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Combining Theory & Practice in an

Entrepreneurial Legal World

Module 1 – Developing a Business Plan


Introduction

1980 2001
Company IPO New product line
focused on stored,
transportable
audio files
1986
Transition of
power – CEO
resigned in prior
year. New CEO
1976 takes over 1998 2010 U Can’t Touch This
First computer New product line Tablet debut
designed by launch focused on
founders….circuit substance and KEY MILESTONE:
board costs under aesthetics Becomes largest
$700 US Tech Company
(Market Value)

1977 1984 1997


Version II
computer with 1
NextGen computer Former CEO
returns; Arch rival
2007 2011
debuts with disk Smartphone debut
mhz processor is drive, built-in invests $150 CEO faces health
first mass monitor and million concerns; Resigns
produced mouse to begin transition
computer of power.

Copyright © 2017 Deloitte Development LLC. All rights reserved. Source: http://www.independent.co.uk/life-style/gadgets-and-tech/key-dates-in-apple-history- 2
2343641.html
Introduction

Source: Wikipedia
Copyright © 2017 Deloitte Development LLC. All rights reserved. 3
(https://en.wikipedia.org/wiki/Timeline_of_Apple_Inc._products#2010s)
Summary of Key Learning Points
Summary of Key Learning Points

Managing the development of a business involves planning


 Business Plan
− Outline the business mission and strategy

− Analyze the industry and market opportunity

− Establish a structure for the business

− Build a product or service and expansion strategy

− Develop a marketing plan and sales strategy

− Summarize funding needs and forecast financial performance for the business

 Financing
− A business needs capital in order to begin and maintain operations

− Consider capital from various sources

 Business structure
− Choosing an appropriate legal structure involves trade-offs

◦ Risks and liabilities

◦ Capital Structure

◦ Taxation

◦ Ease of Transfer

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Agenda

Business Plan Financing Business Structure

 Elements of a business plan  Sources and uses  Selecting Nuggets’ structure


 Nuggets’ business plan  Capital costs
 Working capital

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Where to Begin:
Elements of a Business Plan
Business Plan Financing Corporate Structure

Business Plan Overview


Key
Summary of Content
Elements
Executive Summary Company Description
Business Mission  Snapshot and key highlights  Strategy and mission
and Strategy
− Profile and goals − Differentiating factors

Industry and Market Research Competitor Analysis

Market Analysis  Target industry, market and product analysis  Size, location and market share

− Key trends, demographics and outlook

Ownership Information Management Structure


Organization and  Legal structure and investors  Management background and experience
Management
 Board of Directors composition

Marketing Plan Sales Strategy


 Target market and demographics  Point of sale and sales process
Marketing − Customers, culture, market share and − Location, marketing, headcount
growth plan  Timing

Product or Service Line Life Cycle


 Description of key products / services  Where the product is in life cycle
Product Overview
– Attributes and competitive advantages – Influences on life cycle and product development

Capital Costs Prospective Financial Statements


Financial  Start-up costs: sources, uses and cash burn  Revenue, expense and cash flows
Information  Follow-on financing: timing, sourcing, – Key assumptions
planning, budgeting, monitoring

Copyright © 2017 Deloitte Development LLC. All rights reserved. Sources: www.sba.gov, www.entrepreneur.com 8
Business Plan Financing Corporate Structure

Knowledge Check #1
Mission & Strategy Market Analysis Organization &
 Mission statement: Deliver a game-day Management
atmosphere where customers can
experience the excitement of watching
their favorite sports teams and enjoy
the fresh taste of top quality white
meat nuggets with signature dipping
sauces
 Strategy: Develop the brand locally;
broaden the brand’s regional footprint
by diversifying the product portfolio
and leveraging infrastructure; deliver
best-in-class audiovisual game-day
experience

Marketing Product Financial Information


Overview

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Financing Needs and Sources
Business Plan Financing Corporate Structure

Financing Sources and Uses

Sources Uses

Equity Cash Uses

Personal savings Initial Salaries

Family and friends investments Business licenses and registration fees

Angel investors Real estate (lease or buy) for stores

Crowdfunding Property build-out costs

Institutional investors / Venture Capital Commercial kitchen equipment

Tables, chairs, television sets


Debt
Utilities setup fees
Personal loans to business
Signage, menus, interior decor
Family and friends loans
Advertising
Bank unsecured loans
Consultant fees
Bank secured loans
Legal, accounting and tax advice

Copyright © 2017 Deloitte Development LLC. All rights reserved. Sources: www.sba.gov, www.entrepreneur.com 11
Business Plan Financing Corporate Structure

Starting a business may require significant cash outlays

Capital Costs Nuggets’ Start-Up


Costs
 How much money do I need? Nuggets will need capital to get operations rolling
 What do I need to buy?  Real estate for restaurant location(s) (owned or leased)
− Fixed assets (equipment,  Organization costs, including licenses and permits
machinery)  Commercial kitchen equipment, fixtures and signage
− Licenses, permits, registration fees  TVs and audio visual equipment
− Incorporation costs  Pre-opening costs: hiring, training, advertising, etc.
− Legal, accounting and tax advice

Start-up Start-up
Capital Capital Operating Cash
Raised Invested Flow

Time
Capital investments are leveraged to generate operational cash
flow

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Sources: www.sba.gov, www.entrepreneur.com
Business Plan Financing Corporate Structure

Working Capital
Working Capital Needs Nuggets’ Working Capital Needs
 Working capital is the cash used to operate the business  Continuous chicken purchases (raw materials)
continually
− Payment to suppliers
 Converts sales to cash to reinvest in the business
− Increase inventory
 Comprised of current assets and current liabilities
 Replacement of tables, chairs, plates, glasses, etc.
− Accounts receivable (A/R)
 A/R should convert to cash quickly
− Inventory
 Alternative working capital sources if cash from operation
− Accounts payable (A/P) is not sufficient
 Seasonal or cyclical businesses may require additional − Revolving and amortizing debt
working capital during the off / low season
− Money from family and friends

Working Capital Cycle Managing Timing


Differences
Cash Cash
Injections Withdrawal Build Sell Collect Pay
Product Product cash Vendors
Cash
Cash
A/R
Goods Sold

Payments

Inventory

A/P

Goods
Purchased

Copyright © 2017 Deloitte Development LLC. All rights reserved. Sources: www.sba.gov, www.entrepreneur.com 13
Business Plan Financing Corporate Structure

Income Statement and Balance Sheet

Income Statement Balance Sheet


Three Months Ending December 28, 1990 (US$) As of December 28, 1990 (US$)
ASSETS
Revenue $80,000
Cash and Equivalents $503,444

Accounts Receivable 5,556


Cost of Goods 56,000
Inventory 3,000
Gross Profit 24,000
Total Current Assets 512,000
Selling, General & Administrative Expenses 25,000
Net Plant, Property & Equipment 239,583

Pre-Opening Costs 25,000 Net Intangible Assets (Liquor License) 14,750

Total Assets 766,333


Depreciation & Amortization 10,667
LIABILITIES
Total Operating Expenses 60,667
Accounts Payable 3,000
Operating Income (36,667)
Total Liabilities 3,000

MEMBERS EQUITY
Interest Expense -
Members Equity 800,000
Income Tax Expense -
Retained Earnings (36,667)
Net Income (36,667)
Total Members Equity 763,333

Total Liabilities & Members Equity 766,333

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Business Plan Financing Corporate Structure

Operating Budget
1990 1991
US$ Oct. 1 – Dec. 31 Jan. 1 – Mar. 31 Apr. 1 – June 30 July 1 – Sept. 30

A Revenues $80,000 $60,000 $90,000 $100,000

B Cost of Goods Sold 56,000 42,000 63,000 70,000

C Operating Expenses 50,000 30,000 23,000 23,000

D= A-B-C Operating Cash Flow (26,000) (12,000) 4,000 7,000

E Depreciation & Amortization 10,667 10,667 10,667 10,667

F= D-E Pre-Tax Earnings (36,667) (22,667) (6,667) (3,667)

G Taxes - - - -

H= F-G Profit After Tax (36,667) (22,667) (6,667) (3,667)

E Depreciation & Amortization 10,667 10,667 10,667 10,667

I Working Capital 5,556 3,000 4,500 5,000

J Change in Working Capital 5,556 (2,556) 1,500 500

K Capital Expenses 265,000 3,000 3,000 3,000

L= H-J-K Free Cash Flow (296,556) (12,444) (500) 3,500

Seasonal Events • World Series • Super bowl • NHL Playoffs


• MLB Playoffs
• Bowl games • Mar Madness • NBA Playoffs

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Business Structures
Business Plan Financing Corporate Structure

Summary of Business Structures


Sole Proprietorship Partnership

 Unincorporated trade or business; no requirements  Two or more individuals in business together as a


for filing or registration limited or general partnership

 No personal liability protection for the owner  Personal liability and loss protection for limited
partners; no personal liability and loss protection for
 Profits & losses flow to the owner’s tax return general partners
 Allows mixing of business and personal funds, not  Profits & losses flow to the partners’ tax returns
able to sell stock
 Capital structure of a partnership comprised of
 Lacks continuity of life upon dissolution event; no partnership interests
legal distinction between owner and business
 Continuity and transferability determined by type of
partnership

Corporation Limited Liability Company


 Registered entity with continuous existence  Hybrid entity that combines the pass-through
independent of its shareholders attributes of a partnership with the limited liability of
a corporation
 Personal liability protection to the shareholders; limits
losses to what is contributed to the corporation  Personal liability protection for members
 C Corp taxed at the entity level  Profits & losses flow to members’ individual tax
returns
 S Corp profits & losses flow to shareholders’ tax
returns (i.e., avoids double taxation)  Capital structure of an LLC is made up of units
 Capital structure of a corporation comprised of shares  LLC terminates upon dissolution event; members’
of stock interests may be transferred subject to terms and
conditions
 Business life is not finite; ownership transferred by
selling shares of stock

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Sources: www.sba.gov, www.entrepreneur.com
Business Plan Financing Corporate Structure

Summary of Business Structures

Structure Risks & Liability Taxation Registration cost Ease of


(1) transfer

Sole
Proprietorship

Partnership

Corporation

Limited Liability
Company

Legend

(1) Registration costs used as a proxy for capital structure More Less
favorable favorable
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Business Plan Financing Corporate Structure

Knowledge Check #3
Tax Burden vs. Liability Registration Cost vs. Ease of Transfer

Higher
Higher

C Corp C Corp S Corp

LLC

Registration
Tax Burden

Costs
S Corp Partnership
Sole-proprietorship

Lower
Lower

LLC Partnership Sole-proprietorship

Lower Personal Liability Higher Lower Difficulty of Transfer Higher

Corporate Structure for Nuggets

Copyright © 2017 Deloitte Development LLC. All rights reserved. Sources: www.sba.gov, www.entrepreneur.com 19
Questions and Answers
Appendix
Striking Gold with Nuggets
Mission & Strategy Market Analysis Organization & Management
 Mission statement: Deliver a  Industry and market analysis  Organization
game-day atmosphere where − Size and demographics of the – Privately-held, family run business
customers can experience the local market – Wholly-owned with possible
excitement of watching their • Average income and age franchise opportunities
favorite sports teams and enjoy • Proximity to universities and – Legal structure set up to minimize
sports facilities
the fresh taste of top quality personal risks, maximize value &
• Sports culture
white meat chicken nuggets with personal tax attributes
signature dipping sauces
− Identify and analyze competitor  Management
 Strategy: Develop the brand companies in the market
– Day-to-day management by
locally; broaden footprint by ◦ Buffalo Wild Wings
Coulter siblings
diversifying the product portfolio ◦ Hooters
– Open to strategic guidance by
and leveraging infrastructure; ◦ T.G.I. Friday’s
◦ McDonalds owners / partners / members /
deliver best-in-class audiovisual shareholders
game-day experience

Marketing Product Overview Financial Information


 Marketing plan  Product overview  Capital costs
– Amazing atmosphere and food – Top quality, all white meat – Necessary start-up costs
while you watch the big game chicken • Real estate (lease or own)
– Target sports enthusiasts – Dipping sauces are homemade • Capital equipment
leveraging recipes of Coulter • Cash to run operations
 Sales strategy grandmother – Monthly cash burn
– Advertising to drive customers
to restaurant  Product Life Cycle  Financial forecast
• Local sports facilities – Menu expansion to include: – Monthly cash flow forecasts
• News paper sports section • Lower calorie grilled chicken – Key assumptions (e.g., number
• Online • Vegetarian options of customers, price point)
– Food and drink specials on big • Ethnic and team-specific
game days dipping sauces

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Disclaimer
This presentation contains general information only and Deloitte is not, by
means of this presentation, rendering accounting, business, financial,
investment, legal, tax, or other professional advice or services. This
presentation is not a substitute for such professional advice or services, nor
should it be used as a basis for any decision or action that may affect your
business. Before making any decision or taking any action that may affect your
business, you should consult a qualified professional advisor.
Deloitte shall not be responsible for any loss sustained by any person who
relies on this presentation.

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About Deloitte
Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee
(“DTTL”), its network of member firms, and their related entities. DTTL and each of its member firms are legally
separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not provide services to
clients. Please see www.deloitte.com/about for a detailed description of DTTL and its member firms. Please see
www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.
Certain services may not be available to attest clients under the rules and regulations of public accounting.

Copyright © 2017 Deloitte Development LLC. All rights reserved.


Combining Theory & Practice in an
Entrepreneurial Legal World
Module 2 - Introduction to Accounting
Basics & How to Read Financial Statements
Intelligently and Skeptically
Agenda

• Top 10 Themes/Takeaways for this module


• Financial reporting building blocks and concepts
• US GAAP financial statements and key analysis points
 Balance sheet
 Income statement
 Statement of owner's or stockholder’s equity
 Statement of cash flows
 Notes to the financial statements
• Common accounting terminology
• Role of the Auditors
• Understanding budgeting concepts
• Introduction to Financial Statement Fraud
• Summary of key learning points & Q&A
• Appendix

Note: Any definitions not sourced are from Financial Accounting/Kermit D. Larson, Paul B. Miller – 5th Edition.
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Why is this important?

• Understanding key financial concepts is critical to the ability of attorneys to


effectively advise their clients or organization, as well as, manage legal and
business risks
• Provides greater context for attorneys to help preserve the financial health of a
company
• Provides greater perspective on how operations are accounted for as
compared to the actual use and timing of cash inflows and outflows
• Relevant to transactions, litigation and compliance

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Poll Everywhere

(Text responses to ####):


How would you describe your understanding of basic accounting or business
topics?

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Top 10 Themes/Takeaways

1. Know the key financial statements of a Company and what they show
2. Mind the GAAP
3. Understand how ratio analysis can help you analyze a business’ financial
standing
4. Understand the differences between book income, cash income and tax
income
5. How to read pro forma financial reporting skeptically
6. Don’t be fooled by non-GAAP Measures
7. Even the smallest transactions may be material
8. Understand the role of the Auditors
9. How to prepare budgets for your business
10. Understand the symptoms of financial statement fraud

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Poll Everywhere

(Text responses to ####):


What would you like to cover as we learn today about accounting for attorneys?

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Financial Statement Reporting: A complete set of
Financial Statements

Description

• Shows the financial


Balance sheet position (assets and
liabilities) of the company
at the end of the period.

• Shows the results of the


Income statement
operations for the period.

Set of financial • Shows cash inflows


statements Statement of cash (receipts) and outflows
flows (uses) for the period.

• Explains investments by
Statement of owners’ or and distributions to owners
stockholders’ equity during the period.

• Provides qualitative data.


Notes to the financial
statements
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Building Blocks and Concepts
Sources of Financial Statements/Reporting

Public Private

• www.sec.gov • Company website


• Dun & Bradstreet
−Form 10-K — Annually, audited • Hoover’s
financial statement with notes, • Dow Jones Interactive
and Management Discussion &
Analysis (MD&A)
−Form 10-Q — Quarterly, reviewed
financial statements, MD&A
−Form 20-F — Foreign Private Issuer
−Form 8-K — Filed for significant
events
−Form S-1 — Initial registration
proceedings
−Form S-3 — Debt/Equity offerings
−Other Filings

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Key Concepts

Objectives Requirements

 Provides useful information about:  Relevant - Capacity to make a decision


 Profitability  Predictive Value: increases the likelihood
 How money was earned & spent of forecasting the outcome of events
 Claims to the business  Feedback Value (timely): enables users
 Ownership to confirm or correct prior expectations
 Liquidity & solvency  Reliable - Reasonably free from errors
 Provides useful information in: and bias
 Investment and credit decisions  Representatively Faithful (validity):
 Assessing cash flow prospects information represents what it purports
to represent
 Verifiable: ability to ensure that
information represents what it purports
to represent
 Neutral: absence of bias to attain a
predetermined result

Comparability & Consistency

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What is GAAP?

− Generally Accepted Accounting Principles.


• GAAP varies by country
− Rules or standards that govern what, when, and how to record transactions.
− Prescribes what information should be disclosed and how it should be disclosed, methods
of valuing assets and liabilities and methods of determining profits.
− Organizations are directly responsible for U.S. GAAP and public filings:
• Financial Accounting Standards Board (FASB)
• U.S. Securities and Exchange Commission (SEC)
• American Institute of Certified Public Accountants (AICPA)
• Public Company Accounting Oversight Board (PCAOB)
− U.S. GAAP is not law.

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International Financial Reporting Standards (“IFRS”)

− IFRS are a set of accounting standards developed by the International Accounting


Standards Board (IASB).

− IFRS is used in more than 120 countries:


◦ Required across all EU countries
(starting in 2005).
◦ SEC allows foreign filers to report in IFRS.

− SEC’s Roadmap:
◦ Decision to incorporate IFRS to U.S. issuers is still pending as of May 2016.
◦ Allow public companies a minimum of four years to adjust.
◦ Reported mixed results on a number of convergence projects undertaken by FASB and
the IASB.
◦ Concerned about the quality and enforceability of the standards and IASB independence.

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IFRS – Key Differences

Differences US GAAP IFRS


Underlying Basis of Rule-based standards: Principle-based standards:
Standards • Detailed definitions governing
• Overarching concepts and principles.
transactions and events.
• More adaptable to differing
• As with any set of rules there
environments and more easily
are exceptions that add a level
understood.
of complexity that may result
in applications issues. • May increase inconsistency due to
varying interpretations.
• Application requires more professional
judgment, making enforcement more
difficult.

Ability to make Generally allows for few outright • Historically have allowed more choices
choices choices. given the initial focus of codifying
acceptable practices around the world.
• Today fewer choices, although still more
than those allowed under US GAAP.

Level of specificity Tends to have more specificity, Has overarching concepts, with some
mainly due to the nature of the examples of how those concepts may be
standards. applied when places more weight on the
judgment of management.

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Poll Everywhere

(Text responses to ####):


Do you think IFRS will be adopted by the US in the next few years?

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The Financial Reporting Process

• Economic event occurs


• Transaction generates source documents (verifiable)
• Transaction is recorded in the accounting records (debits and credits)
• Debits & Credits are posted to the general ledgers
• Preliminary Trial Balance is prepared
• Adjusting entries are recorded
• Adjusted trial balance is prepared
• Financial statements are prepared

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Why the Accrual Basis?

Cash Accounting Accrual Accounting

• Accounting measures the financial • Attempts to measure the financial


impact of events and transactions impact of events and transactions
based on when the cash is paid or when they occur and not simply
received. when the cash consequences of
those events and transactions take
place.

VS • The accrual method is the most


common method used by
companies and is required by
GAAP, except in the case of other
comprehensive bases of
accounting.

SOURCE: SFAC 6, Elements of Financial Statements

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The Double-entry Method of Accounting

Debits = Credits

Accounts are increased and decreased with a debit and credit

Debit Credit

(Left-side, positive, Dr.) (Right-side, negative, Cr.)

Assets Assets

Expenses and losses Expenses and losses

Liabilities Liabilities

Revenues and gains Revenues and gains

Equity Equity

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Poll Everywhere

(Text responses to ####):


What does it mean to have a difference between book income vs. taxable income?

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Cash Income vs. Book Income vs. Taxable Income

• Cash Income – Based on the cash method of accounting (e.g. revenue or assets are
recorded when received)

• Book Income – Based on the accrual method (e.g. recorded when the underlying event
has occurred, title or right has transferred)

• Taxable Income – Method used to calculate income tax due


• According to the method of accounting used, an individual/company may experience
differences in the amount of income recorded:
◦ Permanent differences are income that will never be taxable (Included in Book Income
but not Taxable Income)
− Examples: Tax Exempt Municipal Bond Interest or Life Insurance Proceeds
◦ Temporary differences are income or deductions reported for the same amount, but in
different time periods
− Examples: Rent received in advance is taxable when received but recognized as
income when earned

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The Objective of Audits
What is Audited?

The auditor will:

◦ Evaluate the accounting system and methods


◦ Gain understanding of and evaluate internal accounting controls
◦ Test account balances
◦ Assess whether accounting methods comply with GAAP

“The auditor must obtain sufficient appropriate audit evidence


by performing audit procedures to afford a reasonable basis for
an opinion regarding the financial statements under audit”

Source: AU section 326, Audit Evidence, Statement on Auditing Standards, AICPA

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The Audit Report

−Basing judgment on audit fieldwork, the auditor is expected to conclude on


the fairness of the company’s financial statements. The outcome is the audit
report, which becomes an important component of the company’s annual
report.

−The type of audit report the auditor issues depends on the quality of the
financial statements of the company:
◦ Clean or unqualified opinion
◦ Qualified opinion
◦ Disclaimer of opinion
◦ Adverse opinion

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The Audit Opinion

What it is...
−Expression of an opinion on the financial statements taken as a whole.

−As to whether the consolidated statements present the financial position of


the company fairly, in all material respects.

−Audit, conducted in accordance with Generally Accepted Auditing Standards


(GAAS) and PCAOB Standards, provides basis for the opinion for public
companies.

−GAAS requires auditors to plan and perform the audit to obtain reasonable
assurance as to whether the statements are free of material misstatement.

−Audit includes examining, on a test basis, the evidence supporting amounts


and disclosures.

−Audit assesses accounting principles used and significant estimates made


by management.

−Financial statements are the responsibility of management.

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The Audit Opinion

What it isn’t…

−Opinion offers reasonable assurance not insurance.

−Audit examines on a test basis, not every transaction.

−Financial statements are responsibility of management, not the auditors. Auditors are
not responsible for reporting bad management practices in the audit report.

−Based on GAAS and PCAOB audit, not absolute and total knowledge of every
component, activity and transaction incurred.

−Not a direct examination for fraud (SAS 99), nor a guarantee that the financial
statements are free of fraud or intentional misrepresentations of management.

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Balance Sheet
Balance Sheet

− A statement detailing what a company owns (assets) and how a company is capitalized (liabilities and shareholder’s
equity) on a particular date.

Assets = Liabilities + Shareholders’ Equity

− Amounts are measured as of a point in time (a “snapshot”).

− Assets and liabilities are divided into “Current” and “Long Term”. “Current” assets are expected to be converted to cash
within one year. “Current” liabilities are due for payment within one year.

− Accounting treatment for each item can have a significant impact on the company’s financial position.

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Classification of Assets

Assets

Tangible Intangible
Assets Assets
(physical) (not physical)

Current Non-Current Current Non-Current


Assets Assets Assets Assets
(<1 year) (>1 year) (<1 year) (>1 year)

Can you think of an example of each type of asset?

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Balance Sheet Elements: Liabilities

Probable future sacrifices of economic benefits arising from present obligations to transfer
assets or provide services in the future as a result of past transactions or events.

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Classification of Liabilities

Liabilities

Known Estimated
Amounts Amounts

Current Non-Current Current Non-Current


Liabilities Liabilities Liabilities Liabilities
(<1 year) (>1 year) (<1 year) (>1 year)

Can you think of an example of each type of liability?

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Example: Nuggets, LLC Balance Sheet

As of December 28, 1990

ASSETS LIABILITIES
Current Assets Current Liabilities
Cash And Equivalents $ 503,444
Accounts Payable $ 3,000
Accounts Receivable 5,556
Inventory 3,000
Total Current Assets Non-Current Liabilities
512,000
Long-Term Debt -
Non-Current Assets
Gross Property, Plant & Equipment 250,000 Total Liabilities 3,000
Accumulated Depreciation 10,417
Net Property, Plant & Equipment 239,583 MEMBERS’ EQUITY
Intangible Assets 15,000 Members' Equity 800,000
Accumulated Amortization 250 Retained Earnings (36,667)
Net Intangible Assets 14,750
Total Equity 763,333
Total Assets $ 766,333
Total Liabilities And Equity $ 766,333

Assets = Liabilities + Members' Equity

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Example: Nuggets, Inc. Balance Sheet

As of December 27, 2013 (in thousands)


ASSETS LIABILITIES AND STOCKHOLDERS' EQUITY
Current assets: Current liabilities:
Cash and equivalents $ 13,150 Unearned franchise fees $ 1,186
Marketable securities 25,594 Accounts payable 19,274
Accrued compensation and benefits 19,536
Accounts receivable, net of allowance of $25 7,792
Accrued Expenses 4,855
Inventory 4,043
Current portion of deferred lease credits -
Prepaid expenses 2,375 System-wide payables 28,344
Taxes 8,893 Current portion of long-term debt 641
Restricted assets 27,346 Total current liabilities 73,836
Total current assets 89,193 Long-term liabilities:
Property and equipment, net 198,679 Other liabilities 989
Other assets 21,891 Deferred income taxes 24,669
Intangible assets* 11,383 Deferred lease credits, net of current portion 14,763
Total assets $ 321,146 Long-term debt 3,203
Total liabilities 117,460
Commitments and contingencies (notes 4 & 8)
Stockholders' equity:
Common stock 72,708
Retained earnings 131,167
Accumulated other compensation loss (189)
Total stockholders' equity 203,686
Total liabilities and stockholders' equity $ 321,146

* One type of intangible asset is goodwill which will be discussed in detail later in the module.
Copyright © 2016 Deloitte Development LLC. All rights reserved. 31
Key things to look for on the Balance Sheet

− How liquid are the assets?


◦ Assets are classified and presented in a decreasing order of liquidity (convertibility into cash)

− What is the underlying nature of the assets?


◦ Current vs. non-current, tangible vs. intangible assets
◦ Are there restricted assets?
◦ Are asset balances subjective in nature?

− How leveraged is the company?


◦ How much debt is recorded?

Copyright © 2016 Deloitte Development LLC. All rights reserved. 32


Key things to look for on the Balance Sheet (Cont.)

− Can they meet their current obligations?


◦ Will the company be able to pay its debts as they become due, based on their current cash
balance and expected cash inflows?

− What is the breakdown between short-term and long-term debt?


◦ Will the company be able to fund its debt?

− What is the quality of the assets? (e.g., collectability of receivables)


◦ What are the year over year trends?

Copyright © 2016 Deloitte Development LLC. All rights reserved. 33


Poll Everywhere

(Text responses to ####):


Where in the balance sheet may you find recorded a loan obligation of $200,000
that Nuggets has recently entered into?

Copyright © 2016 Deloitte Development LLC. All rights reserved. 34


Income Statement
Income Statement

− Also referred to as the P&L, Profit and Loss Statement, or Statement of Operations.
− Presents detailed information about a company’s revenues and expenses and gains and losses for a
period of time.
− Amounts are measured over a period (e.g., quarter, year).
− Helps investors and creditors evaluate the past performance of a company and use it for forecasting.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 36


Income Statement Elements

Revenue
•Inflows or other enhancements of assets of an entity or settlements of its
liabilities from delivering or producing goods, rendering services, or other
activities that constitute the entity’s ongoing major or central operations.

Gains
•Gains are increases in equity (net assets) from peripheral or incidental
transactions of an entity and from all other transactions and other events and
circumstances affecting the entity, except those that result from revenues or
investments by owners.

SOURCE: SFAC 6, Elements of Financial Statements


Copyright © 2016 Deloitte Development LLC. All rights reserved. 37
Income Statement Elements

Expenses
•Outflows or other “using up” of assets or “incurrence” of liabilities from delivering
or producing goods, rendering services, or other activities that constitute the
entity’s ongoing major or central operations.

Losses

•Losses are decreases in equity (net assets) from peripheral or incidental


transactions of an entity and from all other transactions and other events and
circumstances affecting the entity, except those that result from expenses or
distributions to owners.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 38


Example: Nuggets, LLC Income Statement

For the year ended December 28, 1990


Revenue $ 80,000
Cost Of Goods Sold (56,000)
Gross Profit 24,000

Selling General & Admin Expense 25,000


Pre-Opening Costs 25,000
Depreciation & Amortization 10,667
Total Operating Expenses 60,667

Operating Income (36,667)

Interest Expense -
Net Interest Expenses -
Income Tax Expense -

Net Income $ (36,667)

Copyright © 2016 Deloitte Development LLC. All rights reserved. 39


Example: Nuggets, Inc. Income Statement

For the years ended December 26, 2014 and December 27, 2013 (in 0000s)

Dec. 26, 2014 Dec. 27, 2013

Revenue:
Restaurant sales $ 459,527 $ 355,623
Franc hise royalties and fees 42,970 37,198
Total revenue 502,497 392,821
Costs and Expenses:
Restaurant operating c osts 366,778 290,339
Deprec iation and amortization 31,972 25,113
General and administrative 46,561 34,587
Preopening 9,329 5,379
Loss on asset disposals and store c lo 1,236 1,314
Total c osts and expenses 455,876 356,732
Inc ome from operations 46,621 36,089
Investment inc ome 76 438
Earnings before inc ome taxes 46,697 36,527
Inc ome tax expense 14,397 11,930
Net earnings $ 32,300 $ 24,597

Copyright © 2016 Deloitte Development LLC. All rights reserved. 40


Key things to look for on the Income Statement

− Is the company profitable?


◦ Gross Margin
◦ Income from Continuing Operations
◦ Net Income

− What portion of the income is from non-recurring/non-operating transactions?


◦ Were there any one-time occurrences during the period?
◦ Have any operations been discontinued?

− Which expense items seem out of line?


◦ Compare expense items to prior period results
◦ Certain account balances may be based on management’s estimates

Copyright © 2016 Deloitte Development LLC. All rights reserved. 41


Geography Matters: Income Statement

Properly Stated Misstated


Revenues $ 412,800 $ 412,800
Cost of Goods Sold 200,000 180,000

Gross Margin 212,800 52% 232,800 56%


Operating Expenses:
Sales, General & Administrative Expenses 70,000 55,715
Restructuring Charges 29,400 49,400
Depreciation and Amortization 6,400 6,400
Bad Debt Expense 600 -
Income from Continuing Operations 106,400 26% 121,285 29%
Other Gains / (Losses):
Income from Equity Investments 100 100
Interest Expense (2,000) (2,000)
Income from continuing operations before taxes, extraordinary item 104,500 119,385
and effect of change in accounting principle

Provision for Income Taxes (30%) 31,350 35,816


Income from continuing operations before extraordinary item 73,150 83,570
and effect of change in accounting principle

Loss on Discontinued Operations, net of tax (50,000) (50,420)


Gain on Extraordinary Item, net of tax 10,000 -
Net Income $ 33,150 $ 33,150

Earnings per Share (100,000 issued and outstanding) $ 0.33 $ 0.33

Copyright © 2016 Deloitte Development LLC. All rights reserved. 42


Poll Everywhere

(Text responses to ####):


What additional questions do you have on analyzing the income statement?

Copyright © 2016 Deloitte Development LLC. All rights reserved. 43


Statement of Owners’ or
Stockholders’ Equity
Example: Nuggets, LLC Statement of Members’ Equity

For the year ended December 28, 1990

Members' Equity Retained Earnings Total


Balance at October 1, 1990 $ - $ - $ -

Net earnings - (36,667) (36,667)


Members' Equity 800,000 - 800,000
Balance at December 28, 1990 $ 763,333

Copyright © 2016 Deloitte Development LLC. All rights reserved. 45


Statement of Changes in Owners’ Equity

• Presents the changes (the composition of additional capital, dividends,


earnings) in owners’ equity over a certain period of time
• Reconciles the balance of the retained earnings account from the beginning to
the end of the period
• Shows the interaction between the income statement
(net income) and the balance sheet (retained earnings)

Copyright © 2016 Deloitte Development LLC. All rights reserved. 46


Example: Nuggets, Inc. Statement of Stockholders’ Equity

For the year ended December 26, 2014 (in thousands)


Accumulated
Other
Common Stock Retained Comprehensive
Shares Amount Earnings (Loss) Income Total
Balance at December 26, 2010 18,214,065 $ 65,647 $ 98,866 $ (6) $ 164,507

Net earnings - - 32,300 - 32,300


Other comprehensive loss - - - (183) (183)
Comprehensive income - - - - 32,117
Purchase and cancelation of common st - - 1 - 1
Shares issued under employee
stock purchase plan 30,127 879 - - 879
Shares issued from restricted stock unit 142,797 - - - -
Units effectively repurchased for
required employee withholding taxes (45,539) (4,183) - - (4,183)
Exercise stock options 36,470 216 - - 216
Tax benefit from stock issued - 2,858 - - 2,858
Stock-based compensaton - 7,291 - - 7,291
Balance at December 26, 2014 18,377,920 $ 72,708 $ 131,167 $ (189) $ 203,686

Copyright © 2016 Deloitte Development LLC. All rights reserved. 47


Poll Everywhere

(Text responses to ####):


True or False: The Retained Earnings account balance resets after each year.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 48


Statement of Cash Flows
Example: Nuggets, LLC Statement of Cash Flows (Indirect
Method)

For the year ended December 28, 1990

CASH FLOWS FROM OPERATING ACTIVITIES:


Net Earnings $ (36,667)
Adjustments to reconcile net earnings to cash provided by operations:
Accumulated Depreciation 10,417
Accumulated Amortization 250
Changes in operating assets and liabilities, net effect of acquisition:
Accounts receivable (5,556)
Inventory (3,000)
Accounts payable 3,000
Net cash provided by operating activities 5,111

CASH FLOWS FROM INVESTING ACTIVITIES:


Purchase of property and equipment (250,000)
Intangible Assets (15,000)
Net cash used by investing activities (265,000)

CASH FLOWS FROM FINANCING ACTIVITIES:


Members' Equity 800,000
Net cash provided by financing activities 800,000
Net increase in cash and cash equivalents 503,444
Cash and cash equivalents at beginning of period -
Cash and cash equivalents at end of period $ 503,444

Copyright © 2016 Deloitte Development LLC. All rights reserved. 50


Statement of cash flow ingredients

Operating Activities Investing Activities Financing Activities


Collections from Sale of Productive Assets , Issuance of Long-Term
Customers, Franchise fees, Net Investment Income Debt and Equity
Other

Pool of Cash

Operating Activities Investing Activities Financing Activities


Payments to Suppliers, Payment of Dividends and
Purchase of Productive
Employees, Interest, Loans, Acquiring own
Assets, Debt, or Equity
Income Taxes, Other
Equity Securities, Other
Copyright © 2016 Deloitte Development LLC. All rights reserved. 51
Example: Nuggets, Inc. Statement of Cash Flows1

For the year ended December 26, 2014 (in thousands)

CASH FLOWS FROM OPERATING ACTIVITIES: CASH FLOWS FROM INVESTING ACTIVITIES:
Net Earnings $ 32,300 Purchase of property and equipment $ (83,353)
Adjustments to reconcile net earnings to cash provided by operations: Purchase of marketable securities (62,228)
Depreciation 31,389 Proceeds of marketable securities 73,239
Amortization 583 Acquisition of franchised restaurants (21,615)
Loss on asset disposals and store closures 1,076 Net cash used by investing activities (93,957)
Deferred lease credits 2,326
Deferred income taxes 8,209 CASH FLOWS FROM FINANCING ACTIVITIES:
Stock-based compensation 7,291 Issuance of Common Stock 1,095
Excess tax benefit from stock issuance (2,857) Excess tax benefit from stock issuance 2,858
C hanges in operating assets and liabilities, net effect of acquisition: Tax payments for restricted stock units (1,589)
Trading securities (203) Net cash provided by financing activities 2,364
Accounts receivable (783) Effect of exchange rate changes on cash and cash equiva (30)
Inventory (1,179) Net increase in cash and cash equivalents 3,344
Prepaid expenses 13 Cash and cash equivalents at beginning of year 9,806
Other assets Cash and cash equivalents at end of year $ 13,150
(1,633)
Unearned franchise fees (165)
Accounts payable 11,322
Income taxes 2,093
Accrused expenses 5,185
Net cash provided by operating activitie $ 94,967

1 Indirect method

Copyright © 2016 Deloitte Development LLC. All rights reserved. 52


Key things to look for on the Cash Flow Statement

− Does the company have positive cash flow?


− Did the company’s cash position change significantly?
− How is the company using its cash?
− What were the sources of the company’s funds?
− Comparison on Income Statement to Cash Flow Statement:
◦ Strong income from continuing operations versus weak cash flow provided by operating
activities
◦ Assess the ability of the company to meet its obligation, pay dividends, need for external
financing

Copyright © 2016 Deloitte Development LLC. All rights reserved. 53


Relationships Among Financial Statement Line Items

Income Statement Balance Sheet


Revenue $ 502,497 C Assets
Cost of Sales 366,778 A Cash $ 13,150
Depreciation and Amortization 31,972 Other Current Assets 76,043
Other Operating Expenses 57,126 Property & Equipment 306,988
Other Non-Operating Expenses 14,321
B Accumulated Depreciation (108,309)
Net Income $ 32,300 Other Non-Current Assets 33,274 D
Total Assets $ 321,146
Cash Flow Statement
Net Income $ 32,300 Liabilities
Depreciation and Amortization 31,972 Current Liabilities $ 73,836
Other Cash Flow From Operating 30,695 Long-Term Liabilities 43,624
Cash Flow From Operations 94,967 Total Liabilities 117,460 E
Cash Flow From Investing (93,957) Shareholders' Equity 203,686
Cash Flow From Financing 2,364 Total Liabilities + Equity $ 321,146

Effect of exchange rate changes Statement of Stockholders' Equity


on cash and cash equiv. (30) Beginning Balance $ 164,507
Increase in Cash 3,344 Net Income 32,300
Beginning Cash Balance 9,806 Other Comprehensive loss (183)
Ending Cash Balance $ 13,150 Stock & Option Repurchase (3,087)
Other Equity Transactions 10,149
Total Stockholders' Equity $ 203,686

Copyright © 2016 Deloitte Development LLC. All rights reserved. 54


Notes to the Financial
Statements
Financial statement reporting:

Notes to the financial statements


Provides further explanations or provides the only explanations for significant
transactions and contains required disclosures

• Overview of the business • Business combinations

• Significant accounting policies • Debt offerings and credit risk


‒ Revenue recognition
‒ Principles of consolidation • Income taxes
‒ Property, plant & equipment
‒ Intangible assets & goodwill • Related party transactions
‒ Long-term debt
• Subsequent events
• Discontinued operations
• Commitments and Contingencies

Copyright © 2016 Deloitte Development LLC. All rights reserved. 56


Financial statement reporting:

Limitations on financial statements


• Information often results from approximate, rather than exact
measures.
−Example: Estimates include the allowance for doubtful accounts receivable,
carrying value of certain intangibles, contingencies, etc.

• Information is based upon historical data and does not measure or


discuss management’s plans for the future.
−Example: The benefits of a company’s restructuring plan might not benefit the
company until several years after the plan is announced/implemented.

• Information is generally recorded at cost and may not reflect the


current market value.
−Example: Generally, fixed assets are accounted for at cost, and not at their
fair market value (FMV). For example, a building built in the 1950s will be
recorded at the amount for which it was constructed and not at its FMV in
2013.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 57


Poll Everywhere Question

Which of the following statements is/are true about notes to the Financial
Statements?

a) The notes can provide significant accounting policies or alternative measures for assets or
liabilities
b) The notes will tell you which accounting treatment a company has elected
c) The notes break out the details of amounts or transactions that are generally buried in
the balance sheet or income statement
d) All of the above

Copyright © 2016 Deloitte Development LLC. All rights reserved. 58


Common Accounting
Terminology
Materiality

• A measure of the significance of a transaction or event. A transaction is considered


material if its omission or misstatement would affect the judgment of a reasonable person
relying on the financial statements.

Source: Staff Accounting Bulletin (SAB) No. 99

Copyright © 2016 Deloitte Development LLC. All rights reserved. 60


Conservatism

• A prudent reaction to uncertainty to try to ensure that uncertainty and risks


inherent in business situations are adequately considered.
− If two estimates of amounts to be received or paid in the future are about equally likely,
conservatism dictates using the less optimistic estimate; however, if two amounts are not
equally likely, conservatism does not necessarily dictate using the more pessimistic
amount rather than the more likely one.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 61


Contingencies

Definition
“a contingency is defined as an existing condition, situation, or set of circumstances
involving uncertainty as to possible gain or loss to an enterprise that will ultimately be
resolved when one or more future events occur or fail to occur. Resolution of the uncertainty
may confirm the acquisition of an asset or the reduction of a liability or the loss or
impairment of an asset or the incurrence of a liability.”

Source: ASC 450, Accounting for Contingencies

Copyright © 2016 Deloitte Development LLC. All rights reserved. 62


Loss contingency

Probability that future event(s) will confirm loss

Determination and consideration of facts by


company management and auditors

Probable (high) Reasonably possible


Remote (low)
(medium)

Can amount be
No Yes Is loss guarantee of
reasonably
indebtedness?
estimated?

Yes* No

Accrual, with Neither accrual nor


Disclosure required
disclosure required disclosure required

*Includes estimation of range of loss, in which case the minimum amount is accrued and the amount of the
range is disclosed

Copyright © 2016 Deloitte Development LLC. All rights reserved. 63


Pro Forma vs. Historical financial statements

Pro Forma — provides information about the continuing impact of a particular transaction by showing
how it might have affected historical financial statements if a transaction (acquisition or disposition) had
been consummated at an earlier time.

• Example:
• For a business combination, the financial statements shall include certain pro forma information,
such as the “results of operations for the current period as though the business combination(s) had
been completed at the beginning of the period”
• Source, ASC 805, Business Combinations

Historical — measures income or presents a financial position for past events. The information as
reported in historical financial statements is a summarized presentation of the operations of the business
during a specific period of time.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 64


GAAP vs. Non-GAAP measures

• GAAP are the rules that govern what, when, and how to record transactions and prescribe
what information should be disclosed and how it should be disclosed in the financial
statements.
• Non-GAAP amounts are amounts that are not defined in the GAAP accounting literature,
such as EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization)
• Public companies are required to reconcile Non-GAAP measures to the corresponding GAAP
measure
• Area of manipulation on which regulators focus their attention

Copyright © 2016 Deloitte Development LLC. All rights reserved. 65


Example: Nuggets, Inc. EBITDA Calculation

For the year ended (in thousands) Dec. 27, 2013


EBITDA Calculation
Revenue: Net Earnings $ 32,300
Restaurant sales $ 459,527
Franchise royalties and fees 42,970
Interest -
Total revenue 502,497
Costs and Expenses: Tax Expense 14,397
Restaurant operating costs 366,778
Depreciation and Amortization 31,972
Depreciation and amortization 31,972
General and administrative 46,561
Preopening 9,329 EBITDA $ 78,669
Loss on asset disposals and store clo 1,236
Total costs and expenses 455,876
• A Non-GAAP metric used to indicate
Income from operations 46,621 the operational profitability of the
business
Investment income 76
Earnings before income taxes 46,697 • All interest payments, tax,
depreciation and amortization from
Income tax expense 14,397 the income statement are added back
Net earnings $ 32,300 to the bottom-line net income

Copyright © 2016 Deloitte Development LLC. All rights reserved. 66


Knowledge Check – Poll Everywhere

Scenario:

• On February 2, 2014 a class action lawsuit was filed against Nuggets, Inc. in the Superior court of the
State of California, County of Alameda, wherein it is alleged that Nuggets, Inc. violated certain
California wage and hour laws. The lawsuit purports to be brought on behalf of a class of all persons
who were employed full-time or on an hourly basis by Nuggets, Inc. in the State of California from
March 5, 2010 through the date of resolution of the lawsuit. The complaint alleges that Nuggets,
Inc., violated California law, by failing to: (1) pay overtime wages, and (2) provide meal periods,
among other claims. Nuggets, Inc. is sure the case will end in a settlement and is preparing a
response to the allegations.
• You are General Counsel. You and management guess the company’s liability may range from $2 to
$10 million.

Question (Text responses to 22333):

• Given the above facts, is there any impact on the Q1 10-Q?

Copyright © 2016 Deloitte Development LLC. All rights reserved. 67


Financial Statement Analysis
What is Financial Statement Analysis?

− What is financial statement analysis?


◦ It is the process of reviewing and evaluating a company’s financial statements, thereby
gaining an understanding of how financially healthy the company is, and allows for more
effective decision making by the users of the financial statements.
◦ It is an evaluative method of determining the past, current and project performance of a
company.

− What techniques are used for financial statement analysis?


◦ Horizontal analysis: this compares two or more years of financial data; either by
currency amount or percentage form.
◦ Vertical analysis: each category of accounts on the balance sheet is shown as a
percentage of the total account.
◦ Ratio analysis: this calculates the statistical relationships between data.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 69


Horizontal Analysis

• Also known as comparative analysis.

• Performed by setting consecutive balance sheet, income statement or cash flow


statements side-by-side and reviewing changes in individual categories on a
period to period basis.

• Used in identifying trends and/or unusual spikes in data.

• Example: when you hear someone say that revenues increased by 20% this past
year, that person is using horizontal analysis.
Horizontal
Analysis 2015 2014 % Variance
Revenue $ 60,000 $ 50,000 20%
Cost of Sales 34,000 32,000 6%
Gross Profit 26,000 18,000 44%
SG&A Expense 14,000 10,000 40%
Operating Income 12,000 8,000 50%
Interest Expense 4,000 2,000 100%
Taxes 3,000 2,000 50%
Net Income $ 5,000 $ 4,000 25%

Copyright © 2016 Deloitte Development LLC. All rights reserved. 70


Vertical Analysis

• Also referred to as common size analysis.


• Balance sheet vertical analysis is performed by representing balance sheet line
items as a percentage of total assets or liabilities & equity.
• Income statement vertical analysis is performed by representing all income
statement line items as a percentage of sales or net income.
• Comparing these vertical percentages year to year or against competitors can be
used to identify unusual trends, such as expense items that are increasing faster
than sales or percentages that do not compare with other peer companies.

Vertical
Analysis
Balance Sheet Vertical
Analysis
Assets
Cash $ 3,000 11%
Accounts Receivable 12,000 44%
Inventory 10,000 36%
Prepaid Expenses 2,400 9%
Total Assets $ 27,400 100%

Copyright © 2016 Deloitte Development LLC. All rights reserved. 71


Financial Ratios

The most common types of ratios include:

Copyright © 2016 Deloitte Development LLC. All rights reserved. 72


Profitability Ratios

− A primary measure of the overall success of a company.


− Used to assess the effectiveness of the entity in generating profit from sales and capital
investments.
− Generally show how well companies can achieve profits from their operations.
− Compare income statement accounts and categories to show a company’s return on
investment in inventory and other assets.

The entity’s efficiency in


converting sales into net
income .

Copyright © 2016 Deloitte Development LLC. All rights reserved. 73


Gross Profit Ratio

Nuggets, Inc.
2014 Use of Ratio:
Total Revenue $502,497
− Measures how profitable a company sells it inventory or
Restaurant Operating Costs 366,778 merchandise.

Gross Profit 135,719 − In other words, the gross profit ratio is essentially the
percentage markup on merchandise from its cost.
Operating Expenses
Depreciation &
Amortization 31,972 Example:
General & Administrative 46,561
Preopening 9,329 ◦ Assume Nuggets, Inc. spent $150,000 on restaurant
Loss on Asset Disposal & operations, and they were able to generate revenue
Store Closures 1,236 of $500,000; Nuggets has a ratio of 70%:
Total operating expenses 89,098
$350,000
70% =
Investment Income 76 $500,000

◦ This means that after paying off the restaurant


operating costs, Nuggets still has 70% of their sales
Income Tax Expense 14,397
revenue to cover their other expenses.

◦ Higher ratios are more favorable; meaning that a


Net Income $32,300 company is serving more customers at a higher profit
percentage.

Gross Profit Ratio = Gross Profit


Revenue

Copyright © 2016 Deloitte Development LLC. All rights reserved. 74


Net Profit Ratio

Use of Ratio:
Nuggets, Inc.
2016 − Measures how effectively a company can convert sales
Revenue $ 500,000 into net income.

Cost of Goods Sold 150,000 − Investors want to make sure that profits are high
enough to distribute dividends and creditors want to
Gross Profit 350,000 make sure the company has enough profits to pay back
its loans.
Operating Expenses − Also known as return on sales.
SGA Expenses 120,000
Restructuring Charges 25,400 Example:
Depreciation &
◦ Last year Nuggets had the best year in sales, since
Amortization 14,500
they opened for business. Revenue was $600,000
Bad Debt Expense 1,000
and their net income was $150,000. Nuggets
Total operating expenses 161,000
converted 25% of their sales into profits.
Other Gains/(Losses) 1,900 ◦ Now, contrasting that with the current year’s numbers
of $500,000 revenue and $155,000 net income,
Income Taxes 32,100 results in a return of 31%.

Net Income $ 155,000


$155,000 $150,000
31% = 25% =
$500,000 $600,000
Net Income
Net Profit Ratio =
Revenue
◦ This year Nuggets may have made less sales, but
they cut expenses and were able to convert more of
Copyright © 2016 Deloitte Development LLC. All rights reserved. these sales into profits. 75
Return on Assets (ROA)

Nuggets, Inc. Use of Ratio:


2016
− Measures how effectively a company can earn a return
Net Income $ 155,000
on its investment in assets.

ASSETS 2016 2015 − In other words, ROA shows how efficiently a company
Current Assets can convert the money used to purchase assets into net
Cash $ 3,000 $ 2,000 income or profits.
Accounts Receivable 12,000 13,000
Inventory 10,000 12,000 − The higher the ROA number, the better.
Prepaid Expenses 2,400 1,000
Total Current Assets 27,400 28,000

Noncurrent Assets Example:


Property, Plant, and
Equipment: 188,000 183,000
Less: Accum
◦ Nuggets shows beginning total assets balance of
Depreciation (32,000) (35,000) $178,000 and an ending balance of $185,000; with
Total PPE 156,000 148,000 net income of $155,000, for an ROA of 85%:
Other Noncurrent Assets: $155,000
Equity Investments 1,000 1,200 85% =
Goodwill 500 500 ($178,000+$185,000)/2
Patents 100 300
Total Other Noncurrent
Assets: 1,600 2,000
◦ This means that every dollar that Nuggets invested in
assets during the year produced $0.85 of net income.
Total Noncurrent Assets 157,600 150,000
Total Assets $ 185,000 $ 178,000 ◦ To understand how well Nuggets is managing their
assets, a ROA comparison would need to be made
against other clothing companies.
Net Income
Return on Assets =
Average Total Assets

Copyright © 2016 Deloitte Development LLC. All rights reserved. 76


Return on Equity (ROE)

Nuggets, Inc.
Use of Ratio:
2016
Net Income $ 155,000 − Measures the ability of a company to generate profits
from its shareholders’ investments in the company.
LIABILITIES & STOCKHOLDERS'
EQUITY 2016 2015 − A return of 1 means that every dollar of common
Current Liabilities shareholders’ equity generates 1 dollar of net income.
Total Current Liabilities 32,000 28,000

Long-Term Liabilities
Notes Payable, less current Example:
portion 15,000 14,000
Capital Lease Obligations 12,000 14,500 ◦ Nuggets shows beginning shareholders’ equity of
Total Long-Term Liabilities 27,000 28,500 $121,500 and an ending balance of $126,000; with
Total Liabilities 59,000 56,500
net income of $155,000, for an ROE of 1.25:

$155,000
Stockholder's Equity 1.25 =
Common Stock 1,000 1,000
($121,500+$126,000)/2
Additional Paid-In Capital 55,000 53,000
Retained Earnings 50,000 49,500 ◦ This means that every dollar of shareholders’ equity
Noncontrolling Interest 20,000 18,000 earned about $1.25 this year.
Total Stockholders' Equity 126,000 121,500
◦ In other words, shareholders saw a 125 percent
return on their investment.
Total Liabilities & Stockholders'
Equity $ 185,000 $ 178,000

Net Income
Return on Equity = Average Shareholders’
Equity
Copyright © 2016 Deloitte Development LLC. All rights reserved. 77
Liquidity Ratios

− Measures a company’s ability to pay its short term obligations as they become due.
− In other words, these ratios show the cash levels of a company and the ability to turn
other assets into cash to pay off liabilities and other current obligations.

The entity’s ability to


pay obligations.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 78


Current Ratio

Use of Ratio:

− Helps users of financial statements understand the


Nuggets, Inc. liquidity of a company and how easily that company will
be able to pay off its current liabilities.
ASSETS 2016
− A higher current ratio is more favorable than a lower
Current Assets
current ratio, because it shows that a company can
Cash $ 3,000
more easily make current debt payments.
Accounts Receivable 12,000
Inventory 10,000 Example:
Prepaid Expenses 2,400
Total Current Assets 27,400 ◦ Nuggets is looking to expand it’s business and is
applying for a loan at the bank. The bank asks for
Nuggets’ financial statements.
LIABILITIES &
STOCKHOLDERS' EQUITY 2016 ◦ According to their balance sheet, Nuggets has
Current Liabilities $27,400 current assets and $32,000 current
Accounts Payable $ 20,000 liabilities. Nuggets’ current ratio is 0.86:
Current Portion of Long-Term Debt 10,000
Warranty Reserve 1,000 $27,400
Deferred Revenue 1,000 0.86 =
$32,000
Total Current Liabilities 32,000
◦ This means that Nuggets only has enough current
assets to pay off 86% of their current debt.

◦ Nuggets is somewhat highly leveraged and poses a


Current Assets higher lending risk.
Current Ratio =
Current Liabilities
◦ Banks typically prefer a current ratio of 1 or 2, so
that all current liabilities would be covered by current
assets.
Copyright © 2016 Deloitte Development LLC. All rights reserved. 79
◦ Borrowing capital will cost more
Quick Ratio

Nuggets, Inc. Use of Ratio:

− Measures the ability of a company to pay its current


ASSETS 2016
liabilities when they come due with only quick assets.
Current Assets
Cash $ 3,000 − Quick assets are current assets that can be converted to
Accounts Receivable 12,000 cash within 90 days or in the short-term.
Inventory 10,000
Prepaid Expenses 2,400 − Also known as the Acid Test Ratio
Total Current Assets 27,400
Example:

◦ Nuggets would like to apply for a loan to remodel the


LIABILITIES & storefront.
STOCKHOLDERS' EQUITY 2016
Current Liabilities ◦ The bank asks for Nuggets’ balance sheet, and notes
Accounts Payable $ 20,000 that Nuggets does not have any marketable securities.
Current Portion of Long-Term Debt 10,000
◦ The bank computes Nuggets’ quick ratio of 0.47:
Warranty Reserve 1,000
Deferred Revenue 1,000 ($3,000 + $12,000)
Total Current Liabilities 32,000 0.47 =
$32,000

◦ This means that Nuggets can only pay off 47% of their
current liabilities with quick assets and would need to
Cash + Marketable
Securities + Accounts
convert more assets into cash to pay off all their current
Quick Ratio = Receivable liabilities.
Current Liabilities ◦ Again, a higher ratio would be more favorable.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 80


Leverage Ratios

− Measures a company’s ability to meet long-term financial obligations on a continuing


basis.
− These ratios either compare debt or equity to assets as well as shares outstanding to
measure the true value of the equity in a company.

The entity’s
ability for long-
term solvency.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 81


Debt to Asset Ratio

Use of Ratio:
Nuggets, Inc.
− Measures the amount of total assets that are financed
ASSETS 2016 by creditors instead of investors.
Total Current Assets 27,400
− It shows what percentage of assets is funded by
Noncurrent Assets borrowing compared with the percentage of resources
Property, Plant, and Equipment: 156,000 that are funded by investors.
Total Other Noncurrent Assets: 1,600 − Companies with a higher figure are considered more
risky to invest in and loan to because they are more
Total Noncurrent Assets 157,600 leveraged.
Total Assets $ 185,000
Example:

LIABILITIES & STOCKHOLDERS' ◦ Nuggets is once again applying for a loan from their
EQUITY 2016 bank.
Total Current Liabilities 32,000
◦ Nuggets currently has a debt to asset ratio of 0.32.
Long-Term Liabilities
Notes Payable, less current portion 15,000 $59,000
Capital Lease Obligations 12,000 0.32 =
$185,000
Total Long-Term Liabilities 27,000
◦ This shows that Nuggets has more assets than
Total Liabilities $ 59,000
liabilities and could pay off its obligations by selling its
assets if it needed to.
◦ A ratio of less than 1 is considered to be the least
Total Liabilities risk.
Debt to Asset Ratio =
Total Assets ◦ It would be helpful for Nuggets; bank to compare the
restaurant industry’s debt to asset ratio to determine
whether this is in line with other industry leaders.
Copyright © 2016 Deloitte Development LLC. All rights reserved. 82
Debt to Equity Ratio

Nuggets, Inc. Use of Ratio:


LIABILITIES & STOCKHOLDERS' − Measures the percentage of company financing that
EQUITY 2016
comes from creditors and investors.
Total Current Liabilities 32,000
− A higher debt to equity ratio indicates that more
Long-Term Liabilities
creditor financing (bank loans) is used than investor
Notes Payable, less current portion 15,000
Capital Lease Obligations 12,000
financing (stockholders).
Total Long-Term Liabilities 27,000
− A lower debt to equity ratio usually implies a more
Total Liabilities $ 59,000
financially stable business.

Example:
Stockholder's Equity
◦ Nuggets has total liabilities of $59,000 and total
Common Stock 1,000
Additional Paid-In Capital 55,000
stockholders’ equity of $126,000, resulting in a debt
Retained Earnings 50,000 to equity ratio of 0.47:
Noncontrolling Interest 20,000
Total Stockholders' Equity 126,000 $59,000
0.47 =
$126,000
Total Liabilities & Stockholders'
Equity $ 185,000 ◦ This debt ratio means there are almost half as many
liabilities than there is equity.

◦ In other words, the assets of Nuggets are funded 2-


to-1 by investors to creditors.
Total Liabilities
Debt to Equity Ratio =
Total Equity
◦ This means that investors own almost 66.6 cents of
every dollar of company assets, while creditors only
own nearly 33.3 cents on the dollar.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 83


Times Interest Earned Ratio

Nuggets, Inc. Use of Ratio:


2016 − Measures the proportionate amount of income that can
Revenue $ 500,000
be used to cover interest expenses in the future.
Cost of Goods Sold 150,000
Gross Profit 350,000 − Usually stated in numbers as opposed to a percentage.

Operating Expenses − The larger ratios are considered more favorable than
SGA Expenses 120,000 smaller ratios.
Restructuring Charges 25,400
Depreciation & Amortization 14,500 − Also known as the interest coverage ratio.
Bad Debt Expense 1,100
Example:
Total operating expenses 161,000
◦ Upon applying for a loan, Nuggets provided their
Other Gains/(Losses): bank with their income statement; which shows that
Income from Equity
they made $165,000 before interest and taxes, and
Investments 100
paid $2,000 in interest expenses for the year.
Interest Expense (2,000)
Income from continuing ◦ Nuggets has a ratio of 80.5 times:
operations before taxes 187,100
$161,000
Income Taxes 32,100 80.5 =
$2,000
Net Income $ 155,000 ◦ This means that Nugget’s income is 80.5 times
greater than their annual interest expense.

Earnings Before ◦ In other words, Nuggets can afford to pay additional


Times Interest Interest & Taxes interest expenses and, depending on other ratios,
=
Earned Ratio
Interest Expense should not have a problem securing a bank loan.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 84


Activity Ratios

− Measures a company’s ability to efficiently manage its assets and liabilities.


− Used to assess an entity’s ability to convert certain accounts on its balance sheet to cash
or sales.
− Often look at the time it takes companies to collect cash from customer or the time it
takes companies to convert inventory into cash – in other words, make sales.

The entity’s
ability to convert
assets to sales
and cash.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 85


Accounts Receivable Turnover

Use of Ratio:
Nuggets, Inc.
2016 − Measures how many times a business can turn its
Net Credit Sales $ 100,000 accounts receivable into cash during a period.

− In other words, it measures how many times a


ASSETS 2016 2015
Current Assets business can collect its average accounts receivable
Cash $ 3,000 $ 2,000 during a year.
Accounts Receivable 12,000 13,000
Inventory 10,000 12,000 − Because the receivables turnover ratio measures a
Prepaid Expenses 2,400 1,000 company’s ability to efficiently collect its receivables, a
Total Current Assets 27,400 28,000
higher ratio would be more favorable.
Noncurrent Assets
Property, Plant, and
Example:
Equipment: 188,000 183,000
Less: Accum ◦ Most of Nuggets sales are for cash, however, a small
Depreciation (32,000) (35,000) amount of customers have a credit line.
Total PPE 156,000 148,000
◦ Nuggets’ total net credit sales for the year is
Other Noncurrent Assets:
$100,000, and their average accounts receivable for
Equity Investments 1,000 1,200
Goodwill 500 500 the year is $12,500 which results in a turnover of 8
Patents 100 300 times:
Total Other Noncurrent
Assets: 1,600 2,000
$100,000
8 =
Total Noncurrent Assets 157,600 150,000 ($12,000+$13,000)/2
Total Assets $ 185,000 $ 178,000
◦ This means that Nuggets collects their receivables
about 8 times a year, or once every 45 days.
Accounts Receivable Net Sales
= Average Accounts
Turnover
Receivable
Copyright © 2016 Deloitte Development LLC. All rights reserved. 86
Inventory Turnover

Nuggets, Inc.
2016
Use of Ratio:
Cost of Goods Sold $ 150,000 − Measures how many times a company sold its total
average inventory dollar amount during the year.
ASSETS 2016 2015
Current Assets − It is also a measure of how efficiently a company can
Cash $ 3,000 $ 2,000
Accounts Receivable 12,000 13,000
control its merchandise, and is important to have a
Inventory 10,000 12,000 high turnover. This shows that the company does not
Prepaid Expenses 2,400 1,000 overspend by buying too much inventory and wasting
Total Current Assets 27,400 28,000 resources on storing non-saleable inventory. It also
measures how effectively a company can sell the
Noncurrent Assets
Property, Plant, and
inventory that they buy.
Equipment: 188,000 183,000
Less: Accum Example:
Depreciation (32,000) (35,000)
Total PPE 156,000 148,000 ◦ Nuggets’ total cost of goods sold on its income
statement is $150,000 and their average inventory
Other Noncurrent Assets:
Equity Investments 1,000 1,200
for the year is $11,000; which results in a turnover of
Goodwill 500 500 13.6 times:
Patents 100 300
$150,000
Total Other Noncurrent 13.6 =
Assets: 1,600 2,000 ($10,000+$12,000)/2
Total Noncurrent Assets 157,600 150,000
Total Assets $ 185,000 $ 178,000 ◦ This means that Nuggets turned over their inventory
13.6 times during the year, or once every 27 days.

◦ It appears that Nuggets has good inventory control


Inventory Turnover = Cost of Goods Sold and can easily sell their inventory and turn it into
Average Inventory
cash.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 87


Asset Turnover

Nuggets, Inc.
Use of Ratio:
2016 − Measures how efficiently a company uses its assets to
Net Sales $ 500,000 generate sales.

− A higher ratio is always more favorable, and indicates


ASSETS 2016 2015
Current Assets that the company is using its assets more efficiently.
Cash $ 3,000 $ 2,000
Accounts Receivable 12,000 13,000 − Lower ratios mean that the company isn’t using its
Inventory 10,000 12,000 assets efficiently and most likely have management or
Prepaid Expenses 2,400 1,000 production problems.
Total Current Assets 27,400 28,000
Example:
Noncurrent Assets
Property, Plant, and 188,000 183,000
Equipment:
◦ Nuggets is meeting with a new investor that wants to
Less: Accum (32,000) (35,000) know how well Nuggets uses their assets to produce
Depreciation sales. Nuggets’ total asset turnover ratio is 2.75:
Total PPE 156,000 148,000
$500,000
Other Noncurrent Assets: 2.75 =
Equity Investments 1,000 1,200 ($185,000+$178,000)/2
Goodwill 500 500
Patents 100 300
Total Other Noncurrent 1,600 2,000
◦ This means that every dollar in assets, Nuggets
Assets: generates 2.75 dollars.

Total Noncurrent Assets 157,600 150,000 ◦ This would appear that Nuggets is fairly efficient with
Total Assets $ 185,000 $ 178,000 its use of assets, but would need to compare this
ratio to industry standards.
Net Sales
Asset Turnover =
Average Total Assets

Copyright © 2016 Deloitte Development LLC. All rights reserved. 88


Poll Everywhere

______________ measures a company’s ability to meet long-term financial


obligations on a continuing basis.
Which is the correct option to fill in the blank?

a) Profitability ratios

b) Liquidity ratios

c) Leverage ratios

d) Activity ratios

Copyright © 2016 Deloitte Development LLC. All rights reserved. 89


Budgets
What is a Budget?

− A budget is a detailed plan that outlines future expectations in quantitative terms:


◦ Future income and expenses
◦ Capital expenditures
◦ Understanding Cash Flows
− Planning, Budgeting and Forecasting is a three-step process for determining and
detailing an organization's long- and short-term financial goals. This process is generally
performed by company’s financial department under guidance by the Chief Financial
Officer
◦ Planning outlines the company’s financial direction and expectations for a future time
period (i.e., generally 3-5 years)
◦ Budgeting documents how the overall plan will be executed from month to month,
quarter to quarter, and/or year to year.
◦ Forecasting uses historical data to predict financial outcomes for future time periods

Copyright © 2016 Deloitte Development LLC. All rights reserved. 91


Financial Statement Fraud
Renewed emphasis on accounting fraud by regulators

The SEC “has reinvigorated its


investigative and enforcement efforts …
with a focus on issuers and gatekeepers” “We are intensely focused on
whether companies and their
- SEC Chair, Mary Jo White (December 9, officers evaluate judgmental
2015) accounting issues in good faith and
based on GAAP” said Andrew
Ceresney, Director of the SEC’s
Division of Enforcement

- Wall Street Journal “SEC


Announces Financial Fraud Cases”
“SEC Doubles Number of Financial (April 19, 2016)1
Reporting and Audit Cases in Two
Years”

- By Emily Chasan, Wall Street


Journal (October 22, 2015) 1

1. Used with permission from The Wall Street Journal, WSJ.com. Copyright 2016 Dow Jones & Company, Inc. All rights reserved.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 93


Fraud Frequency

Source: 2016 ACFE Report to the Nation on Occupational Fraud & Abuse

Copyright © 2016 Deloitte Development LLC. All rights reserved. 94


Fraud Risk Symptoms

Fraud is seldom witnessed firsthand.

The fraud risk symptoms (or “red flags”) alert us to the potential existence
of fraud.

FRAUD RISK SYMPTOM CATEGORIES


• Accounting/Document
• Analytical
• Lifestyle
• Behavioral
• Internal Control Override
• Tips and Complaints

Source: Based on the work of Dr. Steven Albrecht

Copyright © 2016 Deloitte Development LLC. All rights reserved. 95


Impact of fraudulent activity on the financial statements

In its December 31, 2013 financial statements, Nuggets, Inc. allegedly records a transaction that actually
occurred in January 2014. This transactions relates to inventory sold at a value of $1,250 with a cost of
$650. Nuggets allegedly conceals the fraud by shipping the inventory to an offsite storage facility.

What is the impact of this intentional misstatement on Nuggets’ financial statements?

Nuggets, Inc. Nuggets, Inc.


Income Statement Income Statement
For the year ended December 31, 2013 For the year ended December 31, 2013

Revenue $ 3,500 Revenue $ 4,750

Cost of Restaurant Operations 1,500 Cost of Restaurant Operations 2,150

Gross Profit 2,000 Gross Profit 2,600

Operating Expenses 1,500 Operating Expenses 1,500

Net Income $ 500 Net Income $ 1,100

Shares Outstanding 100 Shares Outstanding 100

Earnings Per Share $ 5.00 Earnings Per Share $ 11.00

Copyright © 2016 Deloitte Development LLC. All rights reserved. 96


Impact of fraudulent activity on the balance sheet

XYZ Company, Inc. XYZ Company, Inc.


Balance Sheet Balance Sheet
As of December 31, 2015 As of December 31, 2015

Assets Assets
Cash $ 500 Cash $ 500
Accounts Receivable 2,000 Accounts Receivable 3,250
Inventory 1,250 Inventory 600
Fixed Assets 5,000 Fixed Assets 5,000
Other Assets 3,000 Other Assets 3,000
Total Assets $ 11,750 Total Assets $ 12,350

Liabilities Liabilities
Accounts Payable $ 1,000 Accounts Payable $ 1,000

Stockholder's Equity Stockholder's Equity


Common Stock $ 100 Common Stock $ 100
Paid-In Capital 9,900 Paid-In Capital 9,900
Retained Earnings 500 Retained Earnings 1,100
Non-Controlling Interest 250 Non-Controlling Interest 250
Total Stockholder's Equity 10,750 Total Stockholder's Equity 11,350

Total Liabilities & Stockholder's $ 11,750 Total Liabilities & Stockholder's $ 12,350
Equity Equity

Copyright © 2016 Deloitte Development LLC. All rights reserved. 97


Summary of Key Learning Points
Summary of Key Learning Points

• A comprehensive set of financial statements includes the following:


− Balance sheet
− Income statement
− Statement of cash flows
− Statement of stockholders' equity
− Notes to the financial statements

It is important to understand (1) how to read them, (2) how they relate to each other and
(3) how to pull insights from them all.

• Terms such as: materiality, conservatism, and contingency are often used to
describe accounting matters.

• IFRS is a comprehensive, globally accepted set of accounting standards that may


be mandated for U.S. companies down the road.

• Financial statement fraud is an intentional act designed to misstate financial


performance in order to deceive financial statement users.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 99


Questions and Answers
Disclaimer
This presentation contains general information only and Deloitte is not, by means of this
presentation, rendering accounting, business, financial, investment, legal, tax, or other
professional advice or services. This presentation is not a substitute for such professional
advice or services, nor should it be used as a basis for any decision or action that may
affect your business. Before making any decision or taking any action that may affect your
business, you should consult a qualified professional advisor.
Deloitte shall not be responsible for any loss sustained by any person who relies on this
presentation.

Copyright © 2016 Deloitte Development LLC. All rights reserved. 101


Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by
guarantee (“DTTL”), its network of member firms, and their related entities. DTTL and each of its member
firms are legally separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not
provide services to clients. Please see www.deloitte.com/about for a more detailed description of DTTL and its
member firms.
This communication is for internal distribution and use only among personnel of Deloitte Touche Tohmatsu
Limited, its member firms, and their related entities (collectively, the “Deloitte network”). None of the Deloitte
network shall be responsible for any loss whatsoever sustained by any person who relies on this
communication.
© 2016. For information, contact Deloitte Touche Tohmatsu Limited
Combining Theory & Practice in an
Entrepreneurial Legal World
Module 3 – Cyber Security: A Prudent
Approach
Why Cyber Risk cannot be fully eliminated
Cyber risk is a first order business risk that is integrally tied to performance and
operations. As a result, it cannot be fully eliminated. Rather, it must be understood and
managed.

Organizations innovate
The things that organizations do to innovate and
grow are the very things that create cyber risk

Sharing information is imperative


We have connected our economy and our society
using platforms designed for sharing information …
not protecting it

People must be trusted


Organizations must trust people every day

For these reasons, a “secure everything” approach is usually not feasible. Therefore, we
advise our clients to focus not only on being secure, but on being
Secure.Vigilant.Resilient.™
Copyright © 2017 Deloitte Development LLC. All rights reserved. 2
Companies like yours (video)

Copyright © 2017 Deloitte Development LLC. All rights reserved. 3


Breaches are
Breaches are a
a multi-faceted
multi-faceted problem
problem
Any one-dimensional attempt to describe them fails to adequately capture their
complexity.

of actors
92% Known External Actors 95% use
Of breaches are Phishing
perpetrated by
outsiders
55%
Organized Crime Who found the incident

14%
Of breaches are by
21%
insiders (plus some Outside party
State affiliated
outsiders) and are
rising 2%
Customer Business
Activist partners
76%
of incidents are caused by
weak or stolen credentials.
1%
Former employee Multiple
Rogue hardware and malware
parties
are also frequent causes.

Source: 2013 Verizon Data Breach Investigations Report with the U.S. Secret Service, FBI, Deloitte, DHS and others
http://www.verizonenterprise.com/resources/reports/rp_data-breach-investigations-report-2013_en_xg.pdf
Intrusion detection
Copyright © 2017 Deloitte Development LLC. All rights reserved. 4
systems
Privacy regulation is driving new compliance initiatives
The GDPR ushers in vast changes to the privacy landscape
After four years of negotiations, the EU General Data Protection (GDPR) is upon us and due to be
enforceable on 25 May 2018. The new law will introduce a range of requirements which will have
significant impacts on organizations. Combined with increasing demands from consumers, privacy has
suddenly shot to the top of the corporate agenda. Below are just of the some key statistics from the
GDPR – the main headline being a maximum monetary penalty of 4% of annual global turnover
that can be imposed in cases of serious non-compliance.

75,000
$20m
4%
Estimated number
of new Data

21
Protection Officers Cost of a 4% fine
required to a company

72
Potential fines as a worldwide1 with $500m
percentage of turnover Years in the
global turnover making

190 Hours given to


report a data
breach
1.9x
+ 2.7x More recitals
than the
current
Countries More articles
directive
potentially in in the GDPR
scope of the than the
regulation current
directive

11Source: Study: GDPR’s global reach to require at least 75,000 DPOs worldwide https://iapp.org/news/a/study-gdprs-global-reach-to-require-
at-least-75000-dpos-worldwide/

Copyright © 2017 Deloitte Development LLC. All rights reserved. 5


New requirements are not just a concern for legal
The new era of privacy will necessitate cooperation across the organization
Privacy as a concept is broad and far-reaching. For this reason, the GDPR impacts many areas of an
organization, not just legal and compliance. It also engages functions tasked with information technology
and security, and data governance and information management, including sales and marketing and
digital.
Who should pay attention
Legal and Compliance
 General Counsel
The GPDR introduces brand new requirements and challenges for legal and compliance
 Privacy Officer
functions. Many organizations will require a Data Protection Officer (DPO) who will
have a key role in ensuring compliance. It is estimated that 28,000 new DPOs will be  Chief Risk Officer
required in Europe alone. If the GDPR is not complied with, organizations will face the  Chief Compliance
heaviest fines yet—up to 4% of annual global turnover. A renewed emphasis on Officer
organizational accountability will require robust privacy governance, requiring
organizations to review how they write privacy policies, to make these easier to
understand.

Technology
New GDPR requirements will mean changes to the ways in which technologies are  Chief Information
designed and managed—CIOs beware! Documented privacy risk assessments will be Officer
required to deploy major new systems and technologies. Security breaches will have  Chief Information
to be notified to regulators within 72 hours, meaning implementation of new or Security Officer
escalated incident response procedures. The concept of 'Privacy By Design’ has now
become enshrined in law, with the Privacy Impact Assessment (PIA) expected to
become commonplace across organizations over the next few years.

Data
Individuals and teams tasked with information management will be challenged to  Chief Data Officer
provide clearer oversight on data storage, journeys, and lineage. Having a better
 Chief Operating
grasp of what data is collected and where it is stored will make it easier to comply with
Officer
new data subject rights—rights to have data deleted and to have it ported to other
organizations.
Copyright © 2017 Deloitte Development LLC. All rights reserved. 6
Deloitte’s View on Cyber Security
Reduce the impact of cyber incidents and develop a holistic privacy program that enables
holistic cooperation across the organization by becoming: Secure. Vigilant. Resilient.TM
Deloitte’s Cyber Security
Inputs principles

Regulations
and standards SECURE
 Global privacy and data
protection laws Establish risk-
 ISO1 27001/2 prioritized
 NIST2 cybersecurity controls to VIGILANT
framework protect against
 ITIL3 known and Gaining detective
 … emerging threats, visibility and
and comply with preemptive RESILIENT
standards and threat insight to
Preferred practices regulations detect both Establish the ability
 Project / known and to handle critical
engagement unknown incidents, quickly
experience adversarial return to normal
 Published industry Identify activity
research
operations, and
Protect across the repair damage to the
environment business
Threat Landscape
Detect
 Who might attack? Respond
 What are they after?
 What tactics will they Recover
use?

Rather than being a necessary burden, the Cyber Risk program is a positive aspect of managing business
performance.
1International Organization for Standardization As used in this document, “Deloitte” means Deloitte & Touche LLP and Deloitte Consulting LLP, which are separate subsidiaries of
2 National Institute for Standards and Technology
Deloitte LLP. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.
3 Formerly known as the Information Technology Infrastructure
Library Certain services may not be available to attest clients under the rules and regulations of public accounting.
Copyright © 2017 Deloitte Development LLC. All rights reserved. 7
Deconstructing Cyber
Attacks

Copyright © 2017 Deloitte Development LLC. All rights reserved. 8


Anatomy of a Cyber Attack
The lifecycle of a cyber attack involves a progression of several stages.

Data is
Attack Stage

Compromised
Maintaining
the Back • Data theft
Weapon/ Door • Data destruction
Malware • Unmonitored ports • Espionage
Opening Delivery
• Misconfigured data • Denial of service
• Spyware
the Door loss prevention • Unauthorized
Intelligence • Ransomware
Collection • Spear phishing tools system and
• Rootkit
• Peer to peer • Drive by download • Bot • Stolen access network access
networks • Software/hardware credentials
• Search engines vulnerabilities Time to Exploit: Minutes
• Social • Third-party Time to Discovery: Months or
engineering compromise Longer

Time

Copyright © 2017 Deloitte Development LLC. All rights reserved. 9


Cyber Threat Landscape, Trends, and Impact
A complex set of motivations, ecosystem, tools and tactics enable the adversaries.

Threat actors Nation-state actors Ideological groups

Organized crime Individuals

Actor ecosystem Malware Hosting Payment Domain Command Money


authors entities processors generators & control mules

Social Botnets Password


Tool, tactics, and Ransomware theft
engineering
procedures Exploits Website Evasion
compromise tactics
Phishing DDoS

Threat vectors Suppliers Employees Mobile Smart Customers Email


& partners devices devices

IT COMPLEXITY SECURITY OPERATIONS PROCESS/GOVERNANCE


Common corporate • Endpoint diversity • Signature-based controls • Shadow IT
challenges • Rogue devices • Data encryption • Change/asset management
• Shadow users • Device-focused monitoring • Secure SDLC
• Business innovation/ change • Insufficient skills/staffing • Business risk alignment
• Third party entities • Risk-asset mapping

Potential impact
Fraud or Reputation Threat to life Operational
Data loss IP theft
revenue loss damage or safety disruption

Not only have criminals and criminal organizations conducted sophisticated cyber attacks, but we also
witnessed the first “known” cyber attack by a nation state against a private corporation.
Copyright © 2017 Deloitte Development LLC. All rights reserved. 10
Cyber Security
Cyber Security Evolved
evolved (video)

Copyright © 2017 Deloitte Development LLC. All rights reserved. 11


Cyber Security: Essential Truths
The threat landscape has changed, so you must realize the stakes are higher than ever.

1. Speed of attack is increasing and response


4. Everything can’t be protected equally
times are shrinking

 Vigilance to understand new threats,  Understanding the need to define ‘crown jewels’
anticipate and thwart future attacks and associated value chain, high risk
 Resilience to minimize impact and/or recover individuals/events – proportionate risk decisions
gracefully and fast  Use of models such as Value at Risk (VaR) and
Risk Adjusted Rate of Return On Capital (RAROC)
for planning, budgeting, tracking and reporting

5. Traditional controls are necessary but not


2. Cyber damages go beyond dollars
adequate

 While the average cost is known, the long  Preventative security measures are no longer
term effects on reputation, brand, morale, sufficient - New technologies and
trust are significant and take their toll on approaches are required
organizations  Human error/lapses continue to be one of the
 Consideration for Cyber Insurance key reasons for breaches

6. Regulators / government are key


3. No industry or organization is immune
stakeholders with ever increasing focus

 Determine your risk tolerance and the cost  Security and privacy rules, guidelines, and
of protection consumer protection are increasing

Copyright © 2017 Deloitte Development LLC. All rights reserved. 12


Threat actors/motives vary by Industry and Organization
A typical cyber risk heat map for the Life Sciences Sector.

Notable insights: IMPACTS


Financial IP, Mfg. & Dist. Threats
Business Reputation Regulatory
theft / strategic Infrastructure to life
disruption damage issues
• Insiders, hacktivists, and fraud theft Disruption safety
ACTORS
nation-states are actors of
key concern Organized
criminals
• Marketing authorization
holders’ risks are amplified
by heavy reliance on Hactivists

outsourced IT operations
and intricate in-license and Nation
out-license agreements with states
competitors.
Insiders
• Decentralized governance
and geographic dispersion of
physical supply chain Competitor
weaken cyber command and s
control.
Skilled
individual
• General lack of overall hackers
maturity of life sciences
companies in cyber domains

KEY

“94% of healthcare organizations in this study have had at least one data breach in the past two years. 45% reported that they had 5 or more.” Very high Moderate

Ponemon Institute, Third Annual Benchmark Study High Low


on Patient Privacy & Data Security, Dec. 2012

Copyright © 2017 Deloitte Development LLC. All rights reserved. 13


Cyber Threats – Illustrative Risk Appetite
It is important for employees, contractors and suppliers to be aware of how bad guys
target you for carrying out well-planned attacks and what it could mean to your business

Risk Appetite

Prevent Defend Limit Impact

Copyright © 2017 Deloitte Development LLC. All rights reserved. 14


Cyber Security Maturity Model
An organization’s Cyber Security program depends on its current posture

Media & Small


Businesses
Manufacturers &
Life Sciences

Retail Banks & Energy


Providers

Investment Banks

Military & Defense

Copyright © 2017 Deloitte Development LLC. All rights reserved. 15


Building a Cyber Risk
Program

Copyright © 2017 Deloitte Development LLC. All rights reserved. 16


Executive Sponsorship is the Key to Success
Leaders play a key role in driving alignment.

Tone at the top, establish senior management accountability and a


Board & CEO cyber-aware culture

CYBER RISK GOVERNANCE

Senior
Management IT Leadership IT Risk Leadership Legal/Compliance Line of Business
(CFO, COO, CAO, (CIO) (CISO / CITRO) Leadership Leaders
CRO)

Define the Lead in defining Define the right Respond to Support


organization’s and executing the balance between compliance integration of
Cyber Risk strategy to threat-centric vs. obligations and Cyber Risk
appetite and be become compliance- align overall cyber management
accountable for Secure.Vigilant. centric programs. risk program into business
Cyber Risk Resilient. Be a business strategy and growth and
management. Establish an enabler, without initiatives with development
Empower the effective shying away from regulatory activities.
extended interaction model the role of risk requirements. Appoint line-of-
leadership team. with CISO and IT custodian. business risk
risk officer. officers.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 17


Cyber Security Roadmap
Building a broad, sustainable cyber security capability takes leadership, commitment and
focus.

Operational Sustainability
 Further developing the maturity of
basic Cyber Security capabilities, with a
greater focus on standardization,
integration & consistency
 Positioned to evolve towards the next
level of maturity & business partnership

Cyber Security Strategic Program


 Build / mature IS capabilities
 Execute assessments on high risk environments
 Remediate high risk vulnerabilities
 Address regulatory gaps

Cyber Security Transformation & Co-Sourcing


 Focus on high value activities
 Co-source areas of low risk with operational
requirements

Cyber Security Strategy & Roadmap


 Current state maturity assessment
 Strategic objectives & roadmap of approved initiatives
 Rationalized global regulatory requirements and plan for
compliance
Copyright © 2017 Deloitte Development LLC. All rights reserved. 18
Develop a Culture of Cyber Risk Awareness
The example below demonstrates the advantages of embedding awareness into the development cycle
for a new initiative. Though this focuses on privacy considerations for the development of a mobile
application, the concepts are similar when applied to broader Cyber Risk considerations or to business
processes.
Privacy as an Afterthought
Design specifications call
for use of GPS GPS location is built into
user profiles with
notification to consumers Users who decline GPS
can’t use the app,
suppressing downloads
Concept User testing is completed and ongoing usage. Re-
Phase with GPS location design discussions start
back at Concept Phase
Development
and Testing

Pilot

Privacy Impact Assessment


highlights regulatory drivers
Release
for protecting GPS
Privacy by default concepts
provide users the option to
use or disable GPS
Users are able to test and
confirm that GPS settings
Proactive Measures do not inhibit app
functionality. Privacy
Users who decline GPS continue
Impact Assessment finding
to enjoy application features.
Privacy by Default is closed
The development team returns to
Concept to develop new uses and
features
Privacy mechanisms are
confirmed

Privacy by Design
Copyright © 2017 Deloitte Development LLC. All rights reserved. 19
Achieving Cyber Threat Management Capabilities
What it means to be…

SECURE VIGILANT RESILIENT


Establish risk-prioritized controls to Establish situational risk and threat Establish the ability handle critical
protect against known and emerging awareness across the environment incidents, quickly return to normal
threats, and comply with standards and to detect violations and anomalies. operations, and repair damage to the
regulations. business.

 Implement controls to protect sensitive data Establish cross-domain, correlation-based Establish appropriate levels of data recovery
and critical business activity, with monitoring to detect control and policy and system redundancy capabilities for all
investments prioritized in line with business violations, with a focus on detection of events network-dependent services and functions.
criticality. impacting the most risk-sensitive areas.
Ensure well-defined processes for technical
 Hone processes to update, modify and Develop the ability to detect anomalies to handling of incident analysis and remediation.
expand controls as risk guidance, technology “normal” user and application behavior.
utilization, and threat vectors change. Build cross-functional teams to manage longer-
Leverage technology to centrally integrate term recovery issues, including internal and
 Shore up asset management capabilities to threat data for correlation with IT and business external communications.
help operations teams focus on business- data.
critical components and services. Acquire skills and implement policies necessary
Provide upstream reporting on KRIs. for effective post-incident forensics.
 Institutionalize mature vulnerability
management and identity and access Establish change management processes for Establish guidelines to ensure resilience issues
management capabilities. continual improvement of detection capabilities are thoroughly addressed in all new IT projects.
as new knowledge is uncovered.
 Institutionalize Secure SDLC practices. Conduct periodic simulations and rehearsals to
Conduct period testing and assessment of test and hone crisis management processes.
 Implement organization-wide training and foundational controls.
education programs.
Leverage new generations of detection and
 Define and oversee vendor/partner analytic tools to migrate toward improved.
compliance with appropriate security
standards.

GOVERNANCE
Set overall Secure-Vigilant-Resilient Establish KPIs and accountability Ensure business/IT collaboration for Communicate with vendors, partners,
program priorities and ensure proper mechanisms, and track current ongoing re-engineering of processes and customers, law enforcement and peer
allocation of resources. state against key program goals. infrastructure to support ongoing organizations to share awareness of
business innovation. threats and best practices.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 20


Questions Executives need to ask
Leaders should determine if the organization has the right approach

1. Are we focused on the


4. Are we incentivizing
right things?
openness & collaboration?
 Often said, but hard to
 Build strong relationships
execute.
with partners, law
 Understand how value is
enforcement, regulators,
created in your
2. Do we have the right and vendors.
organization, where
talent?  Foster internal cooperation
your critical assets are,
across groups and
how they are vulnerable  Quality over quantity functions, and determine
to key threats.  There is not enough that people aren’t hiding
 Practice defense-in- talent to do everything risks to protect themselves.
depth. in-house, so take a
strategic approach to
sourcing decisions.

5. Are we adapting to
3. Are we proactive or change?
reactive?  Policy reviews,
 Retrofitting for security assessments, and
is very expensive. rehearsals of crisis
 Build it upfront in your response processes
management processes, must be regularized to
applications and establish a culture of
infrastructure. perpetual adaptation to
the threat and risk
landscape.
Copyright © 2017 Deloitte Development LLC. All rights reserved. 21
Top Actions for Executives
The actions that leaders take help balance risks and business needs
1. Assign a senior executive to lead
 Executive must be able to lead the program across diverse functions, drive
collaboration & play a key role in a crisis
2. Establish purpose and direction
 Clearly articulate your cyber risk appetite and strategy. Support it by requisite
action through funding and resourcing
 Establish priorities, and ensure funding and resourcing
3. Adopt a framework & map threats to business assets
 Gather top leaders and threat intelligence specialists
 Identify crown jewels and un-addressed cyber risks
4. Accelerate behavior change among people
 Create a corporate wide cyber mindset
 Create active learning scenarios that instill awareness of the impact of daily activity
on cyber risk
 Embed cyber risk management goals into evaluation of Top 100 executives
5. Provide regular updates to executives and the board
 Provide ongoing communication to avoid surprises and gain assurance that security
controls are in line with the risk tolerance of the organization
 Conduct monthly or quarterly reviews about key risks and risk metrics, and address
roadblocks
Copyright © 2017 Deloitte Development LLC. All rights reserved. 22
Cyber Security Questions – Client Stakeholders
Executives should be prepared to answer questions that stakeholders have
1. Does the C-Suite demonstrate due diligence, ownership and effective management
of cyber risk?
2. Do we have the right leader and organizational talent?
3. Have we established an appropriate cyber risk escalation framework that includes
our risk appetite and reporting thresholds?
4. Are we focused on, and investing in, the right things?
5. How do our cyber security program and capabilities align to industry standards
and peer organizations?
6. Do we have an organization-wide cyber focused mindset and cyber conscious culture?
7. What has management done to protect the organization against third-party cyber
risks?
8. Can we rapidly contain damages and mobilize diverse response resources should a
cyber-incident occur?
9. How do we evaluate the effectiveness of our organization’s cyber program?
10. Are we helping to protect our industry, and the nation against cyber risks by taking a
broad approach to knowledge and information sharing?

Copyright © 2017 Deloitte Development LLC. All rights reserved. 23


Disclaimer

This presentation contains general information only and Deloitte is not, by


means of this presentation, rendering accounting, business, financial,
investment, legal, tax, or other professional advice or services. This
presentation is not a substitute for such professional advice or services, nor
should it be used as a basis for any decision or action that may affect your
business. Before making any decision or taking any action that may affect your
business, you should consult a qualified professional advisor.

Deloitte shall not be responsible for any loss sustained by any person who
relies on this presentation.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 24


About Deloitte
Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee
(“DTTL”), its network of member firms, and their related entities. DTTL and each of its member firms are legally
separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not provide services to
clients. Please see www.deloitte.com/about for a detailed description of DTTL and its member firms. Please see
www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.
Certain services may not be available to attest clients under the rules and regulations of public accounting.

Copyright © 2017 Deloitte Development LLC. All rights reserved.


Combining Theory & Practice in
an Entrepreneurial Legal World

Module 5 – Financing the Business


Part 1 – Equity Financing
Agenda

• Summary of Key Learning Points


• Capital structure
• Cost of capital and time value of money
• Equity capital and investors
• Required rates of return
• Financing example
• Capital budgeting
• Summary of key learning points
• Questions and answers

Copyright © 2017 Deloitte Development LLC. All rights reserved. 2


Summary of Key Learning Points
Summary of Key Learning Points

• Capital Structure
− The capital structure of a firm is the mix of different securities issued by the firm to finance its operations
• Cost of Capital and Time Value of Money
− A dollar received today is worth more than a dollar received tomorrow
− The FUTURE cash flows are discounted at the cost of capital to arrive at their PRESENT VALUE
− The risk inherent in the future cash flows is reflected in the discount rate
− A firm’s cost of debt is always less than its cost of equity
• Equity Capital and Investors
− The different types of equity capital are:
◦ Common equity, preferred equity, limited and general partnership shares
− There are many different sources of equity capital that differ based on how developed the company is and
the need for the capital.
• Required Rates of Return
− Companies have different capital needs at each stage of growth and may approach different capital
providers at each stage of the process.
− Each stage has very different risk profiles and each investor pool has different tolerances for those risks
• Capital Budgeting
− Capital budgeting and planning is the process by which a firm sets capital allocation targets and builds
towards an optimized portfolio of projects
− Capital can be invested to create shareholder value in several different ways

Copyright © 2017 Deloitte Development LLC. All rights reserved. 4


Capital Structure
What are the basic reasons for raising capital?

• Funding a start-up business


• Funding growth after a business is established
◦ Nuggets is looking to fund its international growth plans
• Opportunistically refinancing – optimizing the capital structure
• Funding working capital
• Funding major growth initiatives – capital expenditures or
acquisitions
◦ Nuggets would need capital to fund the potential acquisition of an
international company
• Extending maturities
• Restructuring when financial performance is suffering

Copyright © 2017 Deloitte Development LLC. All rights reserved. 6


What are the basic reasons for raising capital?

Time

Start-Up Growth Major


Funding
Capital Capital Initiatives
Requirements
Working Capital

Typical Capital 100% Limited Optimal


Structure Equity Debt Debt and
Equity

Copyright © 2017 Deloitte Development LLC. All rights reserved. 7


Elements of capital structure

The capital structure of a firm is the mix of different sources of capital issued by
the firm to finance its operations.
Sources of Capital:
– Debt: Bonds, bank loans
– Equity: Ordinary shares (common stock), Preference shares (preferred stock)
– Hybrids: warrants, convertible bonds

Operating Liabilities

Debt
Operating Assets
Capital
Preference Shares
Structure

Ordinary Shares

Copyright © 2017 Deloitte Development LLC. All rights reserved. 8


Balance Sheet

As of December 28, 1990 US$

ASSETS

Cash and Equivalents $503,444

Accounts Receivable 5,556

Inventory 3,000

Total Current Assets $512,000

Net Plant, Property & Equipment 239,583

Net Intangible Assets (Liquor License) 14,750

Total Assets $766,333 Operating Assets

LIABILITIES

Accounts Payable 3,000 Operating Liabilities

Interest Bearing Debt - Debt


Total Liabilities $3,000

MEMBERS EQUITY
Capital
Members Equity 800,000 Structure
Retained Earnings (36,667)

Total Members Equity $763,333 Equity

Total Liabilities & Members Equity $766,333

Copyright © 2017 Deloitte Development LLC. All rights reserved. 9


Knowledge Check #1

What was Nugget's capital structure as an early stage company in December


1990?

A. 100% equity / 0% debt


B. 75% equity / 25% debt
C. 50% equity / 50% debt
D. 5% equity / 95% debt

Operating Liabilities

Debt
Operating Assets
Capital
Preference Shares
Structure

Ordinary Shares

Copyright © 2017 Deloitte Development LLC. All rights reserved. 10


Elements of capital structure (cont.)

Capital structures can range from simple to complex


Enterprise Value Coverage

Secured 1st Lien


Bank Loan Note

Secured Bank
Loans
2nd Lien
Institutional
Loans/
B/C
Notes
Debt Tranches

Unsecured
Mezzanine
Note
Unsecured Note

Payment-in-Kind
Loans / Notes
Hybrid Preferred

Common Equity/ Common Equity/ Common Equity


Shareholder Loan Shareholder Loan Shareholder Loan
Series A/B/C

Copyright © 2017 Deloitte Development LLC. All rights reserved. 11


Cost of Capital and Time Value
of Money
Time Value of Money

• Money has a time value because money can be invested with the expectation
of earning a positive rate of return
− In other words, a dollar received today is worth more than a dollar received tomorrow

− TIME allows you the opportunity to postpone consumption and earn INTEREST

− That is because today’s dollar can be invested so that we have more than one dollar
tomorrow

Which would you prefer -- $10,000 today or


$10,000 in 5 years?

10%
0 1 2 3 4 5
interest

$10,000
Present Value
= $6,210
Copyright © 2017 Deloitte Development LLC. All rights reserved. 13
Knowledge Check #2
Time Value of Money Exercise
Nuggets wants to buy a new software system that will revolutionize the way
customers order their food. The new software system will not be ready for six
years but Nuggets has put its name on the list to buy the system. The new
software system will cost the company $1 million dollars. Company
management wants to reserve some cash and put it away in a bank account
until they actually make the purchase. How much money should they put in the
bank account now in order to have $1 million in six years assuming the bank
account earns an interest rate of 3.5%?

0 1 2 3 4 5 6
3.5%
interest

$1,000,000
Deposit now (closest answer)?
A. $1,200,000
B. $200,000
C. $900,000

Copyright © 2017 Deloitte Development LLC. All rights reserved. 14


Cost of Capital

Debt versus Equity

• A firm’s cost of debt is


always less than its cost
of equity
– debt has seniority over
equity
– debt has a fixed return
– the interest paid on
debt is tax-deductible

• It may appear that a


firm should use as much
Options debt and as little equity
as possible due to the
cost difference, but this
ignores the potential
problems associated
with debt

Copyright © 2017 Deloitte Development LLC. All rights reserved. 15


Optimal Capital Structure – A Practical Approach

• Theoretical approaches to optimal capital structure result in a cash rich and debt light company.
• The optimal allocation of capital is sourced from various instruments and the choice of
instruments is based on the prevailing capital market conditions.
• There are a number of interactive and key practical considerations that drive this decision,
including the specific objectives of the company, the requirement for a stable financing structure
to support the business, the asset security package available to support the debt and financial
flexibility within the company’s cash flows.
Supporting business
objectives

Financing requirements
• New transactions
• Existing business
requirements

Costs
• Interest Stability
margin • Tenor
• Other Capital • Financial/
Financial flexibility fees Strategy other Stability of debt
covenants

Security considerations
• Assets
• Guarantees
• Unencumbered assets

Properly structured
Copyright © 2017 Deloitte Development LLC. All rights reserved.
security 16
Equity Capital and Investors
Basics of Equity Capital

• Long term capital


• Generally comes with no repayment schedule
• Dividends can be paid to equity holders
• Most “expensive” capital

Acitivist
8%

Institutional Family Trust


Fund
39%
17%

Hedge
Fund
5%

Copyright © 2017 Deloitte Development LLC. All rights reserved. 18


Types of Equity Capital

•Common stock
− A voting interest and ownership in an entity. Stock ownership typically does not entitle
owners to scheduled dividends and returns can be highly variable

•Preferred stock
− Characterized by a “preferred returns” usually in the form of scheduled or guaranteed
dividend payments. Typically a non-controlling interest

•Partnership shares
− Structure in which multiple partners, or general partners together control the business.
Partnerships are not taxed at the entity level and profits are passed to the partners and
taxed at the individual level

•Limited partnerships shares


− Structure in which a group of partners, one or more of which are considered “general
partners,” control the business, while the rest are passive partners or investors.

•Limited liability companies member interests


− A hybrid structure that blends the characteristics of partnerships and corporations

Source: investopedia.com
Copyright © 2017 Deloitte Development LLC. All rights reserved. 19
Equity Capital for Start-Ups

• Founders Contributions
− 84% of start-ups are funded through various types of founder
contributions

• Friends and family

− 2.6% of start ups are funded through money contributed by friends and
family

• Other equity sources detailed in the following slides (remainder)

Source: US Census Bureau, November, 2012

Copyright © 2017 Deloitte Development LLC. All rights reserved. 20


Equity Capital for Small, Established Businesses
•Angel investors
− Typically a wealthy individual or group of individuals who contribute capital
to an extremely early stage business or business idea in exchange for
convertible debt or equity

•Venture capital firms


− Firms which provide money to start-up and small businesses with a more
established business model and which have long term growth potential

•“Micro” private equity


− Some private equity firms may focus on later stage start ups and may
provide capital to growth business in certain sectors or areas of firm
expertise

•Crowdfunding
− Collective effort of individuals who pool their resources, usually via the
internet, to support the development of a business in exchange for equity

Copyright © 2017 Deloitte Development LLC. All rights reserved. 21


Equity Capital for Larger, Developed Businesses

•Private equity firms


− Over $2.4 trillion in global assets under management with nearly $1.3
trillion in available capital

•Public equity markets


− Market capitalization of large equity exchanges in the US:

− NYSE Euronext – over $18.7 trillion

− Nasdaq – over $8 trillion

Source: 2016 Preqin Global Private Equity & Venture Capital Report NYX Data; Nasdaq

Copyright © 2017 Deloitte Development LLC. All rights reserved. 22


Capital Sources & Stage of Company

Seed/Start Up:
• Typically $200,00 to $1 million
• Provided by friends & families, nonprofit venture development groups, and grants
• Crowdsourcing: Online matching of investors on a micro loan (equity) basis
• Alpha and Beta stage products – early testing phase

Early Stage:
• $1-5 million
• Angel investors, regional venture capital firms, high net worth individuals
• Beta stage product or early adoption period

Growth Stage:
• $5 million+
• Variety of sources including venture capital, strategic investors, debt capital and
hybrids
• Scaling products and services up to full capacity
• Venture capital investors may start to think about how to exit down the road and look
for ways to pull out capital

Companies have different capital needs at each stage of growth and may approach
different capital providers at each stage of the process. Each stage has very different risk
profiles and each investor pool has different tolerances for those risks.
Copyright © 2017 Deloitte Development LLC. All rights reserved. 23
Required Rates of Return

Time
Stage

Seed / Growth: Growth: Growth: IPO Stage Mature


Start Up 1st Stage 2nd Stage 3rd-4th Stage
Stage

Expected Rate of Return 1

50-70% 40-60% 35-50% 30-45% 25-35% 7-20%

Owner, Angels, Private Funds, Funds,


Investor
Friends & Venture Equity, Institutions insurance,
Types
Family Capital Strategic pensions
1) See Appendix A for more detailed information
Copyright © 2017 Deloitte Development LLC. All rights reserved. 24
Financing Example
Sample Capitalization Table

A capitalization table (cap table) details the ownership of the company

Stage 1 – Initial Investments

# of % $ Share
Common Stock
Shares Ownership Investment Price
1
John Coulter 2,000,000 25% $200,000 $0.10
1
Jen Coulter 2,000,000 25% $200,000 $0.10
2 Friends & Family 4,000,000 50% $400,000 $0.10

Total Common
8,000,000 100% $800,000
Stock

1.The Coulter siblings each invested $200,000 of personal savings in 1990, which gave
them each 25 percent ownership of Nuggets
2.At the same time, friends and family collectively provided $400,000 of additional capital
to help start the business. The investment provided friends and family with a 50 percent
ownership stake in Nuggets

Copyright © 2017 Deloitte Development LLC. All rights reserved. 26


Balance Sheet

As of December 28, 1990 US$ As of December 28, 1998 US$

ASSETS ASSETS

Cash and Equivalents $503,444 Cash and Equivalents $3,297,671

Accounts Receivable 5,556 Accounts Receivable 36,390

Inventory 3,000 Inventory 19,651

Total Current Assets $512,000 Total Current Assets $3,353,712

Net Plant, Property & Equipment 239,583 Net Plant, Property & Equipment 1,566,048

Net Intangible Assets (Liquor License) 14,750 Net Intangible Assets (Liquor License) 99,891

Total Assets $766,333 Total Assets $5,019,651

LIABILITIES LIABILITIES

Accounts Payable 3,000 Accounts Payable 19,651

Interest Bearing Debt - Interest Bearing Debt -

Total Liabilities $3,000 Total Liabilities $19,651

MEMBERS EQUITY SHAREHOLDERS EQUITY

Members Equity 800,000 Shareholders Equity 2,800,000

Retained Earnings (36,667) Retained Earnings 2,200,000

Total Members Equity $763,333 Total Shareholders Equity $5,000,000

Total Liabilities & Members Equity $766,333 Total Liabilities & Shareholders Equity $5,019,651

Copyright © 2017 Deloitte Development LLC. All rights reserved. 27


Sample Capitalization Table (cont.)
• Based on market research as well as a few preliminary, non-binding offers to buy Nuggets,
the Coulter siblings believed the value of Nuggets was approximately $3,000,000
• This valuation implies a $0.38 share price ($3,000,000 value / 8,000,000 shares)

• In order to expand the business regionally, the coulter siblings estimated that they need
an additional $2,000,000 of capital
• Two separate venture capital firms agreed to provide Nuggets with $1,000,000 each at
a price of $0.38 per share

Stage 1 – Initial Investments Stage 2 – Expansion Stage Difference

Original New /
Common Original # Original % New # of New % Inc / (Dec)
Investmen Current
Stock of Shares Ownership Shares Ownership in Value
t Value

John Coulter 2,000,000 25% $200,000 2,000,000 15% $750,000 $550,000

Jen Coulter 2,000,000 25% $200,000 2,000,000 15% $750,000 $550,000

Friends &
4,000,000 50% $400,000 4,000,000 30% $1,500,000 $1,100,000
Family

VC Firm 1 N/A N/A N/A 2,666,667 20% $1,000,000 $0

VC Firm 2 N/A N/A N/A 2,666,667 20% $1,000,000 $0

Total 8,000,000 100% $800,000 13,333,333 100% $5,000,000 $4,200,000

Copyright © 2017 Deloitte Development LLC. All rights reserved. 28


Capital Budgeting
Capital Budgeting Overview

Capital budgeting is perhaps the most important functions financial managers perform

What is capital budgeting?

• Analysis of potential capital projects to undertake


• Long-term decisions involving large expenditures
• Projects selected are expected to produce a cash inflow over a period of time

Steps in making a capital budgeting decision:

• Estimate cash flows (inflows & outflows)


• Assess risk of cash flows
• Determine appropriate cost of capital or discount rate for project
• Evaluate cash flows via Net Present Value, Internal Rate of Return, Payback Period or several other
methods
• Make Accept/Reject Decision
• Payments to stakeholders (i.e. dividends, debt payments)

Sample capital budgeting categories include:

• Upgrade or replace to continue profitable operations


• Upgrade or replace to reduce costs
• Expansion of existing products or markets
• Expansion into new products/markets
• Research and Development (R&D)
• Safety and/or environmental projects
• Mergers & Acquisitions

Copyright © 2017 Deloitte Development LLC. All rights reserved. 30


Capital Budgeting – The Bigger Picture

Capital Planning Framework

Capital budgeting and planning is the


Secured process by which a firm sets capital
The allocation targets and builds towards
Market Raise Unsecured an optimized portfolio of projects. This
Minimize
cost of capital is achieved by:
Equity
 Establishing an iterative capital
Capital
budgeting process that allocates
Expenditures
funding down to the direct ownership
Balance Sheet Deploy level
& Cash Flow Deploy
Maximize
value creation
The
Maximize
value creation  Developing an effective project
Business
Working Capital prioritization methodology that
quantities value and risk
Cash Mobility considerations
Dividend  Implementing a capital management
Distribute Policy governance structure with clear roles
The Signal
to the market Share and responsibilities
Stakeholders
Repurchase

Debt Repayment

Executable Strategies with Measureable Results

Copyright © 2017 Deloitte Development LLC. All rights reserved. 31


Allocation of Funds to Capital Projects

Capital can be invested to create shareholder value in several different


ways.

Options for Investing Capital

Capital Investment Projects Merger and Acquisition Investment in Securities or


Option

and Maintaining Capital Transactions Minority Investments in


Assets Other Companies

 Investment in information  Purchase of another company  Purchase of investment


technology systems securities
 Merger with a company that
 Investment in production requires capital outlay  Purchase of a minority stake
equipment and machinery in another company
Illustrative Examples

 Building or purchasing of new


facilities
 Maintenance of plant, property
and equipment such as
machinery and buildings
 The incremental discretionary
expenditures required to
execute capital projects
 R&D investments

Copyright © 2017 Deloitte Development LLC. All rights reserved. 32


Example – Payback Period

Nuggets wants to invest in a new clean-energy fryer. Management is deciding between a


$1,000,000 fryer and a $1,400,000 fryer, each with different cash flow expectations. If the
decision were based on the payback period alone, which project should the Company
undertake?

Year Project A Project B

0 -$1,000,000 -$1,400,000

1 100,000 600,000

2 500,000 600,000

3 800,000 600,000

2.5 years 2.25 years

What is the payback period for each Project?

Weakness of this approach: Time value of money is ignored as well as the cash flows
that occur after the payback period

Copyright © 2017 Deloitte Development LLC. All rights reserved. 33


Example – Net Present Value
Nuggets’ Management also evaluates each major project on an expected Net Present Value (NPV)
method. The Net Present Value considers the time value of money and discounts the expected future
cash inflows, net of the outflows, of the project to today’s value at an assumed interest rate.

Project A includes a new fryer that enhances the range of flavor possibilities. Project B is a new
technology that reduces amount of oil needed which reduces operating costs.

While Project B has a faster payback period (2.25 years) than Project A (2.5 years), the NPV (assuming a
10% discount rate) of Project A is higher than Project B, which suggests that Project A would be the
preferable project if only one project could be pursued.

Project A Project B

Year 0 Year 1 Year 2 Year 3 Year 0 Year 1 Year 2 Year 3

Cash Flow (1,000,000) 100,000 500,000 800,000 Cash Flow (1,400,000) 600,000 600,000 600,000

NPV Year 0 (1,000,000) NPV Year 0 (1,400,000)

NPV Year 1 90,909 NPV Year 1 545,455

NPV Year 2 413,223 NPV Year 2 495,868

NPV Year 3 601,053 NPV Year 3 450,789

Total NPV 105,184 Total NPV 92,111

Copyright © 2017 Deloitte Development LLC. All rights reserved. 34


Questions and Answers
Appendix
Required Rates of Return

Venture capital rates of return


Seed / Start up
• Start-up investments usually go to companies that are less than one-year
old. The company uses the money for product development prototype
testing and test marketing. This stage involves further study of market
penetration potential, bringing together of a management team, and refining
the business plan.
• Median start-up required returns reported by various studies range from 50
[1]
percent to 70 percent with a standard deviation of 21.5 percent to 42.5
percent.

[1] Standard deviation is defined as how much variation or "dispersion" exists from the average

Source: QED Research


Copyright © 2017 Deloitte Development LLC. All rights reserved. 37
Required Rates of Return

Venture capital rates of return – cont’d


Growth - First stage
• First state investments only proceed if the results from prototype testing are
good enough to warrant further technical risk. Similarly, the market studies
must be good enough that management is comfortable in further establishing
the business (either manufacturing the product or providing the service) and
shipping commercial quantities. First stage companies are unlikely to be
profitable.
• First stage median required returns reported by various studies range from
[1]
40 percent to 60 percent with a standard deviation of 15.9 percent to
25.8 percent.

[1] Standard deviation is defined as how much variation or "dispersion" exists from the average

Source: QED Research


Copyright © 2017 Deloitte Development LLC. All rights reserved. 38
Required Rates of Return

Venture capital rates of return – cont’d


Growth - Second stage
• Second stage companies have shipped enough product, or provided service
to enough customers so that the company has real feedback from the
market. It may not know quantitatively what speed of penetration will occur
later, or what the ultimate limits of penetration will be, but it may know the
qualitative factors that will determine the speed and limits of penetration.
The company may still be unprofitable or only marginally profitable. It
probably needs more capital for equipment purchases, inventories and
receivables financing.

• Second stage median required returns reported by various studies range


[1]
from 35 percent to 50 percent with a standard deviation of 12 percent to
18.9 percent.

[1] Standard deviation is defined as how much variation or "dispersion" exists from the average

Source: QED Research


Copyright © 2017 Deloitte Development LLC. All rights reserved. 39
Required Rates of Return

Venture capital rates of return – cont’d


Growth - Third stage
• Third stage companies experience fast sales growth. Positive profit margins
have taken away most of the downside investment risk. However, the rapid
expansion requires more working capital than can be generated from internal
cash flow. New venture capital may be used for further expansion of
facilities, expanding marketing or product enhancements. At this stage
banks may be willing to supply some credit to the extent that it can be
secured by fixed assets or receivables.
• Third stage median required returns reported by various studies range from
[1]
30 percent to 50 percent with a standard deviation of 9.9 percent to
16.9 percent.

[1] Standard deviation is defined as how much variation or "dispersion" exists from the average

Source: QED Research


Copyright © 2017 Deloitte Development LLC. All rights reserved. 40
Required Rates of Return

Venture capital rates of return – cont’d


Growth - Fourth stage
• Fourth stage companies may still need outside cash to sustain rapid growth,
but they are successful enough and stable enough so that the risk to outside
investors is much reduced. The company may prefer to use more debt
financing in order to limit the degree of equity dilution. Commercial bank
credit can play a more important role. Although the cash-out point for the
venture capital investors are thought to be within a couple of years, the form
(IPO, acquisition, or LBO) and timing of cash-out are still uncertain.
• Forth stage median required returns reported by various studies range from
[1]
30 percent to 40 percent with a standard deviation of 9.9 percent to
17.4 percent.

[1] Standard deviation is defined as how much variation or "dispersion" exists from the average

Source: QED Research


Copyright © 2017 Deloitte Development LLC. All rights reserved. 41
Required Rates of Return

Venture capital rates of return – cont’d


Initial public offering
• The IPO stage, also know as the liquidity, “cash-out,” or “exit” stage, is the
point where the venture capital investors gain liquidity in their holdings. The
liquidity may be due to an IPO or cash-out in the form of an acquisition. In
some cases, the cash-out or exit may be for the stock of another non-public
company or in exchange for other securities. If an IPO, the IPO may have a
restricted holding period due to SEC Rule 144, or due to underwriting
commitments. Thus, the venture capital investor must inquire about
restrictions which may limit the liquidity of the investment at this stage.
• IPO stage median required returns reported by various studies range from
[1]
26 percent to 35 percent with a standard deviation of 10.3 percent to
18.1 percent.

[1] Standard deviation is defined as how much variation or "dispersion" exists from the average

Source: QED Research


Copyright © 2017 Deloitte Development LLC. All rights reserved. 42
Disclaimer
This presentation contains general information only and Deloitte is not, by
means of this presentation, rendering accounting, business, financial,
investment, legal, tax, or other professional advice or services. This
presentation is not a substitute for such professional advice or services, nor
should it be used as a basis for any decision or action that may affect your
business. Before making any decision or taking any action that may affect your
business, you should consult a qualified professional advisor.
Deloitte shall not be responsible for any loss sustained by any person who
relies on this presentation.

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About Deloitte
Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee
(“DTTL”), its network of member firms, and their related entities. DTTL and each of its member firms are legally
separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not provide services to
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www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.
Certain services may not be available to attest clients under the rules and regulations of public accounting.

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Combining Theory & Practice in an
Entrepreneurial Legal World

Module 6 – Financing the Business Part II


Debt Financing
Agenda

• Summary of Key Learning Points

• Overview of debt capital raising considerations

• Types of debt capital investors

• Types of debt capital investments and credit enhancements

• Examples of hybrid capital

• Ways to source capital and typical debt raise process overview

• Credit documentation overview

• Credit metrics overview

• Nuggets case study exercise

• Questions and answers

2
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Summary of Key Learning Points
Summary of Key Learning Points

• Debt is a critical part of most capital structures and is raised for a wide
variety of reasons
• Debt capital comes in many forms and from many different types of providers
• Appropriate debt capital for a company is often determined by the company’s
stage of development
• Primary debt considerations include: pricing, term, security, repayment
terms, availability, and financial covenants / structural flexibility
• Financial covenants are common – be familiar with the calculation of
leverage, interest coverage, fixed charge coverage
• Debt documents, such as credit agreements, are written contracts containing
definitive terms between lenders and borrowers
• Hybrid capital, which has certain advantages, can sometimes replace equity
capital
• Companies can hire advisors to help them raise debt or equity capital, usually
a 3-6 month process

4
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Ways to Source Capital and the
Capital Raising Process
Capital Sources

Raising capital

Corporate Borrowers Capital Providers

Direct approach by companies

Borrowers seeking capital Investment bankers and advisors local and international investors

Typically triggers include: Why companies use intermediaries: Debt providers include:
- Access to investors - Commercial banks
- Need for growth capital - Market and structuring - Debt funds
- Refinancing maturities knowledge - Mezzanine funds
- Acquisitions /M&A - Ability to run a broad process - Insurance
- Shareholder liquidity - Access to senior decision makers companies
- More flexibility required - Execution resource - CLO’s
- Advises on structuring and - Finance companies
negotiations - BDCs
- Regulatory requirements - Family offices
- Hedge funds
- Asset managers

Equity providers:
- Friends and Family
- Venture Capital
- Angel Investors
- Private Equity
Investors
- Public Equity 6
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Typical Capital Raise Process Through an Investment Bank
Investment banker capitalizes on deal execution experience to create a
competitive, effective, and efficient transaction process.

Marketing Lender Due Diligence &


Initial Marketing
Preparation Due Diligence Documentation

Execute
Market Lender Lender Final Lender
Preparation Pre-Marketing Legal Funding
Transaction Meetings Due Diligence Commitments
Documentation

2 Weeks 2 Weeks 3 Weeks 3 Weeks


 Advisor due diligence:  Contact prospective lenders  Extensive potential lender  Facilitate requests for
 Review of historical to execute Confidentiality due diligence. information for
financial results, Agreements.  Receive Lender confirmatory due diligence.
projections  Distribute marketing Commitment Letter.  Advise and assist with
 Understand client materials. negotiating and finalizing
strategic objectives and  Solicit and evaluate terms of transaction.
conduct an capital preliminary Indications of
structure review Interest.  Complete documentation.
 Provide indicative views on  Host lender meetings.  Execute Lender Agreement.
pricing and  Advised and assist with  Funding.
structure/covenants negotiation terms.
 Prepare summary  Advise on selecting group
marketing materials. to move forward.
 Develop marketing
strategy.
 Compile prospective
lenders list.
 Pre-market to lenders.

2 Weeks 4 Weeks 7 Weeks 10 Weeks

Cumulative Transaction Timeline


7
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Types of Debt Capital Investors
Debt Capital Providers

• Traditional Banks • Alternative Debt Capital Providers

– Senior Debt Funds (MM, LC)


– Large National Banks (LC)
– Opportunity Funds (MM, LC)
– Foreign Banks (LC)
– Mezzanine Funds (MM)
– Regional Banks (MM, LC)
– Collateralized Loan Obligation Funds (MM, LC)
– Community Banks (ES, MM)
– SBIC Funds (ES, MM)

– Business Development Companies (ES, MM)


LC = Large Cap
– Hedge Funds (MM, LC)
MM = Middle Market
– Venture Debt Funds (ES)
ES = Early Stage – Distressed Debt Funds (ES, MM, LC)

– High Net Worth Individuals (ES)

9
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Types of Debt Capital
What are the basic reasons for raising Debt Capital?

Opportunistically
Funding Growth Refinance
-Working capital
- Capex
/Extend
Maturities

Why Raise Debt


Capital?

Acquisitions /
Restructuring
M&A

Create
shareholder
liquidity

Remember – Debt is CHEAPER than equity


11
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Basic Ways to Describe Debt Capital

• Secured Debt v. Unsecured Debt

− Asset backed loan (ABL): assets of the business is the collateral


− Cash flow loans: Enterprise Value of the business is the collateral

• Senior Debt v. Junior Debt

• Public (tradable / rated) v. private debt

• Fixed rate v. floating rate (L +)

What Impacts Debt Capacity / Leverage Levels?


 Industry
 Size and diversification of the business
 Quality collateral: High level of fixed assets, accounts receivable, and inventory.
 Quality of cash flows: Steady and predictable cash flow profile. Consistent growth
and healthy margin profile. Lack of seasonality and recession resistant business
model.
 Presence of a Financial Sponsor or access to capital markets funding

12
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Elements of Capital Structure
Capital structures can range from simple to complex
Enterprise Value Coverage

Secured Bank 1st Lien


Loan Note

Secured Bank Loans

2nd Lien
Institutional
Loans/
B/C Tranches
Notes
Debt

Unsecured
Mezzanine
Note
Unsecured Note

Payment-in-Kind Loans /
Notes

Hybrid Preferred

Common Equity/ Common Equity/ Common Equity/


Shareholder Loan Shareholder Loan Shareholder Loan

13
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Indicative
Types of Debt Pricing

An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts
Commercial Paper receivable, inventories and meeting short-term liabilities. Maturities on commercial paper rarely range L + 100
longer than 270 days

Asset Based Loan (“ABL”) Revolving Credit Facility secured by the Company’s working capital assets with availability subject to a
Borrowing Base (formula based, periodic (usually monthly) calculation of the maximum amount of L + 200
Revolver borrowing the assets support)

Revolving Line of Credit that is usually pari passu with other senior secured debt (specifically the Term
Revolver Loans) and is not subject to a Borrowing Base L + 300

Senior secured Term Loan, often referred to as “Bank Debt”, as banks typically invest in this tranche;
Term Loan A (“TLA”) banks often invest in what is referred to as the “Pro Rata Facility” which is a strip of the Revolver and the L + 350
Term Loan A

Senior secured Term Loan, often referred to as the “Institutional” tranche, as institutional investors
Term Loan B (“TLB”) typically invest in the TLB, which most often has lower scheduled amortization than the Term Loan A L + 450
(often 1% per year)

Senior secured term debt that is subordinated in right to the collateral to the first lien debt (Revolver,
Second Lien Loan TLA, and TLB), but typically not subordinated in right to ongoing cash interest payment L + 850

A type of facility that combines senior and subordinated debt into one debt instrument where a single
Unitranche Loan blended interest rate is paid to a single lender. Unitranche loans are designed to simplify debt structure L + 750
and accelerate the closing process. Eliminates intercreditor issues

Subordinated, usually unsecured debt investment typically seen in middle market (where middle market is 12% Cash +
Mezzanine Debt defined as companies with annual revenues ranging from $50 million to $1 billion) transactions and often 2% PIK + 3%
has equity like characteristics (equity co-invest, warrants, options) Warrants

We will touch on various subordinated debt investments including mezzanine, subordinated, high-yield
Subordinated Debt debt, holdco, and seller notes 10%-20%

More Collateral or Quicker Repayment = Less Risk = Less Cost

14
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How an ABL Works - The Borrowing Base Formula
Definition Sample borrowing base calculation
($ in millions) Nuggets Pro Forma
• Comprised of 5 components 2017 2017
• Assets (+) Accounts Receivables
− Trade Accounts Receivable (AR) Gross AR $9.2 $21.6
− Inventory Less: Ineligibles (10%)(1) (0.9) (2.2)
Net AR $8.3 $19.4
− Fixed Assets (Machinery &
Advance rate 85.0% 85.0%
Equipment, Real Estate, etc)
Availaibility from AR $7.1 $16.5
− Other
• Ineligibles (-) Inventory(2)
− Audit trail, hard number, formulaic Gross Inventory $3.9 $6.7
Less: Ineligibles (17.5%) (0.7) (1.2)
• Advance Rates (x)
$3.2 $5.5
− Additional discounting against the Advance rate 65.0% 65.0%
net of the above elements Availability from Inventory $2.1 $3.6
• Reserves (-)
− Soft numbers, estimates Total Availability $9.2 $20.1
• Borrowings are limited to the lower of Less: Estimated Reserves(3) (0.0) (0.0)
the commitment amount or availability Less: Outstandings (0.0) (0.0)
as calculated under the borrowing base Less: Estimated LCs (0.0) (0.0)
Estimated excess availability $9.2 $20.1
• Borrowers typically submit borrowing
base calculations on a monthly basis (1) A/R ineligibles based upon bank estimates, to be
confirmed by bank field examination
(2) Inventory ineligibles and advance rates estimated. Actual
ineligible and advance rates often subject to appraisal
results
(3) Estimated reserves may include rent reserves, and other
relevant reserves. Actual reserves determined following
collateral diligence

15
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Examples of Hybrid Capital
Examples of Hybrid Capital

• PIK Loans – Loans on which interest is paid-in-kind, or accrued, rather than


paid in cash on a current basis

• Subordinated debt with warrants – Loans that contain a type of equity


participation

• Convertible debt – Debt that can be converted into equity

• Participating preferred stock – Preferred Stock that participates in the growth


or “upside” of the common equity

17
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Debt and Equity Documentation
Overview
Major Types of Capital Documentation

• Credit Agreements
−Typically for senior/secured/second-lien debt

• Subordinated Debt Subscription Agreements and Indentures


−Typically for Subordinated Debt/High Yield Bonds/Hybrids

• Inter-creditor Agreements
−An agreement between two lenders with the same borrower

• Stockholder Agreements, Membership Agreements, Stock Certificates


−Typically for various equity investments

19
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Key Sections of a Credit Agreement

The Loans • Description of the loans including: amount, interest and repayment rate

Collateral • Details the collateral pledged as security for the loans

The Guarantee • Details the terms of any guarantees being provided by the borrower

Representations • Representations made by the Borrower prior to close


and Warranties

Conditions • Conditions that must be satisfied before effectiveness of agreement


Precedent

Affirmative • Actions that the Borrower must take on a go forward basis, including
Covenants financial covenants

Negative • Actions the Borrower may not take on a go forward basis


Covenants

Events of Default • Events that will cause the Borrower to be in default of the agreement
and remedies available to lenders after default

Administrative • Detail of the roles of the Administrative Agent in management of the


Agent loan

Lender Voting • Details what % of Lenders may approve Amendments, Waivers and
Rights Consents
20
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Sections of a Credit Agreement
• Although the sections and terms will vary by type of debt facility, the
following is intended to give a general outline of the sections of an agreement
and the terms captured within each section

Cover Page • Date of execution of the agreement


• Total commitment of the facilities
• Key parties to the agreement including:
− Borrowers
− Guarantors
− Arrangers
− Administrative Agent

Table of • Outline of the agreement including:


Contents − Sections
− Exhibits
− Schedules

21
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Sections of a Credit Agreement

The Loans • Detailed description of the borrowing(s) including:


− Commitments
− Initial and subsequent borrowing procedures
− Interest rate (and fees) and calculation method
− Schedule amortization, required prepayments, and application of
optional and mandatory prepayments to scheduled payments

Assignment of • Details the collateral pledge as security for the loans:


Collateral − References separate security documents (UCC filings, etc.)
− References separate Security Agreement
− Describes any lease assignments
− Describes circumstances under which lenders will release collateral

The Guarantee • Details of any guarantees being provided by the Borrower or its
affiliates including:
− Borrower(s)
− Guarantors
− The Guarantee, continuation of the Guarantee, and limitations of
the Guarantee

22
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Sections of a Credit Agreement

Representations • Being provided by Borrower prior to close including:


and Warranties − No material adverse changes in the business
− Properties are appropriately maintained
− Insurance is adequate and current
− Taxes have been paid
− Compliance with all laws and agreements

Conditions • Conditions that must be satisfied before effectiveness of agreement


Precedent (and funding of initial and subsequent borrowings):
− Credit Agreement and all ancillary documents executed (including
security, subordination, and inter-creditor agreements, etc.)
− Opinion(s) of legal counsel
− Certificates delivered (that may be required from the Company,
other lenders, insurance providers, etc.)

Affirmative • Actions that the Borrower must take on a go forward basis including:
Covenants − Reporting requirements
− Payment of obligations
− Compliance with laws
− Maintaining properties (collateral of lenders)

23
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Sections of a Credit Agreement

Negative • Actions the Borrower may not take on a go forward basis including:
Covenants − Limitations on additional debt and liens
− Restricted payments (to subordinated lenders or shareholders)
− Limitations on changes to the fundamental business
• Section also includes financial, or “maintenance” covenants

Events of • Events that will cause the Borrower to be in default of the


Default agreement, which provide the lender with the right to take action,
including:
− Failure to satisfy affirmative covenants (e.g. reporting
requirements)
− Failure to meet financial covenant tests (covenant default)
− Failure to make a principal or interest payment (payment default)
• Section will also include grace periods and remedies available to the
lenders after the occurrence of each type of default

24
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Sections of a Credit Agreement

Administrative • Detail of the roles of the Administrative Agent in management of the


Agent loan facility including:
− Processing payments
− Maintaining documentation
− Delivering notices
− Assignment and participation procedures
• Lenders agree to hold Agent harmless for actions taken as the
Lenders’ representation (except gross negligence or willful
misconduct)
Miscellaneous • Other important terms and conditions including:
− Notice requirements
− Assignment procedures
− Survival of agreement (binding upon successors)
− Governing law
− Waiver/Amendment procedures
− Lender voting rights (on next page)

25
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Sections of a Credit Agreement

Lender Voting • Typical “100% Vote” issues include:


Rights − Change loan pricing
− Extend maturity date
− Change amortization schedules
− Change voting requirements
− Change the “payment waterfall”
− Release substantially all of the collateral
• All other issues are “Required Lender” issues, typically 50% -
75% vote requirement
• Some documents include some “Super Majority” issues, typically
75% - 90% vote requirement

26
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Credit Metrics Overview
Key Metrics in Credit Analysis

Ratio of Debt to TTM EBITDA – commonly tested leverage ratios include senior
Leverage leverage, total leverage, and net leverage; quick test of the level of debt on the
Company; helpful in assessing financial condition and in comp analysis

Ratio of EBITDA to Cash Interest – measurement of the companies ability to meet


Interest Coverage its debt service obligations

Ratio of EBITDA less CAPEX to Fixed Charges (interest, taxes, and scheduled debt
Fixed Charge Coverage amortization) – measurement of the Company’s ability to produce sufficient cash
flow to cover all of its fixed obligations including debt service

Liquidity is availability under the Revolver plus the cash on the balance sheet –
Liquidity / Availability measurement of ability to continue to support operations and service debt in the
event cash flow from operations is insufficient in a given period

Ratio of debt to enterprise value of the Company – provides an indication of how


Loan to Enterprise Value much deterioration in enterprise value the Company could withstand before the
debt becomes impaired

Current Yield, Yield to Maturity, Yield to Call, and Effective Spread – various return
Return Analyses analyses to assess whether or not an investment meets investment criteria and/or
the relative attractiveness of one investment vs. another

Credit metrics can be defined in many ways, the definitions on this page are examples.

28
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Leverage and Loan to Enterprise Value Calculations
Example Capital Structure #1
Commitment Amount % of EV EBITDA Multiple
Revolver ($5MM Commit) 0.0 0.0% 0.00
Term Loan B 12.5 28.6% 2.50
Senior Debt 12.5 28.6% 2.50

Second Lien Term Loan 5.0 11.4% 1.00


Total Debt 17.5 40.0% 3.50

Equity 26.3 60.0% 5.25

Enterprise Value 43.8 8.75

Example Capital Structure #2


Commitment Amount % of EV EBITDA Multiple
ABL Revolver ($7.5MM Commit) 5.0 11.4% 1.00
Term Loan B 10.0 22.9% 2.00
Senior Debt 15.0 34.3% 3.00

Mezzanine 5.0 11.4% 1.00


Total Debt 20.0 45.7% 4.00

Equity 23.8 54.3% 4.75

Enterprise Value 43.8 8.75

Note: In all examples, EBITDA Multiples based an assumed Adjusted EBITDA of $5.0MM

29
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Key Metrics in Credit Analysis
Covenant Key Considerations
 The FCCR is one of the most important financial covenants. It enables lenders and
company executives to better understand how the cash flow profile of the business
Fixed Charge
can service mandatory payments.
Coverage Ratio
 FCCR is typically defined as: (Adjusted EBITDA less Capital Expenditures less Taxes)
(“FCCR”) / (Mandatory Principal Amortization plus Cash Interest)
 Lenders typically mandate that a company’s FCCR remain above 1.25x.
 A maximum net leverage ratio will be set to ensure that a company is sufficiently
paying down the principal balance on its debt facility.
Net Leverage Ratio
 The net leverage ratio is defined as: (Total Outstanding Debt less Cash) / Adjusted
EBITDA.
 Depending on the specifics of the company receiving debt capital, as well as the
type of debt facility in place, lenders may require additional covenants. Some
examples include:
− Minimum EBITDA – Threshold set based on downside or lender
projections.
− If a company’s EBITDA drops below the set level, then the lender
may increase the interest rate on the loan (or charge a default rate)
Other Covenants
in order to compensate for the elevated level of risk assumed.
− Minimum Liquidity – Test how much liquidity a company can access, if
needed.
− This is generally defined as: (Cash on Hand plus revolver
availability).
− Others – May include maximum allowable capital expenditures, minimum
solvency or debt to equity levels, and minimum cash, among others.

Covenant compliance is typically tested on a quarterly basis unless specifically


stated otherwise in the credit agreement.
30
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Nuggets Case Study Exercise
Nuggets Current Situation

• After years of successful organic growth, Nuggets decided to make a strategic


acquisition to accelerate growth and diversify operating risk

• Nuggets has just agreed to acquire Best Brew Pubs (“BBP”) for 8x TTM
EBITDA of $34 million, or $272 million

• Including transaction expenses of $8 million and net of $40 million in


assumed BBP debt, Nuggets will need $240 million in cash to pay for the
acquisition

• Nuggets currently has $40 million in cash earmarked for the acquisition, so it
is considering several debt capital options to finance the remaining cash need

• Nuggets also wants to establish borrowing availability to fund future working


capital and other corporate expenses

32
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Nuggets Transaction Assumptions
(Dollar amounts in millions)

Acquisition Price Cash Required at Closing


Target TTM EBITDA $ 34.0 Acquisition Price $ 272.0
Purchase Price Multiple 8x Less: Assumed Debt (40.0)
Acquisition Price $ 272.0 Plus: 3% Transaction Fees and Expenses 8.0
Net Cash Needed to Close Transaction $ 240.0

Cash Sources & Uses


Sources Uses
Cash $ 40.0 Acquisition Purchase Price $ 272.0
New Debt 200.0 Fees and Expenses 8.0
Assumed Debt of Target 40.0
Total Sources of Cash $ 280.0 Total Uses of Cash $ 280.0

33
Copyright © 2017 Deloitte Development LLC. All rights reserved.
Nuggets Transaction Assumptions
(Dollar amounts in millions)

Debt Leverage Ratio Asset Based Lending Calculation


Total Pro Forma Debt $ 240.0
Pro Forma EBITDA 129.8 Pro Forma Accounts Receivable $ 21.6
Pro Forma Debt Leverage 1.85x Accounts Receivable Advance Rate 80%
Accounts Receivable Availability 17.3

Pro Forma Inventory 6.7


Inventory Advance Rate 50%
Inventory Availability 3.4

Total Asset Based Lending Availability $ 20.7

34
Copyright © 2017 Deloitte Development LLC. All rights reserved.
Pro Forma Income Statement

35
Copyright © 2017 Deloitte Development LLC. All rights reserved.
Pro Forma Balance Sheet
Purchase
(in $millions) Target Nuggets Adjustments Pro Forma
Year 2012 2012 2013
ASSETS
Cash And Equivalents $ 15.0 $ 14.9 $ 29.9
Short-Term Investments - 34.1 (40.0) (5.9)
Total Cash & Short-Term Investments 15.0 49.0 24.0
Accounts Receivable 12.4 9.2 21.6
Other Receivables - 1.0 1.0
Total Receivables 12.4 10.3 22.7
Inventory 2.9 3.9 6.7
Prepaid Expense - 1.7 1.7
Deferred Tax Assets, Current - 4.5 4.5
Other Current Assets - 19.8 19.8
Total Current Assets 30.3 89.1 79.3
Gross Property, Plant & Equipment 100.0 330.6 430.6
Accumulated Depreciation 20.0 124.0 144.0
Net Property, Plant & Equipment 80.0 206.6 286.6
Goodwill - 11.4 179.1 190.5
Other Intangibles - - -
Other Long-Term Assets - 17.9 17.9
Total Assets $ 110.3 $ 325.0 $ 574.3
LIABILITIES
Accounts Payable $ 12.3 $ 18.2 $ 30.5
Accrued Expenses 3.0 20.5 23.5
Other Current Liabilities 2.0 21.0 23.0
Total Current Liabilities 17.3 59.7 77.0
Long-Term Debt 40.0 - 200.0 240.0
Capital Leases - - -
Deferred Tax Liability, Non-Current - 23.7 23.7
Other Non-Current Liabilities - 16.4 16.5
Total Liabilities 57.3 99.8 357.2
Preferred Stock, Convertible - - -
Total Preferred Equity - - -
Common Stock 10.0 74.4 (10.0) 74.4
Additional Paid In Capital - - -
Retained Earnings 42.9 150.8 (50.9) 142.9
Total Common Equity 52.9 225.2 217.3
Total Equity 52.9 225.2 217.1
Total Liabilities And Equity $ 110.3 $ 325.0 $ 574.3
36
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Summary of Debt Capital Options
ABL Term Loan A Second Lien Unitranche High Yield
Term Loan
Commitment $30 Million $160 Million (1.52 $40 Million (0.3 $200 Million $200 Million
Amount LTM pro forma LTM EBITDA)
EBITDA)

Funded Determined by $160 Million $40 Million $200 Million $200 Million
Availability at Borrowing Base
Close

Availability 80% of A/R; 50% N/A N/A N/A N/A


Formula of Inventory

Term 5 Years 5 Years 5 Years 7 Years 9 Years


Amortization Due at Maturity 10% per year with Due at Maturity 1% per year, None
remainder at remainder at
maturity maturity

Pricing Libor + 250 bps Libor + 500 bps Libor + 1,100 bps Libor + 800 bps 10% Fixed
Assume
LIBOR=50bps

Security First lien on ABL First lien on all Second lien on all First lien on all Unsecured
assets assets, subject to assets, subject to assets, subject to
ABL priority on ABL intercreditor ABL liens
assets
Covenants Fixed Charge Interest Coverage; Same as Term A, Same as Term A Negative covenants
Coverage; Total Leverage; but “set back a only
Minimum Net Fixed Charge half-turn”
Worth Coverage

Prepayment N/A N/A 1% in Year 1 2% in Year 1, 1% No prepay allowed


Penalty in Year 2 Year 1; 3%, Year
2;, 2% Year 3; 1%
Year 4

Additional Yield N/A N/A N/A 3% Warrants None

Ability to Add Limited Limited Somewhat Limited Limited More Liberal


More Debt

37
Copyright © 2017 Deloitte Development LLC. All rights reserved.
Nuggets Possible Paths

• Option #1 – ABL + Term Loan A + Second Lien Term Loan

• Option #2 – ABL + Unitranche

• Option #3 – ABL + High Yield

Which capital structure package would you recommend?

38
Copyright © 2017 Deloitte Development LLC. All rights reserved.
Pros and Cons Highlights

• Option #1 - ABL + Term Loan A + Second Lien Term Loan


− Lowest blended pricing at about L+ 6.5%
− Resulting amortization of $16 million per year
− Intercreditor issues could be problematic if covenants are violated
− Shorter term capital (interest rate risk on refinance in five years)

• Option #2 – ABL + Unitranche


− Avoids intercreditor issues
− Little amortization
− Longer term than Option #1, but shorter than #3
− Higher pricing of L+800, plus 3% warrants

• Option #3 – ABL + High Yield


− Long term capital
− Maximum flexibility - no amortization, no financial maintenance covenants, unsecured
obligation
− Highest pricing at 10% fixed
− More flexibility to add additional debt in the future
− High prepayment penalty

39
Copyright © 2017 Deloitte Development LLC. All rights reserved.
The Correct Answer Is?

• Probably Not Option #2 – the benefits of unitranche (single lender, no intercreditor


issues) are outweighed by the higher pricing relative to Option #1

• Option #1 or Option #3?

• The Answer Is …

−It depends on how Nuggets prioritizes its future objectives

− Option #1 provides $6-7 million in interest savings per year vs Option #3, but Option
#1 will allow less operating flexibility because $16 million per year will be used for
amortization payments on the term loan and Nuggets will have to comply with
financial covenants tied to projected performance.

− Option #3 is higher cost, but provides more operating flexibility in future years due to
the lack of amortization payments, longer maturity, and lack of financial covenants. If
Nuggets wants to retain more of its cash flow to invest into growth initiatives in the
future, Option #3 might be the right fit.

40
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Questions and Answers
Disclaimer
This presentation contains general information only and Deloitte is not, by means of this presentation,
rendering accounting, business, financial, investment, legal, tax, or other professional advice or
services. This presentation is not a substitute for such professional advice or services, nor should it be
used as a basis for any decision or action that may affect your business. Before making any decision
or taking any action that may affect your business, you should consult a qualified professional advisor.

Deloitte shall not be responsible for any loss sustained by any person who relies on this presentation.

42
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About Deloitte
Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee
(“DTTL”), its network of member firms, and their related entities. DTTL and each of its member firms are legally
separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not provide services to
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www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.
Certain services may not be available to attest clients under the rules and regulations of public accounting.

Copyright © 2017 Deloitte Development LLC. All rights reserved.


Combining Theory & Practice in an
Entrepreneurial Legal World
Module 8 – Introduction to M&A Part I -
Buying or Selling a Business
Introduction
M&A and Nuggets, Inc.
Background

The sell side analysts and key shareholders of Nuggets had been largely happy with the company’s operational performance and
growth in the U.S. markets. The company’s stock price had largely followed suit and was trading at a 52 week high recently.
Shareholders were content with the company’s high rate of growth as Nuggets expanded its concept across the United States,
but the high stock price implied that they were also demanding continued growth in earnings and cash flow.

Change in Strategy

Nugget’s Management was aware of the high expectations being priced into the company’s stock and as they evaluated their
growth opportunities in the United States they arrived at the conclusion that they were running out of high growth opportunities
in the United States for their core concept. The Management team had proven that they were adept restaurant operators and
felt that they should be able to leverage the Company’s experience to expand quite easily into foreign markets. The Board,
however, demanded that Management proceed in very deliberate and cautious way with their first acquisition, and wanted to
focus on markets that were more similar to the U.S. The Board also asked Management to consider concepts near their core
business but also consider unique foreign concepts that could potentially be leveraged back into the U.S. market one day.

Management was also attuned to the fact that shareholders were beginning to question the Company’s reliance on one key
brand and concept and wanted additional diversification in the restaurant sector. Therefore, Management made the decision to
reassess its corporate strategy and consider M&A since the company had a very strong balance sheet and Management had
some experience, albeit very limited, in executing acquisitions at previous companies.

M&A Advisory

Management engaged an advisor to assist the company in outlining a comprehensive strategy as this was going to be a big
change in direction for the Company. After months of market analysis and careful thought Nuggets decided to engage the
advisor and legal counsel, both with deep experience in the industry and in international M&A, to begin a targeting process to
identify potential acquisition targets in the UK. Through their research, the CEO and CFO concluded that there was a good
opportunity to take advantage of their skillsets in the restaurant and Public House (Pub) sector in the UK.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 2


Agenda

• Summary of Key Learning Points


• Overview of the M&A Process
• M&A Strategy Development
• Target Screening
• Transaction Execution
• Deal Structures
• M&A Integration
• Summary of Key Learning Points

Copyright © 2017 Deloitte Development LLC. All rights reserved. 3


Summary of Key Learning Points
Summary of Key Learning Points

The M&A Life Cycle is a challenging and complex process that requires involvement from all
of the company stakeholders and external advisors

• M&A Strategy and Target Screening • Deal Structures


– Merge overall corporate strategy into a – Asset vs. Stock Deals
cohesive M&A Strategy – Tender offer and short form merger
– Develop clear acquisition goals
• M&A Integration
– Determine Targeting parameters within
the M&A strategy – Establish clear goals and process

– Select most suitable targets and – Timelines are critical in


perform initial diligence and approach communicating progress and issues
targets – Integration is the key to actual
versus planned savings
• Transaction Execution
– Diligence is key to analyzing quality of
inputs
– Remember: QOE drives EBITDA which
directly affects deal value.
While there is a defined M&A
process, there’s also an imperative
– Modeling is key to price and structure
for GOOD BUSINESS JUDGMENT
– Negotiate final terms and manage the
closing process
– Prepare to launch integration plan
Copyright © 2017 Deloitte Development LLC. All rights reserved. 5
Overview of the M&A Process
Overview of M&A – Key considerations

Benefits Risks
• Challenges associated with post-
• Provides access to new products, markets acquisition integration
and revenues
• Inability to capture synergies
• Transfers know-how and intellectual
property • Buyer: overpayment for the asset; Seller:
failure to receive full value
• Gives complete control of capabilities
• Incompatible strategic fit of the
• Creates an opportunity to leverage organization and culture
synergies
• Absence of a strategic end state in mind
• Diversifies the product portfolio and reduce
risk • Retention of key personnel and intellectual
capital

Growth

Copyright © 2017 Deloitte Development LLC. All rights reserved. 7


Overview of the buy-side M&A Process

Due Diligence

Strategy Target Screening Transaction Execution Integration

Implementation Planning Closing and


Merger Target Negotiation Implementation
Preliminary Deal Modeling Execution of
Strategy Screening and of Letter Definitive Negotiation and Transaction
Due Diligence And Valuation of Final Implementation
Development Identification of Intent Due Closing Preparation
Transaction Plan
Diligence

Board or Completed Term Executed Transfer of


Steering letter of sheet purchase ownership/
Committee intent agreement closing
approval documentation
Company

Board of General CEO and CFO Corporate Accounting Finance and IT and HR
Directors Counsel COO Development and Tax Treasury

Advisors / Specialists
Legal

Strategy Industry Accounting Investment Valuation Operations IT HR Integration


/ Tax Banking

Copyright © 2017 Deloitte Development LLC. All rights reserved. 8


Sample roles and responsibilities in a transaction

• Formulates and approve strategy


Board of
Directors • Manages risk
• Approves material transactions
• Confirms strategic fit
• Ensures long term objectives
CEO
• Initiates CEO-to-CEO contact with strategic target
• Champions transaction
• Runs proforma models and set financial metrics
CFO
• Takes responsibility for financial structure of deal (valuation;
accretion/dilution)
• Ensures financing links with transaction model
• Assess needs and evaluate market trends
Business units • Coordinate efforts and ensure buy-in
• Coordinate operational due diligence and synergy analysis
• Facilitate regulatory approval
• Design and document entity structure. Map affiliated companies
Legal/ Tax
• Coordinate Legal and Tax due diligence
• Draft and revise transaction agreements
• Financial : Coordinate deal financing and sourcing; Synchronize
External transaction communications and negotiation strategy
Advisors • Diligence (legal, commercial, accounting, etc.): Conduct diligence and
strategic evaluation
Copyright © 2017 Deloitte Development LLC. All rights reserved. 9
How does an advisor add value in a transaction?

Counsel Other
(inside or
outside) Advisors
Provide insight into current M&A market
 
conditions
Add structure to the process — conveys
 
serious intent to potential buyers
Pre-screen targets to help minimize time

spent with those just “kicking the tires”
Add analytical rigor through financial

modeling and valuation
Help identify transaction exposures and

contractual mitigation strategies
Help identify most advantageous
 
transaction structures
Assist with purchase agreement
negotiations leveraging understanding of  
current market terms

Copyright © 2017 Deloitte Development LLC. All rights reserved. 10


M&A Strategy Development
M&A Strategy
Objectives and roles of advisors Development

Due Diligence

Strategy Target Screening Transaction Execution Integration

Implementation
Planning Closing and
Merger Target Negotiation Implementation
Preliminary Deal Modeling Execution of
Strategy Screening and of Letter Definitive Negotiation and Transaction
Due Diligence and Valuation Implementation
Development Identification of Intent Due of Final Closing Preparation
Plan
Diligence Transaction

Key Action Steps


• Align corporate strategy with a cohesive M&A Strategy
• Develop clear acquisition goals
• Determine targeting parameters within the M&A strategy

Roles of Advisors and Management


• Develop understanding of goals and objectives of shareholders and management
• Develop understanding of the company’s business model and competitive position
• Based on management criteria, develop investment themes and potential acquisition
candidates

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From corporate strategy, to M&A strategy, to clear M&A
Strategy
target criteria Development

Considerations Strategy development Acquisition goals


Illustrative
• Invest in high margin businesses
• Add novel products and services
Capabilities • Strengthen competitive position
BREAK OUT in particular geographic market
• Grow business faster than GDP
Value-add innovation

while maintaining current risk


Aspirations profile
REACH OUT

… of Target screening criteria


existing
EDGE Illustrative
paradigms
Trends OUT
… to • Minimal commodity product
adjacent
spaces offerings
… to
leverage • Market leadership, including
the core
Current patents or unique capabilities
Constraints Business
Core • 75% or more of revenue generated
Industry value chain relationships
from North America
• $50-500M in revenue
• No targets with ongoing, pending,
or rumored environmental issues
Copyright © 2017 Deloitte Development LLC. All rights reserved. 13
Nuggets Example: Aligning Strategic Growth M&A
Strategy
Themes to Company Strategy Development

Company Strategy Strategic Growth Themes Buy-side Ideas

• Become a • Acquire capabilities to • Identify “tuck-in” targets


global leader in enhance existing food and that fill in gaps in current
casual dining beverage offerings menu offerings

• Grow 12%- • Enter international • Identify international


18% annually markets brands and concepts

• Expand • Enter new restaurant • Identify companies with


internationally sectors with high growth unique local knowledge
trends
• Identify targets that
• Diversify customer extend current offerings/
segment to affluent capabilities into new
customer base restaurant market sectors

• Identify concepts that


cater to an older more
affluent audience

Copyright © 2017 Deloitte Development LLC. All rights reserved. 14


Knowledge Check #1
Nuggets investment thesis for Best Brew Pubs

Directions: You are the CEO presenting to your board of directors. What is
the investment thesis behind an acquisition of Best Brew Pubs?

Investment Thesis:

Identify three requirements / attributes regarding BBP needed for Nuggets,


Inc. to invest / acquire BBP.

1.

2.

3.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 15


Target Screening
Target
Objectives and roles of advisors Screening

Due Diligence

Strategy Target Screening Transaction Execution Integration

Implementation
Planning Implementation Closing and
Merger Target Negotiation
Preliminary Deal Modeling and Transaction Execution of
Strategy Screening and of Letter Definitive Negotiation
Due Diligence and Valuation Closing Implementation
Development Identification of Intent Due of Final
Preparation Plan
Diligence Transaction

Key Action Steps


• Implement suitable targeting parameters
• Select most suitable targets and perform initial diligence
• Approach targets

Roles of Advisors
• Assess targets using strategic filters based on management criteria
• Assist management in finalizing list of potential targets
• Assist with target approach and development of Business Case
• Contact targets and identify interested parties
• Assist in negotiating confidentiality agreement and perform initial diligence
• Assist with internal approval process and present Business Case to the Board

Copyright © 2017 Deloitte Development LLC. All rights reserved. 17


Targeting begins with the goals and criteria Target
Screening
developed through the M&A strategy phase

Universe of Companies

Preliminary Search:
Search using industry key words, company 500 Companies
databases, and general internet searches

Coarse screen:
Conduct high-level review to remove low 100 Companies
quality results based on compatibility

Medium screen:
Conduct in-depth review of each company’s 50 Companies
service and product offerings to assess
strategic alignment
Fine screen:
Final filter to select companies with greatest 10
alignment with M&A strategy (e.g. product Targets
and geographic fit, growth profile)
Yields a Manageable
Target Universe

Copyright © 2017 Deloitte Development LLC. All rights reserved. 18


Transaction Execution
Objectives and role of Advisors – Diligence and
Transaction
Preliminary and Definitive Diligence Execution

Due Diligence

Strategy Target Screening Transaction Execution Integration

Implementation
Planning Implementation Closing and
Merger Target Negotiation
Preliminary Deal Modeling and Transaction Execution of
Strategy Screening and of Letter Definitive Negotiation
Due Diligence and Valuation Closing Implementation
Development Identification of Intent Due of Final
Diligence Transaction Preparation Plan

Key Action Steps


• Perform legal, accounting, tax, and other related diligence on target
• Develop and update comprehensive deal model regarding terms, structure and target performance
• Perform valuations, financing, synergy, and related pricing and negotiation analyses
• Negotiate final terms and manage the closing process
• Prepare to launch integration plan

Roles of Advisors
• Assist with pro forma financial statements, detailed assumptions, value drivers and quality of earnings
• Construct detailed financial model and valuations, analyzing potential scenarios (value, IRR, earnings)
• Assist Management to summarize and present analyses for Board presentations
• Advise during negotiations and execute LOI (including exclusivity); Facilitate transaction closing
• Manage final due diligence, structuring payment terms (coordinate with legal counsel), and post closing
• Assist in negotiation of definitive purchase and sale and other ancillary agreements

Copyright © 2017 Deloitte Development LLC. All rights reserved. 20


Diligence is a process of discovery and is key to Diligence &
Transaction
analyzing the quality of inputs Execution

• Quality of earnings • Pre- and post-


• Balance sheet strength employment benefit and
• Asset quality insurance liabilities
Financial
• Pension and benefits • Cultural and organization HR
and tax
• Accounting policies, integration issues
practices and quality • Design of executive
• Pipeline and probability compensation packages

• Customers and markets • Evaluation of the IT

Legal
• Products and pricing technology, organization,
Commercial • Vendor and supply chain operations IT
• Operational effectiveness • Intellectual Property
• Culture • Integration

• Corruption
• Economic and trade
Compliance sanctions • Environmental
and • Money laundering • OSHA Other
integrity • Reputation and business • Contracts
practices of stakeholders
• Regulatory

Copyright © 2017 Deloitte Development LLC. All rights reserved. 21


Quality of Earnings (QOE): A key outcome of Diligence and
Transaction
diligence Execution

Why is it important?
• QoE analysis drives understanding of normalized EBITDA, which can directly affect price, financing and
other value considerations

• Other quality of earnings analyses: organic vs. acquisition growth, significant lost customers, customer
concentration, FX impact

Purposes of QoE Analysis


• Understand operating performance and cash flow, including amounts available for debt service
• Identify items to be considered in determining the company’s financing EBITDA and resulting leverage
and interest coverage ratios
• Identify items to be considered in determining historical EBITDA number for modeling/valuation
purposes
• Bridging operating periods and understanding variances / drivers of change in the business

QOE drives EBITDA which directly affects deal value and transaction
terms

Copyright © 2017 Deloitte Development LLC. All rights reserved. 22


Diligence and
Transaction
Sample diligence Inputs and Outputs Execution

Data management Sample deliverables


Electronic Data Rooms –
Market and Commercial Operational and Financial Analysis
Secure, online repository of data Diligence
allowing ease of access to
information for transaction teams

Normalized Earnings (QoE)


Customized information request
lists

Copyright © 2017 Deloitte Development LLC. All rights reserved. 23


Modeling is an essential tool for estimating price Diligence and
Transaction
and defining transaction structure Execution

Traditional valuation Advanced analytics add insight


analysis as typically and clarity into transaction
performed decision-making

Likelihood of deal delivering intended


strategic value:
High case
Risk profiles and expected values
Base case 1

Cumulative probability
0.9
Low case
DCF

0.8
0.7 Strategy 1
0.6
0.5
0.4 Strategy 2
0.3
0.2
0.1
Time 0
EV EV

Key risk factors and potential impact of


each on deal value
Sensitivity of expected value
Tornado diagram

Risk Factor 1

Risk Factor 2

Risk Factor 3

Risk Factor 4

Risk Factor 5

550 600 650 700 750 800 850


NPV benefit ($ Million)
Copyright © 2017 Deloitte Development LLC. All rights reserved. 24
Board level review is often required to progress Diligence and
Transaction
forward with a transaction Execution

Board review package – Illustrative


• Target overview
• Alignment with strategy
• Transaction rationale
• Key transaction terms
• Key transaction risks
• Valuation analysis
• Summary diligence findings
• Financial impact: accretion / dilution

Copyright © 2017 Deloitte Development LLC. All rights reserved. 25


Diligence and
Transaction
Letter of Intent (LOI) and Purchase Agreement Execution

What is an LOI (Term Sheet)?


• Outlines key deal terms proposed by one
party
• Not typically legally binding
Why is an LOI Helpful?
• Formalizes negotiations
• Outlines key negotiation points

Key Purchase Agreement Sections:


1. Description of Transaction
2. Purchase Price and Adjustments
3. Reps and Warranties (Seller) Significant
4. Reps and Warranties (Purchaser) financial
5. Conditions to Closing advisor and
6. Termination legal input
7. Indemnification
8. Miscellaneous

Copyright © 2017 Deloitte Development LLC. All rights reserved. 26


Deal Structures
Implications of Structure on the Transaction Process

Two key acquisition structures


Asset deals

• Only specific assets and liabilities of the target acquired and assumed, respectively, so may
be able to limit focus of diligence to the specific relevant accounts for which Buyer will
possess the risks and rewards of ownership

• Income tax diligence often lighter

• Consider operational implications of assets and liabilities retained by seller

• Generally increases complexity of contract assignments

• More complex legally due to possibility of multiple selling entities

Stock deals

• All rewards and risks of ownership (all assets, liabilities and exposures) transfer to Buyer
upon closing, subject to indemnifications

• Financial and income tax diligence often more rigorous, especially with respect to exposures
and contingencies

• Potentially less flexibility re: certain operating decisions (head count, severance, benefits)

• Potentially easier from legal / contractual perspective

Copyright © 2017 Deloitte Development LLC. All rights reserved. 28


Asset Deals – Typically preferred by buyers

• Can select the assets purchased


and liabilities assumed
Seller Buyer
• Seller keeps the assets not
bought and the liabilities not
assumed

• Purchasers usually prefer asset Net Book value of


transactions for tax and liability assets
reasons

Fair market value


• Buyer can mark up assets to of the net assets
fair market value

• Gets tax benefits from higher Excess purchase


depreciation and amortization price over book
value (intangibles
• Tax amortization on intangibles and goodwill)
over 15 yrs.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 29


Stock Deals – typically preferred by sellers

Seller Buyer Receives


• Seller typically receives lower
capital gain tax rates on more of
the sale
• No double taxation Assumed
Liabilities
• Buyer “steps in” to the tax basis
of the seller
Fair market of the
• No “step up” in the asset basis Assets common shares +
• However, can preserve Net assumed liabilities
Operating Loss carryforwards
• Due to double taxation, asset Common
purchases from C corporation Shares
sellers are rare

Copyright © 2017 Deloitte Development LLC. All rights reserved. 30


Can a stock deal look like an asset deal?

The Section 338(h)(10) election


• A stock deal can be structured to look like an asset deal for tax purposes
• The buyer and seller may jointly make a Section 338(h)(10) election
• Results in only one level of tax (to extent target has been an “S” Corporation since
inception or for at least 10 years)

Asset Deal
(Including 338 Stock Deal
Election)

Double Tax
Y (Except
N
S-Corp)

Capital Gains
vs. Ordinary CG and Ordinary CG

Step-up in
Asset Basis Y N

NOL Carryover
N Y

Copyright © 2017 Deloitte Development LLC. All rights reserved. 31


A merger is a transaction mechanism, typically
considered for like-size buyers and sellers

• Buyer (aka “Parent”) forms a new Share-


subsidiary that is merged into the Parent holders
target company, with the target
company as the surviving
company. Merger Sub Target Co.

• Shares of target company are


converted into right to receive the
purchase price – called the
“merger consideration.”
• Used instead of stock purchase if Parent
Share-
there is difficulty in obtaining holders
every shareholders’ agreement to
Target Co.
sell its stock.
• Used alone or with a “tender
offer” to acquire public
companies.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 32


Transaction hybrids: Tender offer and short form merger

Tender offer followed by a short Parent SH


form merger
• Purchaser makes offer directly to target Merger Sub Target Co.
company shareholders to purchase their
stock

• If Purchaser obtains 90% of target’s


stock, then Purchaser can proceed with a Parent 10 90
short form merger to acquire the balance % %
of the shares Merger Sub SH SH

• Shareholder consent is not required for a


short form merger
Target Co.
• Often employed in hostile transactions

• Principal advantage is timing

Parent SH SH

Target Co.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 33


Accounting Impacts of M&A

• The application of purchase accounting rules under US GAAP requires that


assets and liabilities be revalued to fair value
• Increased depreciation (tangible assets) and amortization (intangible
assets) can impact future earnings
• The pre-acquisition and post acquisition balance sheet can look significantly
different and potentially cause incremental book earnings (and resulting
EPS accretion / dilution) to be materially impacted:
– PP&E – Step up results in more depreciation
– Intangibles – Step up may result in increased amortization
– Goodwill – Not amortized but subject to impairment testing
• A detailed M&A model for a public company would consider the accounting
impacts of the proposed deal and measure the earnings accretion/dilution
of the deal

Copyright © 2017 Deloitte Development LLC. All rights reserved. 34


M&A transactions will differ considerably, depending on
whether the parties are Public or Private companies

Public Company M&A Private Company M&A

• No seller remaining following closing • Sellers can commit outright to sell the
to which the Purchaser may have company
legal recourse for claims, such as
claims for breaches of reps and • Small shareholder base may make
warranties certain transaction structures feasible
(assets)
• Public transactions require additional
disclosure to shareholders under • Generally no need for the target
federal securities laws company’s board to have a “fiduciary
out” that would allow them to consider
• Additional time between signing and higher offers after signing
closing for shareholder approval

• Diligence can be expedited since


material information regarding the
target should be publicly available

• Generally, the prospect of litigation


requires a more carefully structured
sale process for a public company

Copyright © 2017 Deloitte Development LLC. All rights reserved. 35


M&A Integration
Objectives and role of an advisor M&A Integration

Due Diligence

Strategy Target Screening Transaction Execution Integration

Implementation
Planning Implementation Closing and
Merger Target Negotiation
Preliminary Deal Modeling and Transaction Execution of
Strategy Screening and of Letter Definitive Negotiation
Due Diligence and Valuation Closing Implementation
Development Identification of Intent Due of Final
Diligence Transaction Preparation Plan

Key Action Steps


• Finalize and launch implementation plan (Project Management Office)
• Begin integration elements pre close (where possible)
• Prepare company for Day 0 handover (Accounting, Tax, HR, Customers)

Roles of Advisors

• Leverage experience to facilitate use of leading practices


• Contribute strategy and structure to the implementation plan
• Draw upon deep process knowledge and adjust to changes throughout the transaction
• Use leading edge integration tools and accelerators to track and communicate progress
• Facilitate highest available synergy capture and communicate results to Management
• Assist Management in post close tracking of adjustments to purchase price (e.g. earn
outs)

Copyright © 2017 Deloitte Development LLC. All rights reserved. 37


What is M&A Integration? M&A Integration

 Integration is a detailed process which seeks to create a “Day 1” organization that can
deliver the transaction’s investment theses
 The investment thesis will drive the integration approach:
High
Need for operational linkages

Partial Absorb

Holding
Partial
company
Low

Low High
Need for strategic linkages

Copyright © 2017 Deloitte Development LLC. All rights reserved. 38


Who is involved in M&A integration? M&A Integration

Integration Program
Governance  Keep integration teams
focused and aligned on the
Steering end-state vision
Committee
Integration  Facilitate cross-functional
Leadership Coordination Integration Management
dependencies, issue resolution
Deal Team Office (IMO) and decisions
 Drive cadence and
coordination

 Work cross-functionally to
deliver value to key
Cross- Change stakeholders
Synergy Operating Workforce & Tax & Legal
Functional Mgmt & Regions
Teams
Capture Model / BP Organization
Comms
Entity  Translate the Day 1 priorities
and vision into functional
execution plans

 Develop functional visions and


blueprints aligned with the
Business & Sales & Procuremen
Functional Channels
Marketing IT HR Finance
t operating strategy
Teams Product
Customer Professional  Manage the tactical
Developmen Operations Real Estate Tax
t
Service Services integration activities for their
respective functions

Copyright © 2017 Deloitte Development LLC. All rights reserved. 39


Illustrative tools to capture progress M&A Integration

Integration Blueprint

Blueprints map out the critical


activities of each function to
identify Day 1 decisions, and
determine timing issues and
interdependencies to achieve
overall integration goals

Integration Work Plans


The overall program work plan
facilitates management of
program by providing an
integrated view of key functional
requirements and milestones

Copyright © 2017 Deloitte Development LLC. All rights reserved. 40


Integration: Required to realize the Business
M&A Integration
Case
Examples Challenges

 Leverage scale to renegotiate external  Accelerate integration activities while


services doing your day job
COST  Bring functions in-house to reduce costs  Realize efficiencies without disrupting
SYNERGIES growth (i.e. sales, engineering talent)
 Eliminate redundancies
 Product overlap / legacy product
 SKU Count

 Increase sales through expanded sales  Pricing pressures from customers


force and geographic reach
 Harmonizing go-to-market models
REVENUE  Create additional margin leverage
SYNERGIES through target’s portfolio  Fending off aggressive competitor
tactics
 Enable cross selling / enhanced value
propositions

 Create an infrastructure with added  Repositioning new value proposition


scale in growing, more profitable with customers
markets
GROWTH  Maintaining and enhancing a productive
PLATFORM  Broader product portfolio positions and motivated workforce
company for penetration into new
customers

Copyright © 2017 Deloitte Development LLC. All rights reserved. 41


Knowledge Check #3

How should Nuggets integrate Best Brew Pubs?

No integration Full integration


Rationale: Rationale:

Copyright © 2017 Deloitte Development LLC. All rights reserved. 42


Questions and Answers
Disclaimer

This presentation contains general information only and Deloitte is not, by


means of this presentation, rendering accounting, business, financial,
investment, legal, tax, or other professional advice or services. This
presentation is not a substitute for such professional advice or services, nor
should it be used as a basis for any decision or action that may affect your
business. Before making any decision or taking any action that may affect your
business, you should consult a qualified professional advisor.

Deloitte shall not be responsible for any loss sustained by any person who
relies on this presentation.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 44


About Deloitte
Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee
(“DTTL”), its network of member firms, and their related entities. DTTL and each of its member firms are legally
separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not provide services to
clients. Please see www.deloitte.com/about for a detailed description of DTTL and its member firms. Please see
www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.
Certain services may not be available to attest clients under the rules and regulations of public accounting.

Copyright © 2017 Deloitte Development LLC. All rights reserved.


Combining Theory & Practice in an
Entrepreneurial Legal World
Module 9 – Introduction to M&A Part 2 – Strategic
Considerations in Buy/Sell (M&A) Disputes
Agenda

• Introduction
• Top 10 Themes/Takeaways
• Purchase Price Adjustment
• Purchase Price Considerations in the Merger & Acquisition Cycle
• Balance Sheet Considerations
• Earn-Out Considerations
• Strategic Considerations
• Questions and Answers

Copyright © 2017 Deloitte Development LLC. All rights reserved. 2


Top 10 Themes / Takeaways

1. Purchase price adjustment section of the agreement stipulates modification


of the purchase price (up or down)

2. There are different types of purchase price adjustments:

• Based on the financial results of the business as of the closing date


(balance sheet); and
• Seller is entitled to additional purchase price if the business’ performance
during a specified period of time after closing meets certain agreed-upon
targets (income statement) - Also referred to as “earn-out”

3. The purchase price adjustment cycle consists of the due diligence period,
performance period, and in some cases, the negotiation / settlement period
and submission period

4. Most commonly disputed items after the closing date are purchase price
adjustment mechanism, representations and warranties, and
indemnifications

5. Key sections of an agreement include definitions, the purchase price


adjustment mechanism, arbitration clause, representations and warranties,
and indemnifications
Copyright © 2017 Deloitte Development LLC. All rights reserved. 3
Top 10 Themes / Takeaways
6. Purchase price balance sheet considerations typically involve changes in net
assets or working capital

7. Purchase price earn-out considerations typically involve certain, pre-


determined (usually sales or EBITDA) growth targets

8. Issues between the parties arise for various reasons including:


• Interpretation of the contract
• Record retention
• Timing
• Intent of the parties

9. Common purchase price issues include:


• Role of estimates and judgments
• Governing basis of presentation
• Materiality
• Level of aggregation
• Balance sheet “date”
• GAAP vs. consistency
• Access to financial records

10.Parties need to confirm specific language is incorporated into the agreement


to avoid those issues
Copyright © 2017 Deloitte Development LLC. All rights reserved. 4
Purchase Price Adjustment
Purchase Price Adjustment (“PPA”)

• A purchase price adjustment modifies the price paid for a company (up or
down)

• Different types of purchase price adjustments:


o Based on what is owned/owed as of the closing date – purchase price
adjustment is based on a balance sheet metric:
− Working capital
− Net assets or
− Other balance sheet metric

o “Earn-out” - Seller gets additional purchase price based on how the


company performs during a specified period of time after closing. Purchase
price adjustment is based on an income statement metric:
− EBITDA
− Sales
− Revenue
− Other operational metric

Copyright © 2017 Deloitte Development LLC. All rights reserved. 6


The Purchase Price Adjustment Cycle

• Period of time between signing and closing can be long


• The business continues to operate. Both Buyer and Seller need assurance that
those operations will be conscientious.
• Portion of the purchase price may be tied to the future growth potential of the
target company

Purchase Price Adjustment Cycle


Negotiation/
Due Diligence Period Settlement Period

12/31/16 3/31/17 6/30/17 8/31/17 Dispute Goes


Notice of
Benchmark Agreement Closing Date Closing Date Balance to Arbitrator
Objection
Date/ Base Signing Date Sheet Prepared as
Date of 6/30/17

Company continues normal Company now operated by


operations Nuggets

Changes in: Difference between


BBP BBP
• Cash -$0.5 million the Benchmark WC
Working Working
• A/R -$2.4 million and Closing Date
Capital Capital $8.3
• Inventory +$0.9 million Working Capital is -
$13.0 million
• A/P +$0.9 million $4.7 million
million • Accrued Exp +$1.1
million
• Other Current Liab +$0.7
million

Copyright © 2017 Deloitte Development LLC. All rights reserved. 7


Purchase Price Considerations
in the Merger & Acquisitions
Cycle
The Agreement

• Basic Information:
• Names of Parties
involved • Definitions –
• Purchase price • Seller/Purchaser
• What is being purchased • Purchased Entity
• Key dates for • Assumed
Purpose of transaction Assets/Liabilities
the • Inclusions and • Purchase Price
exclusions related to the Key parts
agreement purchase of the
• Closing Financial
is to set the Statements
• Negotiated Terms: agreement • Purchase Price
terms of the • Purchase Price Adjustment
negotiations Adjustment Mechanism
• Other relevant • Arbitration Clause
provisions, for example
succession planning • Representations and
Warranties
• Indemnifications

Copyright © 2017 Deloitte Development LLC. All rights reserved. 9


Most Commonly Disputed Items after Closing

• List out all the


parties involved
• Purchase Price • Finalize the
negotiated price
Adjustment • Ensure all items to
be included in the • Definitions
Mechanism price are explicitly
listed in the
• Purchase Price
Adjustment
Representations
•Purpose of and agreement
• Ensure important
Major Parts Mechanism
the of the • Arbitration
AgreementWarranties exclusions are listed
in the agreement Agreement Clause
• Representations
• Indemnifications • Include provisions
related to
and Warranties
• Indemnifications
succession planning

Copyright © 2017 Deloitte Development LLC. All rights reserved. 10


Where does the Purchase Price Adjustment fit in the Mergers &
Acquisitions cycle?

The M&A Lifecycle

Key Phases I.Strategy Development II. Transaction Development III. Transaction Execution IV. Integration

Implementation Planning Closing and


Merger Target Synergy and Negotiation Implementation and
Preliminary Definitive Negotiation of Transaction Closing Execution
Strategy Screening and Value Driver of Letter of
Due Diligence Due Final of Implementation
Development Identification Quantification Intent Preparation
Diligence Transaction Plan

These
Board or Steering Completed Term Executed stages
Transfer of
Committee letter of sheet purchase ownership/ are
approval intent agreement closing optional
documentation

Purchase Price Adjustment Cycle


Submissions
Negotiation/
Due Diligence Period Performance Period Settlement Period
Supporting Positions
from each Party

12/31/16 3/31/17 6/30/17 8/31/17 6/30/18 Arbitrator


Notice of Dispute Goes
Reviews all
Benchmark Objections to the
Agreement Closing Date Closing Date End of Submissions
Date/ Base Date Arbitrator
Signing Date Balance Performance and issues the
Sheet Period Determination
Prepared as
of 6/30/17

Copyright © 2017 Deloitte Development LLC. All rights reserved. 11


Representations, Warranties and Indemnification

• Declarations from Parties about facts that exist when the agreement is signed

• For example:
o Seller may need to represent that all applicable taxes have been paid
o Both Parties may need to confirm that no other obligations exist at the time
the agreement is signed that would cause a conflict such as environmental
issues

• Reps, Warranties and Indemnification Considerations:


o Survival period
o Materiality
o Cap
o Basket indemnification
o Escrow account

Copyright © 2017 Deloitte Development LLC. All rights reserved. 12


Representations, Warranties and Indemnification (continued)

• Purchase Price Adjustment (“PPA”) vs. Breach of Representations and


Warranties
o PPA is a mechanism for calculating an adjustment to the purchase price
o Breach of Representations and Warranties involves a number of steps before
a Party can be indemnified for the damages

• A dispute over a potential breach of Representations and Warranties may be


resolved through litigation where a party may seek damages or attempt to
enforce other remedies described in the Indemnification section of the
agreement

• Litigation of a Breach of Representations and Warranties is typically a different


process than a Purchase Price Adjustment dispute but can be handled in the
same arbitration process

Copyright © 2017 Deloitte Development LLC. All rights reserved. 13


Balance Sheet Considerations
Commonly encountered Purchase Price Adjustment metrics –
Balance Sheet

• Typically based on net assets but can be any type of metric previously
negotiated by the Parties as long as it is explicitly stated in the contract.
Examples of common balance sheet metrics include:

o Change in Net Assets – total assets less total liabilities

o Change in Working Capital – current assets less current liabilities

• GAAP definition of Working Capital - current assets less current liabilities:


o Current assets are those expected to be converted into cash or consumed in
the operation of the business within one operating cycle (generally one
year)
o Current liabilities are those that are expected to require the use of cash (or
other assets classified as current assets) within one operating cycle

Copyright © 2017 Deloitte Development LLC. All rights reserved. 15


BBP Balance Sheet at 12/31/16

ASSETS LIABILITIES & SHAREHOLDERS' EQUITY

Cash And Equivalents 15.0 Liabilities


Short Term Investments - Accounts Payable 12.3
Total Cash & ST Investments 15.0 Accrued Exp. 3.0
Curr. Port. of LT Debt -
Accounts Receivable
Other Receivables
Working Capital= 12.4
-
Curr. Port. of Cap. Leases -
Curr. Income Taxes Payable -
Total Receivables Current Asset - 12.4 Unearned Revenue, Current -
Current Liabilities Other Current Liabilities 2.0
Inventory 2.9 Total Current Liabilities 17.3
Prepaid Exp. -
Deferred Tax Assets, Curr. - Long-Term Debt 40.0
Other Current Assets - Capital Leases -
Total Current Assets 30.3 Def. Tax Liability, Non-Curr. -
Other Non-Current Liabilities -
Gross Property, Plant & Equipment 100.0 Total Liabilities 57.3
Accumulated Depreciation (20.0)
Net Property, Plant & Equipment 80.0 Shareholders' Equity
Pref. Stock, Convertible -
Total Pref. Equity -
Goodwill -
Other Intangibles - Common Stock 10.1
Other Long-Term Assets - Additional Paid In Capital -

Net Assets= Retained Earnings 42.9


Treasury Stock -
Total Assets- Comprehensive Inc. and Other -
Total Liabilities Total Common Equity 53.0

Total Equity 53.0

Total Assets 110.3 Total Liability & Owner's Equity 110.3

Copyright © 2017 Deloitte Development LLC. All rights reserved. 16


Selected Items from Balance Sheet Related to Working Capital

Benchmark BS as of Closing BS as of 6/30/2017


12/31/2016
ASSETS
ASSETS Cash And Equivalents $14.5
Cash And Equivalents $15.0 Short Term Investments -
Short Term Investments - Total Cash & ST Investments 14.5
Total Cash & ST Investments 15.0

Accounts Receivable 10
Accounts Receivable 12.4
Other Receivables -
Other Receivables -
Working Capital Working
Total Receivables Capital 10.0
Total Receivables 12.4
as of 12/31/16 as of 6/30/17
Inventory 30.3 – 17.3 = Inventory 28.3 – 20.0 = 3.8
13.0 2.9 Prepaid Exp. 8.3 -
Prepaid Exp. - Deferred Tax Assets, Curr. -
Deferred Tax Assets, Curr. - Other Current Assets -
Other Current Assets - Total Current Assets 28.3
Total Current Assets 30.3

LIABILITIES
LIABILITIES
Accounts Payable 12.3 Accounts Payable 13.2
Accrued Exp. 3.0 Accrued Exp. 4.1
Other Current Liabilities 2.0 Other Current Liabilities 2.7
Total Current Liabilities 17.3 Total Current Liabilities 20.0
Copyright © 2017 Deloitte Development LLC. All rights reserved. 17
Purchase Price Adjustment – Balance Sheet

The M&A Lifecycle


Key Phases I.Strategy Development II. Transaction Development III. Transaction Execution IV. Integration

Implementation Planning Closing and


Merger Target Synergy and Negotiation Implementation and
Preliminary Definitive Negotiation of Transaction Closing Execution
Strategy Screening and Value Driver of Letter of
Due Diligence Due Final of Implementation
Development Identification Quantification Intent Preparation
Diligence Transaction Plan

Board or Steering Completed Term Executed Transfer of


Committee letter of sheet purchase ownership/
approval intent agreement closing
documentation

Purchase Price Adjustment Cycle


Due Diligence Period

12/31/16 3/31/17 8/31/17


6/30/17
Benchmark Agreement Closing Date Balance
Closing Date
Date/ Base Signing Date Sheet Prepared as
Date of 6/30/17

Company continues normal operations Company now operated by Nuggets

Changes in:
• Cash -$0.5 million
BBP • A/R -$2.4 million BBP Working
Working Capital • Inventory +$0.9 million Capital $8.3 Difference between
$13.0 million • A/P +$0.9 million million the Benchmark WC
• Accrued Exp +$1.1 and Closing Date WC
million is -$4.7 million
• Other Current Liab +$0.7
million
Copyright © 2017 Deloitte Development LLC. All rights reserved. 18
Typical Purchase Price Adjustment Provision – Balance Sheet

• Not more than 60 days after the closing date, the Buyer shall prepare a
Closing Date Working Capital Statement in accordance with US generally
accepted accounting principles consistently applied.

• If the working capital as shown in the Closing Date Working Capital Statement
is greater than the Working Capital as shown in the Company’s December 31,
2016 Working Capital Statement included as Exhibit A to this Agreement, then
the purchase price shall be increased by the amount of such excess.

• If the Working Capital as shown in the Closing Date Working Capital Statement
is less than the Working Capital as shown in the Company’s December 31,
2016 Working Capital Statement, then the purchase price shall be decreased
by the amount of such deficiency.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 19


Typical Purchase Price Adjustment Provision – Working Capital
Statement
• Not more than 60 days after the closing date, the Buyer shall prepare a
Closing Date Working Capital Statement in accordance with US generally
accepted accounting principles consistently applied

• If the working capital as shown in the Closing Date Working Capital Statement
are greater than the working capital as shown in the company’s December 31,
2016 Working Capital Statement included as Exhibit A to this agreement, then
the purchase price shall be increased by the amount of such excess

• If the working capital as shown in the Closing Date Working Capital Statement
are less than the working capital as shown in the company’s December 31,
2016 Working Capital Statement, then the purchase price shall be decreased
by the amount of such deficiency

Due Diligence Period


8/31/17
Closing Date Balance
12/31/16 Sheet Prepared as
3/31/17 6/30/17
Benchmark of 6/30/17
Agreement Signing Date Closing Date
Date/ Base
Date
BBP Difference between the BBP Working
Working Benchmark Working Capital Capital $8.3
Capital and Closing Date Working million
$13.0 million Capital is -$4.7 million

Copyright © 2017 Deloitte Development LLC. All rights reserved. 20


Earn-out Considerations
Commonly encountered Purchase Price Adjustment metrics –
Earn-out

• Contractual provision in the purchase and sale of a business that requires the
buyer to pay additional money subsequent to the close of the purchase if the
target meets certain, pre-determined (usually sales) goals.

• Generally Earn-out provisions are used in the sale of businesses that are
newer, smaller and more volatile in their growth prospects.

• While a seller may project increasing growth on a go forward basis, thus


concluding the business is worth a lot more, a seasoned purchaser might see
a smaller growth rate, which translates into a lower purchase price.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 22


Purchase Price Adjustment – Earn-out
The M&A Lifecycle

Key Phases I.Strategy Development II. Transaction Development III. Transaction Execution IV. Integration

Implementation Planning Closing and


Merger Target Synergy and Negotiation Implementation and
Preliminary Definitive Negotiation of Transaction Closing Execution
Strategy Screening and Value Driver of Letter of
Due Diligence Due Final of Implementation
Development Identification Quantification Intent Preparation
Diligence Transaction Plan

Board or Steering Completed Term Executed Transfer of


Committee letter of sheet purchase ownership/
approval intent agreement closing
documentation

Purchase Price Adjustment Cycle


Due Diligence Period

12/31/16 6/30/17 8/31/17 6/30/18


3/31/17
Benchmark Closing Date Closing Date Balance Earn-Out
Agreement
Date/ Base Sheet Prepared as Anniversary
Signing Date
Date of 6/30/17 Period

Company continues normal Company now operated by Nuggets


operations
Performance Period
Changes in:
• Cash -$0.5 million BBP Working
BBP Nuggets and BBP agree on additional
• A/R -$2.4 million Capital $8.3 Purchase Price $272
Working payment of 6/30/18 EBITDA times 3 less
• Inventory +$0.9 million million million plus/ minus
Capital $100 million
• A/P +$0.9 million changes in WC, plus
$13.0
• Accrued Exp +$1.1 6/30/18 EBITDA times
million
million 3 less $100 million
• Other Current Liab +$0.7
million
Copyright © 2017 Deloitte Development LLC. All rights reserved. 23
Typical Purchase Price Adjustment Provision – Earn-out

• The Seller shall be entitled to receive from Buyer additional amounts based on
the Company’s performance during the twelve month period ending on the
one-year anniversary of the Closing Date (often called the performance period
or anniversary period).

• The Earn-out payment shall be an amount equal to (a) the product of three
times (b) the Company’s EBITDA during the one-year anniversary period
minus (b) $100,000,000.

• “EBITDA” means with respect to the anniversary period, the net income for
such period, determined using the US generally accepted accounting principles
consistently applied, prior to the provision of interest expense, income taxes,
depreciation and amortization.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 24


Typical Purchase Price Adjustment Provision – Earn-out

• The Seller shall be entitled to receive from Buyer additional amounts based on
the Company’s performance during the twelve month period ending on the
one-year anniversary of the Closing Date.
• The Earn-out payment shall be an amount equal to (a) the product of three
times (b) the Company’s EBITDA during the one-year anniversary period
minus (b) $100,000,000.
• “EBITDA” means with respect to the anniversary period, the net income for
such period, determined using the US generally accepted accounting principles
consistently applied, prior to the provision of interest expense, income taxes,
depreciation and amortization.
8/31/17 6/30/18
Closing Date Balance Sheet Earn-Out Anniversary
Prepared as of 6/30/17 Period
Due Diligence Period

12/31/16 6/30/17
3/31/17
Benchmark Closing Date
Agreement
Date/ Base
Signing Date
Date

Company continues normal Company now operated by Nuggets


operations Performance Period

Changes in:
• Cash -$0.5 million
BBP Working BBP Purchase Price $272
• A/R -$2.4 million Nuggets and BBP agree on additional payment
Capital Working million plus/ minus
• Inventory +$0.9 million of 6/30/18 EBITDA times 3 less $100 million
$13.0 million Capital changes in WC, plus
• A/P +$0.9 million
$8.3 6/30/18 EBITDA times
• Accrued Exp +$1.1 million
million 3 less $100 million
• Other Current Liab +$0.7
million
Copyright © 2017 Deloitte Development LLC. All rights reserved. 25
Other Provisions Included in the Purchase Agreement:
Succession Planning

• Succession planning is recommended in certain situations.

o After the Closing, the Buyer takes over the company but in some situations
the Seller may stay for an agreed period of time to train new personnel,
help with transition and run parts of the company.

o The agreement should have language that specifies the time period, tasks
and responsibilities as well as an explanation whether that will have any
effect on the performance period related to the earn-out calculation.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 26


Strategic Considerations
Strategic Considerations

• Reasons why the issues arise


• Common Issues related to most Purchase Price Adjustments
• Unique Issues related to Earn-Out Provisions

Copyright © 2017 Deloitte Development LLC. All rights reserved. 28


Why do Issues Arise?

Interpretation of the contract


• Inadequate or ambiguous language

Record retention
• Prior stand-alone financial statements may not have been prepared
• No basis for consistency in terms of GAAP

Timing
• Misappropriation or draining of assets from the business

Intent of the parties, for example:


• Absolute view – strict interpretation of GAAP
• Delta view – strict interpretation of consistency

Source: FASB Statement of Financial Accounting Concepts No. 1

Copyright © 2017 Deloitte Development LLC. All rights reserved. 29


Absolute View vs. Delta View

Delta View:
• Measures a change from the Benchmark Date
to the Closing Date
• Seller insists on calculating the Closing Date
Financial Statements on a historical basis, i.e.
the consistency view

Due Diligence Period

12/31/16 6/30/17 8/31/17


Benchmark Closing Date Closing Date Balance
Date/ Base Sheet Prepared as
Date of 6/30/17

Absolute View:
• A Buyer does not
care how the
Financial Statements
were prepared in the
past, insists on using
GAAP as of the
Closing Date

Copyright © 2017 Deloitte Development LLC. All rights reserved. 30


Absolute View vs. Delta View Example

Company A
• Financial Statements prepared in
accordance with US GAAP
• Spare Parts Inventory shared
between plants and were not
Delta View: written off historically.
• Seller argues that none of the inventory was
written off historically. Therefore, according to Plant 1
the Seller the spare parts should be included as Plant 2
part of the Closing Statement and the Buyer
Plant 3
should pay $1 million for the spare parts.
Plant 4

Plant 4 gets sold together with $1


Due Diligence Period 6/30/17
Closing Date million of spare parts inventory on
hand.
12/31/16
Benchmark
Date/ Base
Date

Absolute View:
• Buyer argues that $500,000
of spare parts are not going
to be used, ever, and are
obsolete. The Buyer argues
according to GAAP the spare
parts should be written off
and should not be included
as part of the assets
acquired.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 31


Common Issues

• Role of estimates and judgment


• Governing basis of presentation
• Materiality
• Level of aggregation
• Balance sheet “date”
• GAAP vs. consistency
• Access to financial records

Source: CON 2, Qualitative Characteristics of Accounting Information

Copyright © 2017 Deloitte Development LLC. All rights reserved. 32


Role of Estimates and Judgment
• Some accounts are more prone to judgment than others, for example:
•Accounts receivable •Contingent liabilities (e.g.,
 Inadequate or overly generous litigation)
reserves  Overaccrual or underaccrual of
liabilities
•Inventories •Warranty reserves
 Inventory reserves (e.g., Excess or  Overaccrual or underaccrual of
Damaged) liabilities
•Long-term contracts
 Failure to accrue losses or accrual of excessive losses

• Nature of Financial Statements


• Buyer and Seller have different motivations
• Accounting definition of "error" in estimates
o Needs to be outside of range of reasonableness
o Burden of proof
• Parties should consider specifying the method for calculating estimates in the
agreement
Copyright © 2017 Deloitte Development LLC. All rights reserved. 33
Governing basis of presentation

• Describes the principles that will be used to prepare the financial statements
as of and for the Base/ Benchmark Period and Closing Period.

• There are various forms that can be used, including:


o GAAP (US or other local GAAP)
o Tax basis
o Regulatory accounting provisions
o International Accounting Standards (“IAS”)
o Other

• Contractual modifications

• Consider explicitly listing account balances to be included or excluded in the


agreement or adding an exhibit to the agreement outlining the form. It is also
important to explicitly state in the agreement which basis will be used to
prevent the Parties from using different forms from one period to another,
which may benefit one party.
Copyright © 2017 Deloitte Development LLC. All rights reserved. 34
Materiality

• Materiality for accounting purposes is generally defined as an amount that


would influence a reasonable user of the financial statements in making a
judgment.

• In buy-sell disputes there are only two users of the closing date balance sheet
– the Buyer and the Seller.

• Since the amount in dispute may mean a dollar for dollar adjustment for one
of the parties, materiality becomes much lower than in normal circumstances

• Benefits/issues with predetermining level of materiality

• Parties should consider defining or addressing the level of materiality in the


agreement.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 35


Level of Aggregation

• Consideration needs to be given to whether objections may be made to the


individually small amounts, or only to balances at the financial statement line
item level
o Accounts receivable – can there be objections to reserves against individual
balances or only at the line item (aggregate) level

• Valid offsets and defenses vs. Raising new objections

• Allows “cherry picking” – objection to amounts that benefit one party while
ignoring those that go the other way

• Confirm this issue is discussed with your client and include explicit language in
the agreement

Copyright © 2017 Deloitte Development LLC. All rights reserved. 36


BBP Balance Sheet at 12/31/16

ASSETS LIABILITIES & SHAREHOLDERS' EQUITY

Cash And Equivalents 15.0 Liabilities


Level of Aggregation
Short Term Investments 0 Accounts Payable “Cherry Picking”
12.3
Total Cash & ST Investments 15.0 Accrued Exp.
Accounts Receivable 3
Curr. Port. of LT Debt -
Accounts Receivable 12.4 CoAccounts
Curr. Port. of Cap. Leases A $2.2 M-
Receivable
Other Receivables 0
CoCo
Curr. Income Taxes Payable B A $700 K - M)
($2.2
Total Receivables 12.4 Unearned Revenue, Current 0
CoCo
Other Current Liabilities C B $4.5 M
$7002 K
Inventory 2.9 CoCo
Total Current Liabilities D C $1.2 M
$4.5
17.3
M
Prepaid Exp. 0
Deferred Tax Assets, Curr. 0 Long-Term Debt Co E
Co D $500 K
$1.240M
Other Current Assets 0 Capital Leases CoCo F E $600 K0 K
$500
CoCo G F $2.2 M 00 K
Total Current Assets 30.3 Def. Tax Liability, Non-Curr.
Other Non-Current Liabilities $600
Gross Property, Plant & Equipment 100.0 Total Liabilities CoCo H G $500 KM
$2.2
57.3
Accumulated Depreciation
Net Property, Plant & Equipment
(20.0)
80.0 Shareholders' Equity
TotalCo H $12.4
$500MK
Pref. Stock, Convertible
Total Pref. Equity
Co I $4.4 --M
Goodwill 0 Total $12.4 M
Other Intangibles 0 Common Stock 10.1
Other Long-Term Assets 0 Additional Paid In Capital 0
Retained Earnings 42.9
Treasury Stock -
Comprehensive Inc. and Other 0.0
Total Common Equity 53

Total Equity 53

Total Assets 110.3 Total Liability & Owner's Equity 110.3

Copyright © 2017 Deloitte Development LLC. All rights reserved. 37


Balance Sheet “Date”

• As of instant before the transaction date

• Closing Financial Statement time frame


o Presumption of “close of business on Closing Date”
o No less, impact of the transaction itself (bonus accruals) are generally
excluded.

• Impact of transaction on carrying values of assets and liabilities

• Subsequent events
o Reserves and accrued liabilities must be based on information known or
knowable when the financial statements are issued.

• The agreement should state the "date" of the Closing Financial Statements in
order for the financial statements to reflect the correct amounts of assets and
liabilities.
Copyright © 2017 Deloitte Development LLC. All rights reserved. 38
Purchase Price Adjustment – Balance Sheet

The M&A Lifecycle


Key Phases I.Strategy Development II. Transaction Development III. Transaction Execution IV. Integration

Implementation Planning Closing and


Merger Target Synergy and Negotiation Implementation and
Preliminary Definitive Negotiation of Transaction Closing Execution
Strategy Screening and Value Driver of Letter of
Due Diligence Due Final of Implementation
Development Identification Quantification Intent Preparation
Diligence Transaction Plan

Board or Steering Completed Term Executed Transfer of


Committee letter of sheet purchase ownership/
approval intent agreement closing
documentation

Purchase Price Adjustment Cycle


Due Diligence Period Subsequent Events

12/31/16 3/31/17 8/31/17


6/30/17
Benchmark Agreement Closing Date Balance
Closing Date
Date/ Base Signing Date Sheet Prepared as
Date of 6/30/17

Company continues normal operations Company now operated by Nuggets

Changes in:
• Cash -$0.5 million
• A/R -$2.4 million Difference between
BBP BBP
• Inventory +$0.9 million the Benchmark WC
Working Capital Working
• A/P +$0.9 million and Closing Date WC
$13.0 million Capital $8.3
• Accrued Exp +$1.1 is -$4.7 million
million
million
• Other Current Liab +$0.7
million
Copyright © 2017 Deloitte Development LLC. All rights reserved. 39
GAAP vs. Consistency

GAAP – Absolute Consistency –


View Delta View
In the In the
agreement agreement
reflected as reflected as

“in accordance with GAAP” “consistently applied”

• "in accordance with GAAP"


o GAAP is a very broad set of criteria
• "consistently applied"
o Same GAAP rule is "consistently applied" but can be used with different
methodologies
o Buyer and Seller may use different methodologies and still be in compliance
with GAAP, but the final numbers they come up with may be different
• When preparing the purchase agreement, include specific principles, practices,
procedures and methodologies.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 40


Access to Financial Records and Other Issues

• Buyer will have control of the books and records after the sale

• Disagreements over to the term “reasonable” access to books and records


typically relate to:
o Period Covered
o Level of Detail
o Emails
o Access to People

• Financial statement preparers may change loyalties from the seller to the
buyer

• The agreement should specifically include a provision related access to the


financial records including details on access period, level of detail, types of
documents and access to employees, etc.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 41


Unique Issues Related to an Earn-Out Provision

• Acquired company is integrated into the Buyer’s operations - Changes in


operations post closing can include:
o Operational changes
o Accounting changes
o System changes

• How will the Earn-out be measured:


o Top line vs. below the line

• How to ensure the Earn-out process will be fair to both Parties:


o Periodic reporting
o Oversight
o Record retention

Copyright © 2017 Deloitte Development LLC. All rights reserved. 42


Questions and Answers
Disclaimer
This presentation contains general information only and Deloitte is not, by means of
this presentation, rendering accounting, business, financial, investment, legal, tax, or
other professional advice or services. This presentation is not a substitute for such
professional advice or services, nor should it be used as a basis for any decision or
action that may affect your business. Before making any decision or taking any action
that may affect your business, you should consult a qualified professional advisor.
Deloitte shall not be responsible for any loss sustained by any person who relies on this
presentation.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 44


About Deloitte
Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee
(“DTTL”), its network of member firms, and their related entities. DTTL and each of its member firms are legally
separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not provide services to
clients. Please see www.deloitte.com/about for a detailed description of DTTL and its member firms. Please see
www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.
Certain services may not be available to attest clients under the rules and regulations of public accounting.

Copyright © 2017 Deloitte Development LLC. All rights reserved.


Combining Theory & Practice
in an Entrepreneurial Legal
World

Module 11 – Valuation
Agenda

• Top 10 Themes/Takeaways for this module


• Case Study Recap
• Recent M&A Valuations
• Valuation Definitions & Considerations
• Introduction to Valuation Methodologies
• Income Approach
• Market Approach
• Cost Approach
• Relative Considerations
• Best Brew Pub Valuation
• Income Approach Valuation
• Market Approach Valuation
• Value Reconciliation & Conclusion
• Public Company Valuation
• Recent Valuations

Copyright © 2017 Deloitte Development LLC. All rights reserved. 2


Top 10 Themes/Takeaways

1. Decisions and behaviors are driven by value judgments


2. Valuation is a mix of both art (professional judgment) and science (economic
and finance theory)
3. Value is estimated based on the income, market and cost approaches
4. Each of the three valuation methodologies have unique strengths and
shortcomings
5. Value estimates based on different methodologies should be reconciled
6. Discount rates reflect the riskiness of the asset/business, time value of
money and inflation; Higher the risk, higher the expected rate of return
7. Increased consensus and consistency in the resolution of valuation issues
both in the courts and business world has led to the demand for business
valuation for many purposes and professions
8. Most business valuations have the potential for legal challenge
9. Courts rely on professional standards and guidance in deciding disputed
issues
10.Common challenges in valuation that may result in litigation include:
a) Failure to reconcile approaches
b) Lack of support/insight into cash flow projections
c) Discount rates and long-term growth rates not supported
d) Comparable/peer companies are not representative of the subject
business

Copyright © 2017 Deloitte Development LLC. All rights reserved. 3


Nuggets Inorganic Growth Strategy
Case study recap…

• Nuggets shareholders expect continued high growth and strong financial


performance
• Coulter siblings believe the US is running out of high-growth opportunities
and that international markets may have untapped potential
• Nuggets BOD support an inorganic growth strategy (i.e. growth through
acquisition) but demand they proceed with caution as this is their first
acquisition
• Nuggets has hired a financial and legal advisor to explore transaction
opportunities in the UK
• After an extensive process, and multiple discussions with targets, Nuggets
identified and qualified a potential acquisition target, Best Brew Pubs (“BBP”)

Copyright © 2017 Deloitte Development LLC. All rights reserved. 4


Recent M&A Valuations

CVS Makes Blockbuster


Aetna Deal
Sources say CVS Health has proposed to
buy Aetna for $66 billion

Copyright © 2017 Deloitte Development LLC. All rights reserved. 5


Valuation Overview
Value Definitions & Considerations

Definitions Considerations

Fair Value Investment Value Unit of Measure

Specific to financial reporting Specific to investment decisions What is being valued?


• Defined by FASB (ASC 805) • No formal definition / • Enterprise
• Assumes willing buyer and guidance • Equity
seller • Reflects value to a specific • A single share
• Used for stockholder dissent investor (but not price paid) • Intangible asset (e.g
and value estimates on • Includes expected synergies technology)
financials

Fair Market Value Book Value Basis of Value

Specific to tax reporting Specific to accounting records Considerations that impact


value
• Defined by US Treasury Reg • Equals recorded value of
• Assumes hypothetical asset / liability on financials • Going concern vs. liquidation
transaction • Book value equals assets less • Marketability / Liquidity
• Used for US tax analyses liabilities • Control vs. minority share
• Valuation date

Copyright © 2017 Deloitte Development LLC. All rights reserved. 7


Introduction to Valuation Methodology
How do you measure the value of….

House
Income Approach Market Approach Cost Approach

Equivalent to the sum of Estimated based on the Estimated based on the


expected rental income value of comparable hypothetical costs to re-
(less costs of marketing homes at a point in time build the exact same
and maintenance) over (e.g. location, size, house in the exact same
life of property ownership features, etc.) location with the exact
same furnishings

Business
Income Approach Market Approach Cost Approach

Equivalent to the cash Estimated based on the Estimated based on the


inflows and outflows value of comparable hypothetical costs to
expected to be generated companies based on recreate/build the exact
by the business over time publicly available same business with the
information (including same performance and
share price, recent outlook
transactions)

Copyright © 2017 Deloitte Development LLC. All rights reserved. 8


Income Approach

Cash Inflows
• Sales from
goods/services
Business
• Rental income
• Licensing income Cash in
• Subscription income Cash Outflows
• Salaries/wages
• Raw materials
Cash out
• Rental expense
• Machinery/equipment
• Sales & marketing
• Utilities & insurance

Historical Forecasted
2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025
Revenue 100 120 130 135 150 145 145 145 145 145 145
COGS 30 36 39 40 45 43 43 43 43 43 43
SG&A 15 18 20 20 23 22 22 22 22 22 22
Taxes 17 20 21 22 25 24 24 24 24 24 24
NOPAT 39 46 50 52 58 56 56 56 56 56 56
CF Adjustments 10 (5) 5 15 (10) 2 2 2 2 2 2
Free Cash Flows 49 41 55 67 48 58 58 58 58 58 58
Present Value of FCFs 46 35 41 45 29 31 28 25 22 20 18

The income approach estimates the value of a business as the sum of the present value of cash flows
generated over time by the business.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 9


Market Approach

$460k $600k

?
$550k
$425k

Summary Metrics

Subject Comp 1 Comp 2 Comp 3 Comp 4 Low Average High

Value $437,500 $550k $425k $600k $460k $425k $508.5k $600k

Transaction Date May ‘15 June ‘15 Aug ‘15 Aug ‘15 May ‘15 N/A Aug ‘15

Sq. Ft. 3,500 4,000 2,500 6,000 3,500 2,500 4,000 6,000

Yr. Built 1992 2001 2010 1948 1995 1948 N/A 2010

Pool No Yes Yes Yes Yes N/A N/A N/A

Price / Sq. Ft. $125 $137.5 $170 $100 $131 $100 $134 $170

The market approach estimates the value by looking at publicly available information regarding the value
of similar assets. Data points may include publicly traded stock prices and value of recent mergers &
acquisitions

Copyright © 2017 Deloitte Development LLC. All rights reserved. 10


Cost Approach

Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Total


Labor 70,000 33,000 34,000 34,000 $171,000
Materials 45,000 33,000 34,000 34,000 $146,000
Furniture 40,000 5,000 $45,000
Fixtures 28,000 5,000 $33,000
Landscaping 15,000 15,000
Total 115,000 66,000 68,000 68,000 68,000 25,000 $410,000

The cost approach estimates the value by estimating the cost that would be incurred to independently
recreate the same asset

Copyright © 2017 Deloitte Development LLC. All rights reserved. 11


Relative Considerations
Which approach should I use?
Approach Strength Weakness
• Common and generally accepted • Highly subjective
• Applicable for nearly all businesses • Dependency on financial projections
• Flexible, easily adaptable • Sensitive to inputs such as the discount
• Incorporates future expectations rate and projections
Income (DCF) regarding prices, costs, investment, etc. • Easily manipulated
• Only market data is discount rate • Projections not directly linked to market
• Provides a measure of economic • Inability to incorporate key assumptions of
obsolescence market participants
• Common and generally accepted • Sensitive to small changes
• Based primarily on market data • May lack adequate guideline companies or
• Use of market participant inputs data on guideline transactions
Market • Reflects buyers' and sellers' current • Comparability is subjective
actions • May need many adjustments
• Applicable for nearly all business
interests
• Easily understandable concept • Difficult to forecast less tangible costs
• Relatively easy to estimate costs of (e.g. training employees, acquiring
tangible assets (e.g. buildings, customer base)
Cost machinery) • Can be skewed by estimated depreciation
of tangible assets
• Value does not consider value of
intangibles (e.g. going concern value)
Copyright © 2017 Deloitte Development LLC. All rights reserved. 12
Best Brew Pub Valuation
Best Brew Pub – Income Approach

ABC, Inc.
Income Statement as of December 31, 2013
• Food sales
Sales • Beverage sales
• Possible licensing income
• Cost of food and beverage ingredients
Costs of good sold • Cost of tables, chairs, cutlery, flatware, glasses, etc.
• Cost of entertainment (e.g. A/V)

= Gross profit • Money earned on sales after accounting for direct costs

• Wages of staff at pubs Income


Salary & wages
• Salaries of managers and executives Statement
Sales, General & • Rent for pubs & corporate offices, utilities, insurance
Administrative • Expenses for advertising
• Non-cash expense related to usage of owned buildings,
Depreciation
restaurant equipment, etc.

Taxes • Income taxes payable on profits generated by pubs

= Net operating profit after • Money earned on sales after accounting for operating
tax expenses and taxes

+ • Cash payments for purchasing / building / repairing


Capital expenditures
restaurants, offices, kitchen equipment, etc.
Cash Flow
- • Non-cash expense related to usage of buildings, restaurant
Depreciation Adjustments
equipment, etc. (see above)
• Changes in required level of cash for daily operatinos (i.e.
+ Changes in Net Working
delay in making payments to suppliers and collecting cash
/- Capital
from customers)

= Free cash flow • Cash flow available to investors (debt and equity holders)

Copyright © 2017 Deloitte Development LLC. All rights reserved. 14


Best Brew Pub – Income Approach
Discounted Cash Flow Analysis Estimate
long-term
growth
1 Estimate cash flow until steady
growth 2

2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 Terminal
2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026
Year
Food Sales 75 76 78 77 79 80 84 86 85 86 86 88
Drink Sales 185 187 192 191 194 197 207 213 209 211 213 216
Total Revenue 260 263 270 268 273 277 291 300 294 297 300 304
% growth 1.0% 3.0% -1.0% 2.0% 1.5% 5.0% 3.0% -2.0% 1.0% 1.0% 1.5%
Food & Beverage Costs 47 46 49 50 52 49 48 54 53 56 52 52
Salary & Wages 37 35 36 35 33 33 35 36 35 36 36 37
Sales, General & Administrative 115 116 120 118 121 123 129 133 130 131 133 135
Depreciation 20 22 22 24 23 23 30 40 38 35 35 25
Operating Profit 41 43 44 41 45 50 49 37 38 39 44 56
Margin % 15.9% 16.4% 16.3% 15.3% 16.3% 18.0% 17.0% 12.4% 12.8% 13.0% 14.8% 18.3%
Income Taxes 35% 14 15 15 14 16 17 17 13 13 13 16 19
NOPAT 27 28 29 27 29 32 32 24 25 25 29 36

Cash Flow Adjustments


Capital Expenditures 25 25 25 25 25 25 30 25 25 25 25 25
Depreciation 20 22 22 24 23 23 30 40 38 35 35 25
Incremental Working Capital 15% 1 0 1 (0) 1 1 2 1 (1) 0 0 1
Free Cash Flows 21 25 25 26 26 30 30 38 38 35 38 36
Terminal Value 338
Partial Period 50% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%
Periods Discounting 0.250 1.000 2.000 3.000 4.000 5.000 6.000 7.000 8.000 9.000 10.000 10.000
Discount Factor 12% 0.972 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.322
Present Value of FCFs 10 22 20 19 17 17 15 17 16 12 12 109

Business Enterprise Value (rounded) $ 290 Discount back to


present
3

Copyright © 2017 Deloitte Development LLC. All rights reserved. 15


Valuation Overview
Income Approach – Discount Rates
Higher the risk, higher the expected rate of return

High risk High rate


Investment Profile Discount rate

Venture/early stage equity 20%-40%

Growth stage equity 15%

Mature/Blue chip equity 9%

Corporate bond 5%

Risk-free rate 2%

Low risk Low rate

Copyright © 2017 Deloitte Development LLC. All rights reserved. 17


Market Approach
Guideline Public Company Method
Identify publicly traded
1 comparable companies 2 Select metrics

LTM 2016Multiples
2015 Multiples
Business Enterprise
Company BEV / BEV /
Value (BEV) Revenue EBITDA
Revenue EBITDA
The Cheesecake Factory Incorporated 2,375 2,073 252 1.1x 9.4x
Ruby Tuesday, Inc. 502 1,125 78 0.4x 6.4x
Texas Roadhouse, Inc. 2,381 1,757 205 1.4x 11.6x
DineEquity, Inc. 2,885 674 255 4.3x 11.3x
Red Robin Gourmet Burgers, Inc. 1,079 1,253 144 0.9x 7.5x
Best Brew Pubs 255 34
Average 1,376 187 1.6x 9.3x
Median 1,253 205 1.1x 9.4x
Maximum 2,073 255 4.3x 11.6x
Minimum 674 78 0.4x 6.4x

Select / adjust multiple to fit


3
subject company
Selected 1.0x 8.0x

Best Brew Pubs 255 34


Preliminary Indications 255 272
Weighting 50% 50%
Apply multiples to subject
4 company metrics to estimate Estimated Value (rounded) 260.0
value
Source: Capital IQ
Copyright © 2017 Deloitte Development LLC. All rights reserved. 18
Market Approach
Guideline Transactions Method

Identify transactions with targets that are similar to Select


1 2
the subject company metrics

Implied Multiples
Close Date Target Buyer BEV BEV / LTM BEV / LTM
Revenue EBITDA
12/16/2011 Morton's Restaurant Group, Inc. Landry's Restaurants, Inc. 184.3 0.6x 7.6x
7/25/2011 Bojangles Restaurants Advent Int'l 360.8 1.1x 6.9x
6/13/2011 Cracker Barrel Old Country Store, Inc. Biglari Capital Corp. 1,558.0 0.6x 6.6x
5/25/2011 California Pizza Kitchen, Inc. Golden Gate Capital 451.5 0.7x 7.9x
11/8/2010 Bubba Gump Shrimp Co., Inc. Landry's Restaurants, Inc. 112.5 0.6x 6.5x
10/29/2010 Claim Jumper Restaurants, LLC Landry's Restaurants, Inc. 76.6 0.3x n/a
5/10/2010 Rubio's Restaurants, Inc. Mill Road Capital 80.9 0.4x 6.7x

Average 0.6x 7.0x


Median 0.6x 6.8x
Maximum 1.1x 7.9x
Minimum 0.3x 6.5x

Selected 0.5x 7.0x

Apply multiples to subject


3 company metrics to estimate
value

Source: Capital IQ
Copyright © 2017 Deloitte Development LLC. All rights reserved. 19
Value Reconciliation
How much should we pay?

• Considers company-specific growth and


profits
Income Approach $290 • Inherent risks of forecasting 10+ years 33%
• Discount rate may be subjective

• Best Brew Pubs has comparable companies


Market Approach $260 • Availability of recent market data 67%
• May not represent pure comparability to BBP

• Given the strength of the market data


related to companies similar to Best
Concluded Value $272 Brew Pub, it may be more appropriate to 100%
weight the market approach heavier than
the income approach

Based on the relative value indications from each approach, as well as our selected weighting based on
our analysis of the relatives strengths and weaknesses of each, we have decided to offer $272 million
for Best Brew Pubs.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 20


Acquiring Public Companies

Market Trading Value + Control Premium Control Premium Estimate

Calculation Known?
Share price Market data
x Shares outstanding Market data
= Market Cap (i.e. equity value) Calculation
on a minority basis
+ Control premium Transaction
data
= Equity value (control) Calculation
+ Debt Balance sheet
- Excess cash Balance sheet
= Business Enterprise Value Calculation

Sources: Google Finance, Factset Mergers


Copyright © 2017 Deloitte Development LLC. All rights reserved. 21
Making Sense of Valuations

Copyright © 2017 Deloitte Development LLC. All rights reserved. 22


Disclaimer

This presentation contains general information only and Deloitte is not, by


means of this presentation, rendering accounting, business, financial,
investment, legal, tax, or other professional advice or services. This
presentation is not a substitute for such professional advice or services, nor
should it be used as a basis for any decision or action that may affect your
business. Before making any decision or taking any action that may affect
your business, you should consult a qualified professional advisor.
Deloitte shall not be responsible for any loss sustained by any person who
relies on this presentation.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 23


About Deloitte
Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee
(“DTTL”), its network of member firms, and their related entities. DTTL and each of its member firms are legally
separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not provide services to
clients. Please see www.deloitte.com/about for a detailed description of DTTL and its member firms. Please see
www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.
Certain services may not be available to attest clients under the rules and regulations of public accounting.

Copyright © 2017 Deloitte Development LLC. All rights reserved.


Combining Theory & Practice in an
Entrepreneurial Legal World

Module 12 – Bitcoin/Blockchain
Contents

Module Title Duration (min)

Introduction 5

Module 1 – What is Blockchain? 15

Module 2 – When & How Should Blockchain be Used? 20

Module 3 – Solution Architecture 20

Module 4 – Market & Regulatory Environment 10

Conclusion 10

Copyright © 2017 Deloitte Development LLC. All rights reserved. 2


Introduction
What is Blockchain?
Fundamentally a digital ledger system for recording business
transactions and events

Near real time


The blockchain enables the near real time settlement of recorded
transactions, removing friction and reducing risk, but also limiting ability
to charge back or cancel transactions.

Trustless environment
Blockchain technology is based on cryptographic proof, allowing any two
parties to transact directly with each other without the need for a trusted
third-party.

Distributed ledger
The peer-to-peer distributed network records a public history of
transactions. The blockchain is distributed and highly available. The
blockchain retains a secure source of proof that the transaction occurred.

Irreversibility
The blockchain contains a certain and verifiable record of every single
transaction ever made. This mitigates the risk of double-spending, fraud,
abuse, and manipulation of transactions.

Censorship resistant
The crypto-economics built into the blockchain model provide incentives
for the participants to continue validating blocks, reducing the possibility
of external influencers to modify previously recorded transaction records.

Copyright © 2017 Deloitte Development LLC. All rights reserved. 4


Three Innovations Laid the Groundwork for Blockchain’s
Invention

1 2 3
Peer-to-peer network Public key cryptography Proof-of-work

In a peer-to-peer model, every peer Public key cryptography is a method Proof-of-work is a piece of code
in the network is a server and client, for verifying digital identity with a appended to data that validates that
both supplying and consuming high degree of confidence, enabled data’s authenticity and controls when
resources by the use of private and public keys it can be written into the system
Enables the facilitation of a Allows for individual ownership Prevents double spend by
currency without a central, and exchange of bitcoin among ensuring data is recorded
privileged third party users chronologically

Blockchain

The first blockchain was created through


the formation of bitcoin Transaction 1 Transaction 4 Transaction 7 Transaction 10
Transaction 2 Transaction 5 Transaction 8 Transaction 11
In its bitcoin application, a blockchain is a Transaction 3 Transaction 6 Transaction 9 Transaction 12
continuously growing database of transactions,
organized in chronological blocks, that is shared Past Future
between multiple nodes in a network In a blockchain, data is captured chronologically in blocks

Copyright © 2017 Deloitte Development LLC. All rights reserved. 5


Module 2
When and How Should Blockchain
be Used?
When is Blockchain the Right Fit?
There are a handful of requirements that, when met in part or in full,
should indicate whether blockchain will sufficiently address a client’s
needs

Shared Data Structured repository of information

More than one entity generating the transactions


Multiple Writers
that modify the database

Level of mistrust between the entities writing to


Absence of Trust the database (e.g., one user will not accept the
“truth” as reported by another user)

Opportunity for Lack of trusted intermediary or central gatekeeper


Disintermediation to verify transactions

Transaction Interaction or dependency between the


Interaction transactions created by different entities

Copyright © 2017 Deloitte Development LLC. All rights reserved. 7


When is Blockchain Not The Right Fit?
Conversely, there are several factors that, when present, may indicate
that technologies other than blockchain would meet client needs

Technical Reliability System Operators System Users


To what degree can you To what degree can you To what degree can you
trust the system will not trust that those who have trust users to act in the
fail of its own accord (e.g., set up and operate the system’s best interest?
software bug, hardware system will act in the
failure)? To what degree system’s best interest?
can you trust that the
system will not be
compromised through
malicious actions?

As the degree of trust in system actors and confidence in system infrastructure


rises, non-blockchain technologies should be considered

Copyright © 2017 Deloitte Development LLC. All rights reserved. 8


If Blockchain is the Right Solution, What
Are Some Potential Applications?

A blockchain solution can be initiated as a store or transaction record,


but also serve as a fabric for further innovation and value extraction

Description Examples
Low
 Digital certificate of
Create an immutable record without
ownership for physical
Record reliance on a trusted third party (e.g., assets
Keeping financial clearing house, government) while  Transaction validation of digital
Degree of Sophistication

improving efficiency of recordkeeping via assets


automation  Financial accounts

 Domestic and international


• Enable low-cost, near real-time value remittance
Transfer transfer without an intermediary, with the  Internal payments settlement
of Value ability to expand to transfer of assets  Clearing and settlement of
beyond “money” securities
 Exchange of low liquidity assets

• Program protocols to execute transactions  Digital cheques / IOUs


Smart  Automatic financial instruments
Contracts when a set of pre-determined conditions  Parametric insurance contracts
are met  Automated market making

High

Copyright © 2017 Deloitte Development LLC. All rights reserved. 9


Common Use Cases
Numerous use cases for blockchain have already been identified

Cross Border Clearing and


Transfer of Value Payments Digital Identity Settlement

Blockchain can efficiently Blockchain can transfer Blockchain can create an Blockchain shows promise
facilitate transfers on peer- payment across currencies auditable source of to drive efficiency in the
to-peer, business-to- almost instantly for a information shared and clearing and settlement
business, and computer-to- fraction of today’s cost and verified across a network of process of digital assets
computer transactions for provide access to the organizations (e.g., KYC through the use of colored
minimal cost unbanked in remote areas compliance) coins

Multi Party
Provenance Aggregation Record Keeping Smart Contracts

Blockchain offers an Blockchain can be used as a Blockchain provide a Contractual terms and
immutable and irreversible shared master data method for collectively obligations can be
source of information that repository for common recording and notarizing programmed directly into
can track the true industry information any type of data, whose the blockchain, maximizing
ownership of a product allowing members to query meaning can be financial or adherence (e.g., syndicated
across the supply chain the data otherwise loans, derivatives)

Copyright © 2017 Deloitte Development LLC. All rights reserved. 10


Use Case Deep Dive: Cross-Border Payments
One example of our work with a client, a cross-border payments
solution based on Stellar’s blockchain platform
Near Real-Time Experience
Select Enter Payment Confirm Receive
Recipients Amount Transaction Payment
Customer Journey
Description & Enablers

Federation FX Rate Information Encryption / Distributed Notification &


Lookup Pathfinding Handshake Security Ledger Receipt
Resolve Find the most Share rich data Secure Reach Notify
recipient optimal FX rate (e.g., invoice transactions consensus and recipient of
information available on number, using public- confirm incoming
based on network from terms) and sender private key transactions transaction
recipient’s pre-selected / receiver cryptography on the and post
unique address providers information distributed payment to
on blockchain between ledger recipient
network transacting banks account
to pre-authorize
transactions
Copyright © 2017 Deloitte Development LLC. All rights reserved. 11
Moving from POC to Production
The following table highlights some of the important open questions
that will have to be addressed prior to launching a scaled application
for mass use beyond it’s proof of concept stages
# Open Questions to Consider Deloitte Suggestion

Which legal entity will own the


1. A dedicated consortium owned by various stakeholders
platform?
Who will provide the technology
2. Each stakeholder will host at least 1 node
infrastructure?
ITIL processes (service desk, monitoring, config, change,
problem, etc.) will be performed by stakeholders for their
3. Who will operate the platform?
respective nodes and by the consortium via a technology services
application management provider
Where will the ultimate liability
4. With the consortium
reside?
Who will own the source code and
5. The consortium as a legal entity OR the lead platform stakeholder
IP?
Who will be the technical
Technical Steering Committee / Group with members represented
6. authority and recommend
from all stakeholders
technology upgrade and changes?
How will the cost and revenue will A non profit consortium or for profit with distributed allocations to
7.
be allocated? stakeholders participants
Who owns & manages the risks An all stakeholder represented Risk Committee manages and
8.
associated? provides recommendation for risks to Consortium i.e., shared risk
Copyright © 2017 Deloitte Development LLC. All rights reserved. 12
Barriers to Implementation
Challenges related to integration and adoption need to be addressed to
realize potential of blockchain efficiencies
Challenge Description Potential Mitigation

 A critical mass of individuals and organizations would


Market  Higher traction in adoption
need to participate in a Blockchain, or specific
of this use case by big firms
adoption sidechain, to entice enough activity to make it viable
and individual investors
for transactions

Evolving  Blockchain as a technology is still maturing and


 Build with microservices so
various platforms and applications are still evolving. A
Technology your solutions are portable
global standard does not yet exist

Integration  Blockchain infrastructure


with legacy  To realize the full potential of operational benefits that
that supports smooth
Blockchain can offer, it must function in close
systems and linkage between multiple
collaboration with other peripheral systems
processes applications

 Programming a smart contract requires a


determination of the execution of events during the
 Pre-programmed recourse
Contract life of the investment at the onset of a transaction,
mechanisms, to allow for
flexibility and any change in regulations during the life of an
amendments
investment reduces flexibility, unless provisions for an
amendment were incorporated

Legal and  Legal recognition of programmable contracts and  Involving legal stakeholders
digitally transferred assets in the court of law; lack of and identifying and working
regulatory
regulatory bodies approving applications of blockchain with appropriate regualtory
constraints
technology for specific use cases bodies from early stages
Copyright © 2017 Deloitte Development LLC. All rights reserved. 13
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Copyright © 2017 Deloitte Development LLC. All rights reserved.