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Chapter 15: Harvesting the Business Venture Investment 223

Chapter 15

HARVESTING THE BUSINESS VENTURE INVESTMENT

DISCUSSION QUESTIONS AND ANSWERS

1. What is the meaning of harvesting a venture?

Harvesting a venture refers to the process of exiting a privately-held business venture


to unlock the owners’ investment value.

2. What evidence exists as to whether entrepreneurs think about and/or develop


exit strategies?

Holmberg documented that over ½ of entrepreneurs have developed, or at least


though about exit strategies, at the start of their ventures.

3. What are unicorns? How might their exit values be impacted when they go 

public?

Unicorns are high­expected­growth companies with valuations in excess of $1 
billion. 

Such ventures have been questioned for not “going public” or, when they do, doing so
at a price below previous rounds, creating concern that the private valuations in 
excess of $1 billion are inflated.  Planning welcome exits is important even for 
exceptionally well­funded ventures, including the rare unicorns.

4. Describe how the relative value method is used to value a firm’s equity.

      The relative value method estimates a firm’s value by examining how comparable 
firms are valued based on value­related multiples. 

      Comparable firms are firms with lines of business, size, and growth characteristics 
similar to the firm being valued. Multiples­based valuations may be used to value the 
firm’s enterprise value or its direct equity value similar to the application of DCF 
methods.  Analysts often estimate a firm’s enterprise value by calculating multiples of
earnings before interest, taxes, depreciation, and amortization (EBITDA). This works 
because EBITDA gives a “crude” estimate of cash flow available to both debtholders 
and equity holders.
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5. What is a systematic liquidation of a venture? What are some of the advantages


and disadvantages of a systematic liquidation?

A systematic liquidation of a venture is the process of liquidating the firm by


distributing the cash flows of the firm to the owners. This usually happens when the
firm is in the mature stage and their free cash flow exceeds the amount need to
maintain sustainable growth.

Potential advantages include: (1) the entrepreneur and other owners maintain control
throughout the harvest period, (2) the harvesting of the investment value can be
spread out over a number of years, and (3) the time, effort, and cost of finding a buyer
for the venture can be avoided.

Potential disadvantages include: (1) the treatment and taxation of liquidation proceeds
as ordinary income (rather than capital gains), (2) the commitment of the
entrepreneur’s wealth, abilities, and focus to a dying venture, rather than other
venture pursuits that might be more lucrative, and (3) acceleration of the rate of
decline in the going concern value as other industry participants respond to the
reduction in investment.

6. Describe an outright sale of a venture. What are the four categories of possible
buyers?

An outright sale of a venture occurs when it is sold to others. The four categories of
outside buyers in an outright sale are family members, managers, employees, or
external buyers.

7. Describe what is meant by (a) a leveraged buyout (LBO), and (b) a


management buyout (MBO).

An LBO occurs when a firm is bought out by investors who finance the majority of it
with debt. An MBO is a type of LBO with the managers’ being a large part of the
equity investors.

8. What is an employee stock option plan (ESOP)? How is an ESOP used to buy
out a venture?

An ESOP is typically a benefit plan where employer and employee contributions are
combined with debt to purchase a venture’s equity. If the ESOP plan is sufficiently
large in a mature firm, it can possibly take the role of the majority equity investor in
the venture after venture investors have exited.

9. Describe the terms (a) “control premium” and (b) “illiquidity discount” when
discussing possible external or outside buyers of a venture.
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(a) A control premium is an additional dollar or percentage value on top of the base
value of the firm for the advantage of being able to control the firm instead of being a
minority shareholder.

(b) An illiquidity discount is a decrease in the price paid for unregistered shares that
cannot be easily sold or transferred.

10. Describe an initial public offering (IPO). What are the differences between a
primary offering and a secondary offering?

An IPO is the first public sale of a venture’s equity ownership. The primary offering
refers to the sale of new shares to their first owners. A secondary offering is the sale
of shares previously owned by others (typically founders and those still owning
shares from the time when the venture was privately held).

11. What is investment banking? What is an underwriting spread?

Investment banking facilitates the issue of new securities by creating markets for a
firm’s security.

An underwriting spread is the difference between the price paid in the market for the
new security and the amount given to the issuing firm. It is the investment bank’s
commission for creating the deal.

12. Describe the terms “tombstone ad” and “red herring disclaimer.”

A tombstone ad is an SEC requirement and an advertisement used to notify the public


of an upcoming offering,

A red herring disclaimer is a required statement on the tombstone ad (or elsewhere)


notifying the public that the ad (or preliminary prospectus) is not an offer to purchase
or a solicitation of an offer to buy. It also notifies the reader that the actual offer can
only be made upon delivery of the final prospectus.

13. What is meant by due diligence? How does a traditional registration differ from
a shelf registration?

Due diligence is the process whereby an investment bank investigates an issuing


company’s financial condition and investment intent.

A traditional registration specifies details ahead of time including date, price range
and underwriter, while the shelf registration procedure allows the firm more
flexibility by issuing within a two year period.
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14. When an investment banking firm decides whether to underwrite or market a


securities issue, what is meant by a firm commitment and best efforts?

A firm commitment by an investment bank means that the bank will purchase the
security issue and then resell it in the market.

A “best efforts” by an investment banking firm is when they only provide marketing
and distribution efforts but do not guarantee a certain price.

15. Describe the two following terms that may be involved in underwriting a new
securities issue: (a) green shoe and (b) lockup provision.

A green show provision is a contract option for the investment bank to sell more
shares than allotted in the underwriting if the issue is broadly oversubscribed.

A lockup provision prohibits insiders in the company from selling their shares during
a certain period of time after the initial offering.

16. What is meant by initial public offering (IPO) underpricing?

IPO underpricing is when the offering price by the syndicate is lower than the first
trade in the secondary market or more generally under the prices during the first day
of trading.

17. Briefly describe how securities are traded on an organized stock exchange such
as the New York Stock Exchange.

Organized exchanges have specialized geographic (or electronic) places where


trading in a given security takes place. The official designation of “stock exchange”
within the U.S brings the trading venue under the regulatory authority of the SEC.
Typically such exchanges have publicly posted listing requirements, specific types of
orders (e.g. “market” and “limit”), standards for order processing and clearing, and
rules for maintaining orderly markets. Typically an individual places an order with a
broker who is a member of an exchange and who assumes responsibility for
executing and clearing the order according to the exchange’s rules.

18. Indicate some of the differences between the NASDAQ’s National Market System
and SmallCap listing requirements.

One listing option for IPOs is the National Association of Securities Dealers (NASD)
Automated Quotation (NASDAQ) system.

[Note: The NASDAQ no longer uses the terms National Market System and
SmallCap listing requirements.] Tables 15.1 and 15.2 now provide NASDAQ Global
Market Initial Listing Requirements and NASDAQ Capital Market Initial Listing
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Requirements. Differences exist in terms of stockholders’ equity and market value of


publicly held shares. Similarities exist in terms of bid price, publicly held shares, and
market makers.

19. Describe some of the preparations that a venture can undertake that may
increase the possibility of IPO success.

Typical preparations for an IPO include, but are not limited to: (i) cleaning up
confusing financing and compensation arrangements, (ii) clarifying the main business
strategy; (iii) eliminating potentially annoying special arrangements with insiders;
(iv) arranging for 2 years of audited financial statements by a major accounting firm;
(v) preparation for the scrutiny of ongoing research by establishing formal
communication channels for external dissemination of corporate news; and (vi)
establishing an investor relations function.

20. What are the steps or stages in a “typical” execution and time line schedule used
in planning and executing an IPO?

The execution and time line include:


1. Organization Meeting and Due Diligence
2. Drafting and attendant Activities
3. Initial 30-day SEC Review
4. Premarketing
5. Marketing
6. Pricing and Closing

21. From the Headlines – Tesla: Comment on Tesla’s trip from incorporating in 2003 to
its IPO in 2010. What impact do you think the IPO had on competitors in the
electric car market?

Answers will vary: The trip has been a bumpy one and the road ahead is full of large
potholes. Scaling into competitive manufacturing will remain a challenge. There
are many competitors and close substitutes (for example hybrids and cars that run on
cleaner burning, more widely available fuels). As the updated story indicates the
market is growing with multiple brands and approaches. It is not clear that the IPO
forestalled competitors, including those subsidized by foreign governments. There
appears to be a continuing bumpy road ahead.
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