Inside M&A: The Need for Capital Forces Sale of Demand Energy

In the 20th century, electrical power generation relied primarily on fossil fuels and distributing power on the electric grid. Concerns about reliance on foreign oil, air pollution, and global warming have spawned the growth of solar and wind power as renewable energy sources. But these power sources are not without their limitations. Wind power may be generating electricity when no additional power is needed. Solar power generation varies with cloud cover and at best is only available during daylight hours. However, demand tends to peak after dark. These issues have spurred interest in developing technologies to store power generated by these renewable energy sources.

In recent years, both domestic and foreign utilities have acquired startups that offer high potential to create the next generation of energy storage technology. European utilities in particular have taken the lead in making renewable energy investments and have moved quickly to buy startups to help them better manage generation, distribution, and usage of this power.

On January 11, 2017, Italian utility Enel Group acquired Demand Energy, a US-based intelligent control software¹ provider, project developer, and operator specializing in battery storage systems and software. Enel Group is an Italian multinational manufacturer and distributor of electricity and natural gas. In an effort to reduce the firm's dependence on hydrocarbons, the company has expanded aggressively into renewable sources of energy.

The Enel Group will operate Demand Energy within its renewable energy subsidiary Enel Green Power, which is engaged in the production of electricity from renewable sources. As of 2016, the firm has 735 active power plants with a presence on four continents (Europe, North America, South America, and Africa). In each country, its renewable operations are managed through an operating division. Demand Energy will be operated by Enel Green Power North America (EGPNA), which owns and operates 100 renewable facilities in 23 states and two Canadian provinces. These facilities in North America and on other continents provide both domestic and global opportunities to expand use of Demand Energy's DEN.OS energy management software, which allows for the most efficient use of storage systems in real time.

Demand Energy is an American startup founded in 2008 with a current staff of thirty people. The company provides a turnkey solution (hardware, software and services) that combines modeling, design, and simulation with installation and operational monitoring, and control systems. Its DEN.OS software platform was designed to be easily scaled to support larger renewable energy facilities. The firm currently has little penetration in the energy storage market outside of New York City. Recently, the firm began developing and managing microgrids (i.e., small networks of electricity users with a local source of supply attached to a centralized national grid). Each microgrid is capable of functioning independently of the national grid.

Demand Energy's goal is to quickly obtain the resources and capabilities to grow the firm. Confronted by growth opportunities it could not fund, the firm looked at a range of options from partnership to the outright sale of the firm. While allowing for continued control, partnerships require consensus on strategy and prioritization of investment opportunities. Consequently, decision making can be slow and sometimes contentious. Outright sale to the right company seemed to be a better way to accelerate growth and for the owners to pull cash out of the startup.

While the firm had many suitors, Enel stood out because of its huge global renewables investment portfolio in need of optimal battery storage solutions. As part of a much larger company, Demand Energy could get access to both capital and opportunities within Enel's expansive and geographically diverse investments in renewable facilities. Moreover, Enel and Demand Energy shared the same belief that renewable energy represented the wave of the future.

The challenges of being a small entity within a large bureaucratic firm can become daunting. Large parent firms are likely to fund what they see as the fastest growing opportunities offering the greatest impact on consolidated earnings. Small units sometimes have huge potential to display meteoric growth in percentage terms but their contribution to the consolidated parent's financial statement is miniscule in terms of actual dollars. Thus, the funding expected by Demand Energy may come more slowly than the firm's founders believe is warranted. Unlike the nimbleness of many startups, decision making often advances at a glacial pace in large firms leading to low morale, with key personnel eventually leaving. While Enel retains the value of the intellectual property they acquired, the real loss is the innovative capability of those that leave.

Chapter Overview

Most firms are privately held. Such firms are those whose securities are not registered with state or federal regulators and, therefore, cannot be listed on public markets.² They account for about 86% of all US corporations³ and more than three fourths of US acquisitions.⁴ According to JPMorgan Asset Management, the number of public companies has plummeted by more than 50% in recent years from their peak of about 7400 in 1996. This precipitous decline relative to their privately owned counterparts reflects substantial consolidation and an exit of companies that has far outpaced the rate of IPOs.⁵ The cost of IPOs is high and with interest rates in recent years at historical lows firms could simply borrow money rather than issue new shares diluting the ownership of the founders. Moreover, privately held firms are remaining private longer and going public at a much later stage than in past decades. The ability of private firms to avoid having to register as public companies is in part a result of the Jumpstart Our Business Startups Act of 2012 which raised the number of shareholders required to register from 500 to 2000 (see JOBS Act in Chapter 2). While publicly traded firms do have substantial economic impact, these trends suggest that much more attention needs to be given to analyzing privately held firms.

The lack of “tradeable” markets makes valuing these businesses challenging. Nonetheless, the need to value such businesses may arise for a variety of reasons. Investors and small business owners may need a valuation as part of a merger or acquisition, for settling an estate, or because employees wish to exercise their stock options. Employee stock ownership plans (ESOPs) also may require periodic valuations. In other instances, shareholder disputes, court cases, divorce, or the payment of gift or estate taxes may necessitate a valuation

This chapter discusses how the analyst deals with problems uncommon to public firms. Since issues concerning making initial contact and negotiating with the owners of private businesses were addressed in Chapter 5, this chapter focuses on the influence of family control and the difficulties of valuing such firms and adjusting firm value for control premiums, minority discounts, and liquidity discounts. This chapter also includes a discussion of how corporate shells, created through reverse mergers, and leveraged ESOPs are used to acquire privately owned companies and how so-called private investment in public equity financing may be used to fund their ongoing operations. The chapter also discusses the mechanics of early stage investment in embryonic firms. A review of this chapter is available in the file folder entitled “Student Study Guide” on the companion site to this book (https://www.elsevier.com/books-and-journals/book-companion/9780128150757).

How Family Control Affects M&A Activity

Most privately held firms are owned (or controlled) by members of the same family. As such, the terms privately held or family-owned often are used interchangeably. Ownership tends to be more concentrated in family owned firms with a few large shareholders than in more widely held publicly traded companies. Challenges facing family owned firms include management succession, limited access to financing, informal management structure, poorly trained management and a potential preference for ownership over growth.⁶

Because most firms are family owned, they do account for the vast majority of M&As. However, such firms exhibit on average a low propensity to engage in M&As, which can threaten the family's control if they dilute ownership, alter succession planning, change the founder's legacy, and impact the firm's reputation. M&As also can have adverse consequences such as layoffs that run contrary to the family's core values. While such factors can make family owned firms reluctant to make acquisitions, their interest in M&As seems to vary with the degree of shareholder protections provided by a country's legal system, with such firms being more inclined to engage in takeovers in countries where shareholders are better protected.⁷

When they do engage in M&As, family owned firms seem to achieve a substantial amount of success. Family controlled acquirers generate more positive total M&A gains than more widely held acquirers⁸ and tend to achieve greater profitability during the 3 years following closing than firms in which ownership is less concentrated.⁹ This may reflect more active monitoring by large shareholders of manager performance, a longer-term view for the firm, and a greater commitment to making value enhancing investments than in public firms where CEOs may engage in empire building. Family owned firm CEOs also are less likely to pursue empire building or excessive pay packages as is often the case with nonfamily owned firms because they are closely monitored by family members.¹⁰

Excessive ownership concentration can hurt performance as family members dominate decision making, alienating minority shareholders and nonfamily managers who do not see advancement opportunities within the firm. Highly concentrated ownership also can enable large shareholders to exploit smaller shareholders by buying products and services at above market prices from firms owned by the large shareholders. Furthermore, family controlled firms tend to focus acquisitions in a single industry; however, as their control increases significantly, such firms often diversify by making unrelated acquisitions. This may reflect an effort by owners whose wealth is tied up in their firms to reduce risk by making investments whose cash flows are uncorrelated with the firm's primary business.¹¹

Private Versus Public Company Governance

Chapter 3 addressed differences between vertical disputes (management/shareholder) and horizontal disputes (those arising between nonmanagement constituencies). Vertical disputes arise when management chooses to run a firm to maximize their wealth and power rather than to maximize shareholder value. Horizontal disputes arise between different shareholder classes, creditors and shareholders, long-term versus short-term investors, etc. While public companies’ tend to focus on “vertical” incentive problems between management and shareholders, privately held firms are more often confronted by horizontal disputes involving different shareholders (or classes of shareholders) seeking to gain influence and control relative to other shareholders.

Key differences between private and public company governance structures relate to founder control, informal structures, succession planning, and a lack of skilled managers. In private companies, effective control often resides with the patriarch or matriarch of the founding family. This control can be exercised as a controlling shareholder or as chairman of the board and chief executive officer. Governance policies and practices in private firms are often informal and undocumented and implemented by founding family members. Financial reporting and accountability is likely to be lax. Succession planning and recruitment is made more difficult by family ties, with decisions made more on a familial relationship and less on merit. Decisions often are made based on the family interests of the dominant shareholder rather than sound business principles. Limited financial resources make it difficult to hire executives with the right skills to promote good governance practices.

One thing is clear from this discussion here and in Chapter 3: the notion that one single form of ownership and governance is optimal is false. Companies have different ownership and governance requirements depending on the social and political conditions in the countries in which they reside and the industries and markets in which they compete.¹²

Challenges of Valuing Privately Held Companies

The anonymity of many privately held firms, the potential for data manipulation, problems specific to small firms, and the tendency of owners of private firms to manage in a way to minimize tax liabilities create a number of significant valuation issues. These are discussed next.

Process for Valuing Privately Held Businesses

To address the challenges presented by privately owned firms, an analyst should adopt a four-step procedure. Step 1 requires adjustment of the target firm’s financial data to reflect true profitability and cash flow in the current period. Step 2 entails determining the appropriate valuation methodology. Step 3 requires estimating the proper discount rate. Finally, in the fourth step, firm value is adjusted for a control premium (if appropriate), a liquidity discount, and a minority discount (if an investor takes a less-than-controlling ownership stake in a firm).

Step 1: Adjusting Financial Statements

The purpose of adjusting the income statement is to provide an accurate estimate of the current year’s net or pretax income, earnings before interest and taxes (EBIT), or earnings before interest, taxes, depreciation, and amortization (EBITDA). The various measures of income should reflect all costs actually incurred in generating the level of revenue, adjusted for doubtful accounts the firm booked in the current period. They also should reflect other expenditures (e.g., training and advertising) that must be incurred in the current period to sustain the anticipated growth in revenue. The importance of establishing accurate current or base-year data is evident when we consider how businesses are often valued. If the current year’s profit data are incorrect, future projections of the dollar value would be inaccurate, even if the projected growth rate is accurate. Valuations based on relative valuation methods such as price-to-current year earnings ratios would be biased to the extent estimates of the target’s current income are inaccurate.

EBITDA is a popular measure of value for privately held firms. The use of this measure facilitates the comparison of firms because it eliminates the potential distortion in earnings performance due to differences in depreciation methods and financial leverage among firms. Furthermore, this indicator is often more readily applicable in relative valuation methods than other measures of profitability, since firms are more likely to display positive EBITDA than EBIT or net income figures. However, EBITDA is only one part of cash flow and ignores the impact on cash flow of changes in net working capital, investing, and financing activities.

Step 2: Applying Valuation Methodologies to Privately Held Companies

Methods employed to value private firms are similar to those discussed elsewhere in this book. However, in the absence of public markets, alternative definitions of value often are employed, and the valuation methods are subject to adjustments not commonly applied to public firms.

Step 3: Developing Discount Rates

While the discount rate can be derived using a variety of methods, the focus in this chapter is on the weighted-average cost of capital or the cost of equity. The capital asset pricing model (CAPM) provides an estimate of the acquiring firm’s cost of equity, which may be used as the discount rate when the firm is debt free. There is evidence that CAPM tends to understate financial returns for private companies. What follows is a discussion of ways to adjust CAPM to improve its accuracy in estimating the cost of equity for small privately owned firms.

Step 4: Applying Control Premiums, Liquidity, and Minority Discounts

The maximum purchase price an acquirer should pay for a target firm (PV_MAX) is defined as its current market or stand-alone value (i.e., the minimum price, or PV_MIN) plus the value of anticipated net synergies (i.e., PV_NS):

${\text{PV}}_{\text{MAX}}={\text{PV}}_{\text{MIN}}+{\text{PV}}_{\text{NS}}$

Since the acquirer must earn more than the premium it pays for the target firm when the firms are combined to realize its required cost of capital, the purchase price paid should be less than the maximum price. Otherwise, all value created by combining the firms would be transferred to the target firm’s shareholders. This observation is discussed in greater detail in Chapter 14.

Eq. (10.3) is a reasonable representation of the maximum offer price for firms whose shares are traded in liquid markets and where no single shareholder (i.e., block shareholder)²⁸ can direct the activities of the business. Examples of such firms could include Microsoft, IBM, and General Electric. When markets are illiquid and there are block shareholders with the ability to influence strategic decisions made by the firm, the maximum offer price for the firm needs to be adjusted for liquidity risk and the value of control. These concepts are explored next.

Early Stage Investment

Investment in emerging businesses consists of a series of funding rounds starting with seed financing and extending to Series A, Series B, Series C, etc. A new series of rounds can continue as long as the business requires and can attract new investment. The letters in the series refer to the stages of development of firms interested in raising capital. Before each round, the firm is valued based on the quality of management, track record, growth potential, and risk. The firm's valuation in the most recent funding round is the starting point for valuation in the next round.

Valuations in this context are referred to as premoney or postmoney. Premoney refers to a firm's valuation before it receives its financing or its value in the latest financing round; postmoney is the firm's value including both its premoney valuation plus capital raised in the current round. Assume an investor agrees that a startup is worth $2 million and is willing to inject $.5 million into the firm. Premoney the firm is valued at $2 million and postmoney its value is $2.5 million. Ownership percentages vary depending on whether the valuation is pre- or postmoney: premoney the investor will own 25% of the firm ($.5/$2) and 20% postmoney ($.5/$2.5).

Series A funding usually runs from $2 million to $15 million and is intended to enable the business to pay for market research, build a management team and supporting infrastructure, and to launch their initial products. The Series B round refers to moving beyond the initial development stage by growing market share and expanding into new and larger markets. By this stage, investors have a clear vision for the business. Series C rounds attract investors to already successful businesses with the hope of more than doubling their investment. The objective here is to grow the business quickly, possibly by acquiring other firms. This round is most likely to attract private equity firms, hedge funds, and investment banks.

Ride hailing firm Uber Technologies Inc. (Uber) has shown meteoric growth since its inception in early 2009. The firm required frequent but comparatively small cash infusions to sustain rapid growth. By mid-2016, the firm entered its Series G funding round which valued the business at an eye-popping (postmoney) $69 billion. However, the firm stumbled subsequently, ensnared in sexual harassment scandals, intellectual property lawsuits, and controversy over how its software was used to track drivers and customers. The firm also failed to report a computer hack for more than a year that resulted in the loss of personal data on thousands of drivers and millions of customers. While investor confidence had been shaken, interest in Uber remained high due to its game changing potential. Exhibit 10.4 illustrates how Japanese conglomerate SoftBank Group (SoftBank) along with other investors showed interest in buying a portion of Uber's outstanding shares in late 2017.

Taking Private Companies Public

Initial public offerings (IPOs) represent the traditional way of taking a private firm public and refer to the first time a private firm offers shares to the public. Usually an investment bank (underwriter) is hired by the firm wishing to sell the shares to determine the type and number of shares to be offered and at what price. The investment bank collects data for a registration statement to be filed with the Securities and Exchange Commission. This statement provides information about the offering and company including financial statements, managers' backgrounds, how the money raised is to be used, and who owns the firm's pre-IPO stock.

During the last decade, private firms were more likely to be acquired than to go public through an IPO. Good at innovating but less so in bringing products to market, many small businesses have chosen to be acquired believing they can more rapidly achieve scale within the infrastructure of a larger firm. And there is evidence, that selling to a strategic buyer can result in valuations superior to IPOs.⁴³ IPOs may also be less attractive than selling to venture capital firms such as Japanese conglomerate SoftBank's venture capital fund which after having raised $93 billion in 2017 announced plans in late 2018 to raise even more. With the amount of cash SoftBank is willing to invest continuing to grow, target firm valuations are likely to increase. Other private investor groups are forced to increase the size of their funds if they wish to participate in the most promising investment opportunities. The resulting flow of new money into private markets enables founders of attractive new firms to “cash out” by selling to venture capital and private equity groups rather than to public market investors.⁴⁴

For those businesses choosing not to go the merger route and wanting to go public, nontraditional options are available: reverse mergers and special purpose acquisition companies. These are discussed next.

Using Leveraged Employee Stock Ownership Plans to Buy Private Companies

An ESOP is a trust established by an employer for its employees; its assets are allocated to employees and are not taxed until withdrawn by employees. ESOPs generally must invest at least 50% of their assets in employer stock. Employees frequently use leveraged ESOPs to buy out owners of private companies who have most of their net worth in the firm. For firms with ESOPs, the business owner sells at least 30% of their stock to the ESOP, which pays for the stock with borrowed funds. The owner may invest the proceeds and defer taxes if the investment is made within 12 months of the sale of the stock to the ESOP, the ESOP owns at least 30% of the firm, and neither the owner nor his or her family participates in the ESOP. The firm makes tax-deductible contributions to the ESOP in an amount sufficient to repay interest and principal. Shares held by the ESOP, which serve as collateral for the loan, are distributed to employees as the loan is repaid. As the outstanding loan balance is reduced, the shares are allocated to employees, who eventually own the firm.⁵¹

Empirical Studies of Shareholder Returns

As noted in Chapter 1, target shareholders of both public and private firms routinely experience abnormal positive returns when a bid is announced for the firm. In contrast, acquirer shareholders may experience abnormal negative returns on the announcement date, particularly when using stock to purchase large publicly traded firms. However, substantial empirical evidence shows that public acquirers using their stock to buy unlisted firms (i.e., both privately held firms and subsidiaries of publicly traded firms) experience significant abnormal positive returns around the transaction announcement date. Other studies suggest that acquirers of private firms often experience abnormal positive returns regardless of the form of payment. In general, acquirers tend to show better performance and have better growth opportunities over their corporate life cycle (i.e., high growth, stable growth, and declining growth periods) when they acquire private (rather than publicly traded) firms.⁵² These studies are discussed next.

Public-company shareholders earn an average positive 2.6% abnormal return when using stock rather than cash to acquire privately held firms.⁵³ Ownership of privately held companies tends to be highly concentrated, so an exchange of stock tends to create a few very large block stockholders. Close monitoring of management may contribute to these returns. These findings are consistent with studies conducted in Canada, the United Kingdom, and Western Europe.⁵⁴

Firms acquiring private firms often earn excess returns regardless of the form of payment. Acquirers can also earn excess returns of as much as 2.1% when buying private firms or 2.6% for subsidiaries of public companies. The abnormal returns may reflect the tendency of acquirers to pay less for nonpublicly traded companies, due to the relative difficulty in valuing private firms or subsidiaries of public companies.⁵⁵ In both cases, shares are not publicly traded and access to information is limited. Moreover, there may be fewer bidders for nonpublicly traded companies. Cash starved public companies may be forced to sell subsidiaries to gain liquidity. For these reasons, private firm shareholders seeking to liquidate their shareholdings or public firms seeking liquidity may be forced to sell at a discount from their true economic value due to their weak bargaining positions. This allows acquirers to realize more of the synergy, which is reflected in their positive abnormal announcement date returns. Consistent with the notion that private firms sell at a discount is that the CEOs of private firms that undergo IPOs or sales to a public firm earn more than those of private firms that are not going public. The additional compensation could reflect the difficulty in selling private businesses.⁵⁶

Other factors contributing to positive abnormal returns for acquirers of private companies include the introduction of more professional management into the privately held firms and tax considerations. The acquirer’s use of stock rather than cash may induce the seller to accept a lower price, since it allows sellers to defer taxes on gains until they decide to sell their shares.

There is some evidence that premiums paid for family owned firms may be higher than for nonfamily owned private firms. Acquirers buying private firms controlled by nonfamily members average announcement date returns of 1.6% versus 1.1% when the target is a family owned firm.⁵⁷ Acquirers may have to pay more to get family members to surrender the benefits that accrue to ownership such as family pride, the opportunity to employ other family members, and the ability to set their own salaries and pay dividends.

While announcement date financial returns tend to be higher for acquirers of private than of public targets, there is little difference in their ongoing operating performance following closing.⁵⁸ The higher announcement date returns may reflect the tendency for acquirers to pay smaller premia for private targets than are paid for public targets. For private target acquirers, postclosing performance improvements are greatest when they make relatively large acquisitions; for public target acquirers, performance improvement is greatest when they make relatively small acquisitions.

Despite the various studies attempting to explain why acquirers of unlisted firms achieve higher announcement date returns than acquirers of public targets, the true explanation for this differing performance around announcement date returns remains elusive. A recent study found little empirical support for unlisted firms selling at a discount from their true economic value due to their need for liquidity or because they were difficult to value.⁵⁹ These results may reflect the use of different samples, time periods, and methodologies.

Some Things to Remember

Valuing private firms is more challenging than valuing public firms, due to the lack of published share price data and the unique problems associated with private companies. When markets are illiquid and block shareholders exert control over the firm, the offer price for the target must be adjusted for liquidity risk and the value of control. Buyers of private firms in the United States and abroad often realize significant abnormal positive returns, particularly in share-for-share deals.

Chapter Discussion Questions

1. 10.1 What is a capitalization rate? When is it used and why?
2. 10.2 What are the common ways of estimating capitalization multiples?
3. 10.3 What is the liquidity discount, and what are common ways of estimating this discount?
4. 10.4 Give examples of private company costs that might be understated, and explain why.
5. 10.5 How can an analyst determine if the target’s costs and revenues are under- or overstated?
6. 10.6 Why might shell corporations have value?
7. 10.7 Why might succession planning be more challenging for a family firm?
8. 10.8 What are some of the reasons a family-owned or privately owned business may want to go public? What are some of the reasons that discourage such firms from going public?
9. 10.9 Why are family-owned firms often attractive to private equity investors?
10. 10.10 Rank from the highest to lowest the liquidity discount you would apply if you, as a business appraiser, had been asked to value the following businesses: (a) a local, profitable hardware store; (b) a money-losing laundry; (c) a large privately owned firm with significant excess cash balances and other liquid short-term investments; and (d) a pool cleaning service whose primary tangible assets consist of a 2-year-old truck and miscellaneous equipment. Explain your ranking.

Answers to these Chapter Discussion Questions are available in the Online Instructor’s Manual for instructors using this book (https://textbooks.elsevier.com/web/Manuals.aspx?isbn=9780128150757).

Practice Problems and Answers

1. 10.11 An analyst constructs a privately held firm’s cost of equity using the “build-up” method. The 10-year Treasury bond rate is 4% and the historical equity risk premium for the S&P 500 stock index is 5.5%. The risk premium associated with firms of this size is 3.8% and for firms within this industry is 2.4%. Based on due diligence, the analyst estimates the risk premium specific to this firm to be 2.5%. What is the firm’s cost of equity based on this information? Answer: 18.2%
2. 10.12 An investor is interested in making a minority equity investment in a small privately held firm. Because of the nature of the business, she concludes that it would be difficult to sell her interest in the business quickly. She believes that the discount for the lack of marketability to be 25%. She also estimates that if she were to acquire a controlling interest in the business, the control premium would be 15%. Based on this information, what should be the discount rate for making a minority investment in this firm? What should she pay for 20% of the business if she believes the value of the entire business to be $1 million? Answer: Discount rate = 9.78% and purchase price for a 20% interest = $180,440
3. 10.13 Based on its growth prospects, a private investor values a local bakery at $750,000. She believes that cost savings having a PV of $50,000 can be achieved by changing staffing levels and store hours. She believes the appropriate liquidity discount is 20%. A recent transaction in the same city required the buyer to pay a 5% premium to the average price for similar businesses to gain a controlling interest in a bakery. What is the most she should be willing to pay for a 50.1% stake in the bakery? Answer: $336,672
4. 10.14 You have been asked by an investor to value a restaurant. Last year, the restaurant earned pretax operating income of $300,000. Income has grown 4% annually during the last 5 years, and it is expected to continue growing at that rate into the foreseeable future. The annual change in working capital is $20,000, and capital spending for maintenance exceeded depreciation in the prior year by $15,000. Both working capital and the excess of capital spending over depreciation are projected to grow at the same rate as operating income. By introducing modern management methods, you believe the pretax operating-income growth rate can be increased to 6% beyond the second year and sustained at that rate into the foreseeable future.
   The 10-year Treasury bond rate is 5%, the equity-risk premium is 5.5%, and the marginal federal, state, and local tax rate is 40%. The beta and debt-to-equity ratio for publicly traded firms in the restaurant industry are 2 and 1.5, respectively. The business’s target debt-to-equity ratio is one, and its pretax cost of borrowing, based on its recent borrowing activities, is 7%. The business-specific-risk premium for firms of this size is estimated to be 6%. The liquidity-risk premium is believed to be 15%, relatively low for firms of this type due to the excellent reputation of the restaurant. Since the current chef and the staff are expected to remain when the business is sold, the quality of the restaurant is expected to be maintained. The investor is willing to pay a 10% premium to reflect the value of control.
   1. a. What is free cash flow to the firm in year 1? Answer: $150,800
   2. b. What is free cash flow to the firm in year 2? Answer: $156,832
   3. c. What is the firm’s cost of equity? Answer: 20.2%
   4. d. What is the firm’s after-tax cost of debt? Answer: 4.2%
   5. e. What is the firm’s target debt-to-total capital ratio? Answer: 0.5
   6. f. What is the weighted average cost of capital? Answer: 12.2%
   7. g. What is the business worth? Answer: $2,226,448

Solutions to these practice exercises and problems are available in the Online Instructor’s Manual for instructors using this book (https://textbooks.elsevier.com/web/Manuals.aspx?isbn=9780128150757).

The recovery in the stock market and investors' thirst for greater returns in the wake of record low interest rates have enabled biotech firms to use IPOs as the preferred way to “go public” since the 2008–2009 recession. Despite continued gains in the broad market indices, biotech stocks dropped precipitously in 2016 following a remarkable 5-year bull-run. While such stocks have recovered in 2017, they are for the most part below their 2015 peaks. Consequently, biotech firms, wanting to go public, have had to seek alternative means of doing so. Reverse mergers represented one such alternative.

In a reverse merger, private firms become publicly traded by merging with a publicly listed shell company, with the public company surviving.⁶⁰ In a merger, it is common for the surviving firm to be viewed as the acquirer, since its shareholders usually end up with a majority ownership stake in the merged firms; the other party to the merger is viewed as the target firm as its former shareholders often hold only a minority interest in the combined companies. In a reverse merger, the opposite happens. Even though the publicly traded company survives the merger with the private firm becoming its wholly owned subsidiary, the former shareholders of the private firm end up with a majority ownership stake in the combined firms.

While conventional IPOs can take months to complete, reverse mergers can take only a few weeks. Moreover, as the reverse merger is solely a mechanism to convert a private company into a public entity, the process is less dependent on financial market conditions because the company often is not proposing to raise capital. The cost of regulatory filings and approvals is less with reverse mergers than with IPOs. Finally, firms lacking in historical financial statements often find the reverse merger as the only practical option.

Early in 2015, biotech firm Tobira Therapeutics went public through a reverse merger after its IPO fizzled. This successful reverse merger seemed to pave the way for more deals such as Catalyst and Targacept in May 2015 using a reverse merger to form Catalyst Biosciences.

On October 31, 2016, Miragen Therapeutics Inc. (Miragen), a developer of drugs utilizing micro RNA, merged with diagnostics company Signal Genetics (Signal) in a reverse merger. The combined firm will be 96% owned by Miragen shareholders, keep the Miragen name, be run by Miragen senior management, remain based in Boulder Colorado, and trade under the ticker symbol “MGEN.” The new board will consist of 8 members, all of whom will be selected by Miragen. Signal shareholders owned the remaining 4% of the new company. The merged companies subsequent to closing will change their name to Miragen Therapeutics.

As part of the deal, Carlsbad, California based Signal, whose shares closed at $.36 on the announcement date, agreed to sell its main operating asset, a multiple myeloma diagnostic technology called MyPRS. While Signal was selling most of its assets, it would retain both known and unknown (off-balance sheet) liabilities. In a separate but concurrent transaction, an investor group consisting of new and existing Miragen shareholders would invest $40 million into the combined company. This left the new firm with more than $60 million in cash at closing. Each owner of Miragen common stock received approximately 0.7031 shares of Signal common stock, with the combined company having approximately 21.3 million shares outstanding.

Existing Miragen shareholders, as well as those in the concurrent financing (so-called PIPE investment), receive newly issued shares of Signal common stock. Signal’s board of directors approved a 1-for-15 reverse stock split of its common stock, which took effect immediately following the close of trading on the NASDAQ on November 4, 2016. The reverse stock split is being implemented by Signal to maintain the listing of its common stock on the NASDAQ.⁶¹

The motivation for the merger reflected Miragen's promising micro RNA therapeutics programs, its limited resources to fully develop these programs, and its desire to have its shares publicly listed. In contrast, publicly traded Signal was prepared to raise cash by selling its proprietary technology and issuing new shares through a private placement.

For accounting purposes the merger is considered to be a reverse merger under the acquisition method of accounting in which Signal is considered the acquirer and Miragen the target firm. For tax purposes, the merger will be treated as a reorganization rather than an actual sale in accordance with the US tax code (see Chapter 12 for a more detailed discussion). Consequently, Miragen shareholders will not recognize a gain or loss upon the exchange of Miragen shares.

The merger closed on February 23, 2017 creating a clinical-stage, biopharmaceutical company developing proprietary drugs targeting complex diseases. Thinly traded Signal shares dropped by almost 21% due to the issuance by the firm of millions of new shares. The activities that took place at closing included the following: the issuance of new Signal common stock, the change of control, the change in Signal's name to Miragen Therapeutics, a 1 for 15 reverse stock split, an increase in the number of authorized shares of Signal common to 100 million from 50 million, and the sale of Signal's operating assets to Quest Diagnostics.

Fig. 10.1 illustrates the reverse merger process. Signal created a wholly owned subsidiary shell corporation (Merger Sub) and exchanged the Merger Sub shares for its shares. Merger sub is merged with Miragen in a reverse triangular merger⁶² with Miragen surviving as a wholly owned subsidiary of Signal. The reverse triangular merger preserves licenses, contracts, and intellectual property owned by Miragen. Miragen is then merged with Signal in a backend merger and the firm is renamed as Miragen Therapeutics, which now trades as a public company.

Lack of interest in biotech stocks in 2016 would have made an IPO difficult. Miragen lacked sufficient resources to complete the needed clinical trials for its attractive drugs before they could get Food and Drug Administration approval. In contrast, Signal had cash (or access to cash) and few attractive internal investment opportunities. Signal was also a listed firm. These complementary needs illustrate the conditions in which reverse mergers often take place.