expenditures, because you will multiply a lower forecast net income by a higher Payout Ratio, with the final valuation being lower. The economic approach always is to equalize the costs of both alternatives to achieve equilibrium.
Managing Net Working Capital:
Management of net working capital is often an overlooked area of maximizing value. Paying close attention to, and management of, credit policy may help a business lose its "flab." Loose credit policy leads to high accounts receivable, which increases net working capital, lowers the Payout Ratio, and lowers value. Of course, an overly tight credit policy loses sales and net income. So, ultimately there has to be balance. Equalize the costs of both extremes.
The above mentioned are few very crucial areas where Kent dauten can keep an eye on to maximise his business Value.
Q.4 Suggest how local owner's incentives can be aligned with the goals of dauten?
Achieve unique levels of profitability (OI% of 15+%) through high degree of acquisition selectivity, aggressive profit improvement programs, and meaningful management incentives.
The Consolidated profitability of 4 franchises for 1993 was 16.13% & the Gross Profit is 36.8 % (pg 23 & pg 9 of case study). Historically the GP is lowest @ 28.6% this was in 1989. Else the GP has always been 33.4% - 37.9%, hence achieving Dauten's expected level of profitability is very much possible. Dauten plan of aggressive profit improvement programs could done by retaining the employees of the 4 franchises as they already know in & out of the business which would help him to understand things properly in the initial years & use their expertise along with his management skills to implement the plan.
Achieve $25-$50 million in revenues within five years by closing one core acquisition in the next year.
4 franchises of Record Master's have a Revenue of $7million in year 1993 & has a potential of growing at a phenomenal rate of 20% which would mean that after 5 years it would be at a level of $ 17 million. This is only from his one of the acquisitions & if he is able to buy the rest of the franchises of the network he would be able to achieve $ 25 - $ 50million in revenue as 4 franchises is just the 50% of the business.
Control own destiny by growing at a deliberate pace, maintaining voting control, employing a conservative financial structure, and having dependable operating management in place.
This could be achieved by maintaining the growth rate of the Record Master's effectively. Dauten can maintain the control voting in the hands by becoming the CEO & Chairman of the franchise. Dauten can retain the employees of the Record Master's which would result in the dependable operating.
Have fun working with a more concentrated group of referral sources, managers, suppliers and customers.
This could be achieved by retaining all the employees of Record Master's franchises as they would be the one who would be able to generate the referral sourcing, due to their experience with this company.
Build wealth over a long-term time frame through price discipline, reinvestment, growth, debt, pay down, pre-tax compounding of value and QSBS tax treatment.
This could be achieved as the Revenue of 4 franchises of Record Master's is at $ 7million & with growth rate of 20 % for next 5 could achieve the Revenue figure of $ 18million. The revenue figure of 4 franchises of Record Master's constitutes 50% of the total network, so Kent Dauten can acquire rest of the franchises resulting in a total Revenue of $ 30+million. Kent Dauten need to lower the payout ratio for the 5years as the retained earning could be reinvested to support the phenomenal growth.
QSBS Stands for qualified small business stock, but Record Master's don't qualify for it as they are into health care industry & is excluded from the list. But he could use AMT (alternative minimum tax) which is 20%.
Conclusion.
The prospect of the 4 franchises of the Record Master's is very good & could be acquired for minimum price of $ 11.5 m + premium price of $ 1.5 (negotiable). Kent Dauten has a 15 years of experience in the venture capital predominantly in health care Industry, which he can use to maximise the value of the business by achieving the possible growth (20%). He was interested in this business six years ago, so now again he has the chance of buying it. In past 6 years the business has grown at phenomenal growth rate, which Kent Dauten would like to take this advantage.
