Case Study:
Builder's Depot
In October of 2010, Ryan Cochran, the 42 year old President of Builder's Depot, was pondering the future of his company. Although the company had a long history of profitability, he and the other three shareholders of the company (Andy Peterson, Ron Thompson, and Mike Schaeffer), were interested in selling the company and moving on to new adventures. Earlier in the year, the company received a buyout offer of $8 million in cash and stock from National Building Supply Co., a publicly traded company in the same industry. However, a stipulation of the deal was that Ryan must stay with the company and manage the daily operations. Ryan was not thrilled with this offer. If he was to be responsible for the financial performance of the company, he wanted to be able to reap the rewards that ownership often provides. After deliberations with the other shareholders, the offer from National Building Supply Co. was rejected. No subsequent offers had been received in 2010.
It had become apparent to Ryan that he was the key to the recent success enjoyed by the company, and any subsequent offers would most likely contain the same stipulation as the offer from National Building Supply Co. As a result, Ryan considered the idea of personally buying out the ownership of the other three shareholders. This option would provide Ryan with the potential rewards from the effective management of the company while allowing the other shareholders to pursue their other interests. Although Ryan found this option extremely appealing, a number of issues would have to be resolved before any deal could be finalized. The basic and important issues included the following:
1. How much was the company worth?
2. How should the potential buyout be financed?
3. Are there important tax considerations that need to be considered in the deal? If so, what is the best way to structure the purchase to minimize the tax impact and maximize the likelihood that all of the shareholders will agree to the deal?
Because of the complexity of the issues, it was clear to Ryan that he would need assistance to properly plan a buyout that is beneficial to all the shareholders. He came to Ready and Able, LLP, in Portland, Oregon. Like many CPA firms today, this firm's core practice was in tax and audit, but it also offered assistance in helping clients navigate the purchase and sale of businesses. Will B. Ready, the firm's managing partner, met with Ryan to discuss the buyout options available and determine whether this transaction was indeed feasible from Ryan's perspective.
Company History
Builder's Depot was created by Henry Bass in 1955 as a wholesale supply company for the construction industry. In 1990, the company was purchased by Andy Peterson (who remained the sold shareholder of the company from 1990 to 2001) for $400,000. During this time period, the company experienced consistent growth in revenue and profitability. In 2001 revenue passed the $5 million plateau. By 2001, at the age of 52, Andy decided to reduce his participation in the company, and in 2002 he sold some of his share to Ryan and Mike. In 2004 he further reduced his involvement in the company by selling shares to Mike. Since that time the company has been managed by Ryan (President), Ron (Vice President for Operations), and Mike (Vice President for Finance). During the first decade of the 2000s Andy continued to divest his interest in the company by gifting additional shares to Andy, Ron and Mike. By 2006 Andy owned just 381 shares of the company's 5,100 shares outstanding, while Ryan, Ron and Mike owned 1,573 shares. The three managers had individual strengths that contributed to the success of the company. Ron was a very good marketer and salesman. His "people" skills attracted many new customers. Mike was in charge of the company's finances. Ryan was responsible for managing the everyday activities, building strong relationships with key customers, and creating a strong employee culture. Ryan in many ways was the key to the success enjoyed recently by the company.
Since 1990 Builder's Depot had become the recognized industry leaders in its geographic market. The combination of engineering expertise and extensive product offering made the company the distributor of choice for its market. Unique to its market, Builder's Depot entered into long-term supply contracts with many of its larger accounts. These contracts name the company as the sole source supplier for various building supply needs. These contracts show the great trust and confidence that customers place in Builder's Depot. In addition, the company has a diversified client base with over 600 active accounts in 2010. Its customers included many construction firms and the top account was just 8% of sales.
Builder's depot has also been very dedicated to its employees. In particular, Ryan has stressed the importance of each employee, and he believes that a harmonious workplace is the key to success. Not only does the firm have little turnover, but it has received tremendous productivity from its employees.
During the early 2000s, the company experience sustained growth. In 2010 Builder's Depot had thirty employees and sales of $13.2 million. The growth of the company resulted in the company's need for new office and warehouse space. In 2006 the four shareholders formed a partnership for the purpose of acquiring land and a building. After an appropriate location was acquired, Builder's Depot moved its operations to its current location and entered into a long-term lease for the property with the partnership. As a result, Builder's Depot has a 15 year lease on a building with a 50 year useful life, and the land and buildings are not included on the books of Builder's Depot.
By 2010, the four stockholders mutually agreed that it was time to sell the business and move into other ventures. At this time, Andy had become an outside shareholder and did not actively participate in the management of the company. Although each of the other three shareholders were in their early 40s, they had desires to start new challenges in their lives. In particular, Ron and Mike had each reduced their role in the company management for the past couple years. The company hired a business broker to prepare the necessary information and begin a search for a buyer. The broker was able to locate one potential buyer - National Building Supply Co. - that offered cash and stock valued at $8 million. For Ron and Mike, who each owned 30.8% of the company, this created an implied value of $1.85 million for their respective shares. As noted earlier, this offer was rejected by the shareholders and no subsequent offer was received.
Feasibility of Ryan's Buyout
In October 2010, Ryan came to Ready and Able, LLP to explore the option of purchasing the company. Andy, who was no longer active in the operation of the business, was willing to go along with whatever the other three shareholders decided. Ron and Mike were willing to sell their shares, but the offer received in early 2010 had established a company value of $8 million in their minds. Unfortunately, neither the company, nor Ryan personally, had the assets available to support a purchase price of that magnitude. In order to consummate the purchase, funds would have to be financed externally.
Ryan's initial instinct was to purchase the company through an ESOP (Employee Stock Ownership Plan) structure. Ryan had a genuine concern for the employees and believed this method would provide the employees with the necessary motivation to work harder and become "company oriented." The ESOP would need to obtain a loan from a bank and then use the proceeds to purchase the shares of Andy, Ron and Mike. After this initial transaction, the ESOP is formally the owner of the shares (its assets) and has a liability for the bank loan. Because the ESOP is a separate legal entity, Builder's Depot would need to guarantee the future payments of the loan. In subsequent years, Builder's Depot would make annual profit sharing contributions to the plan. The ESOP would then use these proceeds to make interest and principal payments on the bank loan. In addition, as the payments are made, the shares of stock are awarded to the accounts of the individual employees.
Unfortunately, Ryan would not significantly increase his ownership share through this type of structure. Will Ready offered a different idea - use the company's assets and future cash flows to secure bank financing, plan a financial and tax structure for the acquisition, and use the proceeds from the bank debt along with the company's strong cash flow to finance the acquisition. It was this latter method that became the focal point in formulating a buyout proposal. Because of the complexity of the deal, negotiating between the shareholders continued well into 2011.
Financial Information
A separate spreadsheet, Builders Depot.xls, is available with the balance sheets, income statements, and statements of cash flow from 2006 - 2010.
Related Party Transactions
As is common for many small privately held companies, Builder's Depot, had numerous transaction with its four shareholders. Because Ryan would be the sold shareholder after the buyout, these transactions must be considered when evaluating a "post buyout" value of the company. Following is a summary of related party transactions for the five-year period covered by the financial statements that were included in operating expenses.
Because Builder's Depot is a C-Corp, the company would annually distribute earnings in the form of compensation to the owners in tax deductible benefits, salary and dividends. This accounts for the relatively large salary adjustments outlined above. If Ryan acquired the company, he believed that other employees could assume Ron's primary duties, and Mike's current assistant (with the help of Will Ready) could handle Mike's financial responsibilities. Therefore, Ryan did not foresee the need of hiring additional employees after the buyout was completed.
The interest expense above represents amounts paid to Andy on loans made to the company. The balance of this loan was included in long-term debt. Andy would continue to carry the loan as long as payments were made as previously scheduled. Andy would also was willing to subordinate his loan to the primary financing for the buyout.
Required:
Part A
1. Using the data on spreadsheet provided for builder's depot, determine value for the following assumptions for the period of 2011 - 2016. Your team will be assigned a role of Neutral , Pessimistic or Optimistic). Using these assumptions develop prospective financial statements for Builders Depot for the period of 2011 - 2016.
Part B
Using the above assumptions develop prospective financial statements for Builders Depot for the period of 2011 - 2016.
Part C_
i Calculate the Beta Factor for Builders Depot using the data supplied
You may assume that the following information represented comparable public company information at the end of 2010.
Part C
ii Calculate the discount rate for free cash flow to debt and equity holders .
Your answer needs to explain your assumptions about the risk model that applies to Builders Depot
Part D:
Using the discount rate that you established in the above question, calculate an estimated value of Builder's Depot's equity using the discounted cash flow method.
How does the value that you computed in compare to the $8 million offer the company received from National Building Supply Co.? Discuss possible reasons for the discrepancy. What changes in the assumptions used in would be required to obtain an $8 million value?
Assuming that the value you established in Part D is used determine the cash payments made to the respective shareholders solely in return for the net assets of the company (e.g., Ryan would purchase all of the company's assets and assume all of the company's liabilities). What would be the tax ramifications for the company of structuring the sale of the business in this way? What would be the tax implications for the shareholders of structuring the sale of the business in this way?
From the perspective of a lending institution would you be willing to make a loan to Builder's Depot for the amount need in this buyout? Over what period of time would you structure the loan, and can Builder's Depot make the payments need to retire the loan? If so, what covenants would you include in the loan agreement to safeguard the bank's investment?
List 3 thing that you have learned from this exercise ?