PRACTICE PROBLEMS AND ANSWERS 389

10.14 Based on its growth prospects, a private investor values a local bakery at $750,000.
She believes that cost savings having a PV of $50,000 can be achieved by changing
staffing levels and store hours. She believes the appropriate liquidity discount is
20%. A recent transaction in the same city required the buyer to pay a 5% premium
to the average price for similar businesses to gain a controlling interest in a bakery.
What is the most she should be willing to pay for a 50.1% stake in the bakery?
Answer: $336,672.
10.15 You have been asked by an investor to value a restaurant. Last year, the restaurant
earned pretax operating income of $300,000. Income has grown 4% annually during
the last 5 years, and it is expected to continue growing at that rate into the
foreseeable future. The annual change in working capital is $20,000, and capital
spending for maintenance exceeded depreciation in the prior year by $15,000. Both
working capital and the excess of capital spending over depreciation are projected to
grow at the same rate as operating income. By introducing modern management
methods, you believe the pretax operating income growth rate can be increased to
6% beyond the second year and sustained at that rate into the foreseeable future.
The 10-year Treasury bond rate is 5%, the equity risk premium is 5.5%, and the
marginal federal, state, and local tax rate is 40%. The beta and debt-to-equity ratios
for publicly traded firms in the restaurant industry are 2 and 1.5, respectively. The
business’s target debt-to-equity ratio is 1, and its pretax cost of borrowing, based on
its recent borrowing activities, is 7%. The business-specific risk premium for firms of
this size is estimated to be 6%. The liquidity risk premium is believed to be 15%,
relatively low for firms of this type due to the excellent reputation of the restaurant.
Since the current chef and the staff are expected to remain when the business is sold,
the quality of the restaurant is expected to be maintained. The investor is willing to
pay a 10% premium to reflect the value of control.
a. What is free cash flow to the firm in year 1? Answer: $150,800
b. What is free cash flow to the firm in year 2? Answer: $156,832
c. What is the firm’s cost of equity? Answer: 20.2%
d. What is the firm’s after-tax cost of debt? Answer: 4.2%
e. What is the firm’s target debt-to-total capital ratio? Answer: 0.5
f. What is the weighted average cost of capital? Answer: 12.2%
g. What is the business worth? Answer: $2,226,448.
Solutions to these practice exercises and problems are available in the Online
Instructor’s Manual for instructors using this book.

END OF CHAPTER CASE STUDY:

SHELL GAME: STK STEAKHOUSE CHAIN GOES
PUBLIC THROUGH A REVERSE MERGER
Case Study Objectives: To Illustrate
• Some of the motivations for “going public”
• The mechanics of reverse mergers
• Risks and rewards associated with reverse mergers.

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390 10. ANALYSIS AND VALUATION OF PRIVATELY HELD FIRMS

Introduction
With growth slowed by limited resources, a robust stock market, and intensifying investor
interest in high-end restaurant dinning chains, One Group LLC, the owner of steakhouse
chain STK faced a critical decision. Should the firm go public now and dilute their owner-
ship stake or continue to rely on their financial resources and risk missing an opportunity to
enter the public stock market? This is a choice commonly faced by fast growing successful
privately held firms.
One Group is a hospitality holding company that develops and operates upscale restaurants
and lounges. It opened its first restaurant in New York City in 2004. Its primary brand is STK.
Managing member,a Jonathan Segal, owns about 35% of the firm and has additional ownership
stakes in subsidiaries operated by the holding company. With annual revenue of more than $130
million (up from $6 million in 2006), STK is a New York-based steakhouse restaurant that mar-
kets itself to women with the mantra “STK is not your daddy’s steakhouse.” In a departure from
steakhouses typically serving huge steaks, STK focuses on serving smaller portions to its targeted
female clientele. STK has seven locations in major metropolitan areas and a hospitality business
providing food service for restaurants, bars, and hotels. STK plans locations in Washington, DC,
Chicago, Dubai, London, and Montreal. Longer term, the firm intends to launch a chain of
smaller, less expensive restaurants under the name Rebel STK. To realize these objectives, One
Group knew it needed additional funding.

The Decision
The timing appeared to be right. The broad stock market indices were up by almost 30%
during the first 9 months of 2013 over the same period the prior year. Niche high-end restaurant
chains appeared to be in vogue. In mid-2013, Del Frisco’s Restaurant Group undertook an IPO at
$13 per share. Since then its shares have risen by 40%. In early October 2013, hedge fund
Barrington Capital took a 2.8% stake in Darden Restaurants Inc. urging the dining conglomerate
to separate its faster growing Capital Grille and Eddie V’s from its larger restaurant chains
through spin-offs or divestitures.
Committed Capital Acquisition Group (CCAC), a special purpose acquisition company
(SPAC), seemed to offer an immediate vehicle for entering the public stock market. SPACs are
shell or so-called blank-check companies that have no operations but which raise funds through
an initial public offering with the intention of merging with or acquiring companies. SPACs often
raise additional funds by issuing warrants enabling investors to buy additional shares in the
SPAC at a later date at a preset price.b On October 16, 2013, One Group LLC merged with
CCAC in a deal that converted the privately held firm to a public company in which CCAC
investors paid One Group owners a combination of CCAC common shares and cash. The merger
occurred simultaneously with a private equity placement (often referred to as private investment
in public equity) to raise cash.
The investors valued the deal at $5 per share giving the firm a market value of about $118
million or as much as $147 million if warrants are exercised before expiration. Warrants are

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 PRACTICE PROBLEMS AND ANSWERS 391

issued by firms and grant their holders the option but not the obligation to buy stock in the
issuing firm at a predetermined price during some future time period. The shares initially traded
over the counter, although the longer term objective is to list the firm on the NASDAQ Stock
Exchange. The cash will initially be used to open new restaurants, retire existing debt, and to
buy out minority investors in individual restaurants.

The Process
The combination of One Group and CCAC involved a process called a reverse merger. To
undertake a reverse merger, a firm finds a shell corporation with relatively few shareholders
who are interested in selling their stock. The shell corporation’s shareholders often are interested
in either selling their shares for cash, owning even a relatively small portion of a financially
viable company to recover their initial investments, or in transferring the shell’s liabilities to new
investors. Alternatively, the private firm may merge with an existing special purpose acquisition
company already registered for public stock trading.
In a merger, it is common for the surviving firm to be viewed as the acquirer, since its
shareholders usually end up with a majority ownership stake in the merged firms; the
other party to the merger is viewed as the target firm as its former shareholders often hold
only a minority interest in the combined companies. In a reverse merger, the opposite
happens. Even though the publicly traded shell company survives the merger with the pri-
vate firm becoming its wholly owned subsidiary, the former shareholders of the private firm
end up with a majority ownership stake in the combined firms. While conventional IPOs can
take months to complete, reverse mergers can take only a few weeks. Moreover, as the reverse
merger is solely a mechanism to convert a private company into a public entity, the process is
less dependent on financial market conditions because the company often is not proposing to
raise capital.
In recent years, private equity investors have found the comparative ease of the reverse
merger process convenient, because it has enabled them to take public their investments in both
domestic and foreign firms. The story of the rapid growth of Chinese firms has held considerable
allure for investors prompting a flurry of reverse mergers involving Chinese-based firms. With
speed comes additional risk. Shell company shareholders may simply be looking for investors to
take over their liabilities such as pending litigation, safety hazards, environmental problems, and
unpaid tax liabilities. To prevent the public shell’s shareholders from dumping their shares
immediately following the merger, investors are required by US law to hold their shares for a
specific period of time following closing.
What follows is a description of a reverse merger with a shell corporation. The shell corpora-
tion in this instance is a SPAC established by the investment group Committed Capital
Acquisition Corporation (CCAC) through an initial public offering in 2011. The expressed
purpose of the SPAC, which holds only cash raised from the public offering and its own com-
mon shares, is to acquire operating companies. SPAC shareholders make money when the SPAC
liquidates through a public offering or sale to strategic investors at a later date.

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392 10. ANALYSIS AND VALUATION OF PRIVATELY HELD FIRMS

The Deal
On October 16, 2013, CCAC, a publicly traded Delaware Corporation, agreed to merge its
wholly owned CCAC Acquisition Sub (Merger Sub) into One Group LLC. CCAC had created
Merger Sub transferring cash and its common shares in exchange for all of Merger Sub’s shares.
One Group was the surviving legal entity of the merger. As such One Group became a wholly
owned subsidiary of CCAC (Figure 10.1).
Simultaneously, CCAC issued 12.6 million shares of its common shares having a par value of
$0.0001 per share plus $11.8 million in cash for their ownership interest (membership interest) in
One Group LLC. CCAC also issued 1 million common shares to the former managing member
of One Group, Jonathan Segal, as a control premium. These shares are in addition to the 7.7
million common shares issued to Mr. Segal for his ownership stake in One Group and his inter-
est in certain One Group operating subsidiaries.
The total merger consideration paid to One Group owners was $118.4 million consisting of
shares with a market value of $106.6 plus cash of $11.8 million. Warrants set to expire 2 years
from the date of closing to purchase 5.8 million in new common shares with an exercise price of
$5 per share could boost the merger consideration to as much as $147 million.
Committed Capital Acquisition Corporation announced the change in its ticker symbol
(CCAC) to STKS. The common shares trade under that symbol over the counter. The firm’s
name also was subsequently changed to The One Group, Inc.
Coinciding with the closing date, CCAC completed a private placement of 3.1 million
common shares at a purchase price of $5 to investors consisting of some CCAC’s existing
shareholders realizing proceeds of $15.5 million. In connection with the private placement,
CCAC agreed to register the shares with the Securities and Exchange Commission within 120
days of closing. This activity is sometimes called private investment in public equity or PIPE
financing.

Committed Capital
Acquisition Corporation One Group becomes One Group LLC
(The Company) wholly owned CCAC sub
membership interests

Cash &
CCAC Merger sub
common shares
shares Cash & CCAC
common shares

CCAC Acquisition Sub

(Merger Sub)

FIGURE 10.1 Reverse merger process.

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 PRACTICE PROBLEMS AND ANSWERS 393

Companies that become public through a reverse merger with a shell company are not
permitted to list on a major public securities exchange until certain conditions have been satis-
fied. The new firm must complete a 1-year “seasoning period” in the United States by trading
over the counter market or another regulated US or foreign stock exchange following a reverse
merger and be registered with the SEC. The shares must maintain a minimum share price
required by the exchange for a sustained period for at least 30
60 trading days.

Concluding Comments
One Group had the choice of remaining private or taking STK public. Each ownership
structure has its pros and cons. For example, after 20 years as a publicly traded company, Dell
Inc. converted from to a private corporation. While gaining access to additional capital, STK will
face new challenges as a public company. To go public, One Group chose a reverse merger from
a range of options. While sometimes effective, reverse mergers often create more problems than
alternative strategies.

Discussion Questions
1. What are common reasons for a private firm to go public? What are the advantages and
disadvantages or doing so? Be specific.
2. What are corporate shells, and how can they create value? Be specific.
3. What were the options available to One Group LLC to raise capital to finance their expansion
plans?
4. Discuss the pros and cons of each. Be specific.
5. Discuss the pros and cons of a reverse merger versus an IPO.
6. Why is it likely that shares trade at a discount from their value when issued if investors
attempted to sell such shares within 1 year following closing of the reverse merger?
7. What is the purpose of One Group ultimately listing of a major stock exchange such as
NASDAQ?
Solutions to this case are provided in the Online Instructor’s Manual available for instructors using
this book.
a
Limited liability company owners are called members. The managing member is organizationally equivalent to a
chief executive officer.
b
SPACs and reverse mergers are similar in that they both use shell companies to take private firms public.
However, they differ in how they are created. In a SPAC, a shell is created and funded through an IPO with the
specific intent of acquiring or merging with a private firm. With a reverse merger, a private firm is merged into an
existing publicly listed shell company as a means of taking the private firm public. For a detailed discussion of
SPACs and reverse mergers, see Cumming et al., 2014.

III. MERGERS AND ACQUISITIONS VALUATION AND MODELING