E N T R E P R E N E U R I A L F I N A N C E

FENCHEL LAMPSHADE COMPANY

Maria ChekulaevaCorina Fendrihan

Chris KleijneRodica Timotin

Lionel Uijttenhove

SUMMARY OF FACTSTRANSACTION

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Discussion starts Deal breaks Negotiations restoreBlack Monday

Fenchel Family Steve & Michele RogersFenchel Lampshade Company

• “Emotional” deal from both the seller and the buyer sides

SELLER• Fenchel family (Ken, his uncle and

aunt)• Founded by Ken’s uncle in 1926• Operated by Ken alone for the past 5

years• Desire to retire but no real pressure

BUYER• Successful HBS MBA graduates• Dream of owning a business• Experienced a couple of unsuccessful

attempts in acquiring a company

TIMELINE OF THE DEAL

SUMMARY OF FACTSFENCHEL LAMPSHADE COMPANY

• Premium quality segment ($20 million)• total market $70 million in 1985 growing at 5% p.a. since 1972

• Strong cash flows• turnover of approximately $1 million• cash flow margins of 15% to 30%• low growth rate (1.3% p.a.) because of no aggressive strategy

• Loyal and diversified customer base• 65 accounts: department stores, retail stores, showrooms and few lamp manufacturers (2% of

sales)• largest customer Marshall Fields yields 10% of sales• 60% sales to upscale department stores, where they are monopolists• strong reputation and high-quality hand-made products with no discounts

• Experienced and dedicated employees• 18 ethically diversified employees (13 are African American)• 10 employees are older than 50 years old• Fenchel management will continue their positions

• Low competition• 34 manufacturers in USA• competition is regional (NY/New Jersey) due to high transportation costs

Q1. THE FINANCING PLANOVERVIEW

• Proposed financing plan creates a highly levered company => debt overhang and risk shifting• Financed by government institutions => add value• Seller financing => mechanism to guarantee family commitment

DEBT FINANCING

  Principal Maturity (years) Interest Rate Annual

InterestPrincipal

RepaymentSBA Loan (government agency) $300 000   10.33% $30 990  

City of Chicago $100 000 5 6.25% $6 248 $20 000 State of Illinois $50 000 5 5.00% $2 500 $10 000 Fenchel Family (note) $75 000 5 10.00% $7 500 $15 000 Fenchel Trade Debt $105 000      TOTAL DEBT $630 000     $47 238 $45 000 EQUITY FINANCING

  Amount Redemption period Dividend Rate Annual

Dividend Equity stake

MESBIC/SBIC (Preferred Stock) $115 000 after 3 years 9.00% $10 350 15% −− 25%Steve and Michele Rogers $50 000       85% −− 75%TOTAL EQUITY $165 000     $10 350  

Q1. THE FINANCING PLANSHORT-TERM PERSPECTIVE

Feasibility of repaying loans attracted through initial financial plan •Following the pro forma projections ICR are high and DSR are above 1 for both scenarios, therefore, there should be no problems repaying debt?•“Selling pro formas” perhaps driven by overoptimistic assumptions and ambitious estimates of the entrepreneur, therefore, a more conservative scenario is a more probable one

INTEREST COVERAGE RATIOS (ICR) AND DEBT SERVICE RATIOS (DSR)

Excluding repayment of MESBIC financing Including repayment of MESBIC financing 1988F 1989F 1990F Average 1988F 1989F 1990F Average

BEST Case Scenario BEST Case ScenarioEBIT $230 000 $330 000 $430 000   $230 000 $330 000 $430 000  ICR 4.87 6.99 9.10 6.99 3.99 5.73 7.47 5.73 DSR 2,49 3.58 4.66 3.58 2.24 3.22 1.98 2.48

WORST Case Scenario WORST Case ScenarioEBIT $159 000 $168 000 $177 000   $159 000 $168 000 $177 000  ICR 3.37 3.56 3.75 3.56 2.76 2.92 3.07 2.92 DSR 1.72 1.82 1.92 1.82 1.55 1.64 0.81 1.33 1984 1985 1986 1987

  HISTORICAL RatiosEBIT -$20 771 -$9 291 $19 379 $108 366ICR -0.44 -0.20 0.41 2.29DSR -0.23 -0.10 0.21 1.17

Q1. THE FINANCING PLANLONG-TERM PERSPECTIVE

•Current loans are one-time loans provided under specific conditions. In order to fuel further growth new standard bank loans will be required. •No guaranteed access to additional capital in the future to sustain projected growth

WORST Case Scenario BEST Case Scenario1987 1988F 1989F 1990F 1987 1988F 1989F 1990F

EBIT (pro forma)

$159 000 $168 000 $177 000 $230 000 $330 000

$430 000 Debt payments (estimated) $92 238 $92 238 $92 238 $92 238 $92 238 $92 238 Net income $122 426 $66 762 $75 762 $84 762 $122 426 $137 762 $237 762 $337 762 Dividends $10 350 $10 350 $10 350 $10 350 $10 350 $10 350

Equity Reinvestment Rate 84% 86% 88% 92% 96% 97%

Implied growth rate in Net Income 35% 36% 36% 38% 39% 40%

Growth rate in net income -45% 13% 12% 13% 73% 42%

Implied ROE -54% 16% 14% 14% 76% 43%

ROE 1986 27%ROE 1987 55%Average ROE 1986-1987 41%

Q2. SMALL BUSINESS ASSOCIATION (SBA) LOAN

Section 8a nowadays: “small businesses owned and controlled by individuals certified as socially and economically disadvantadged”

Steven and Michele as an Afro-American married couple can be seen as the owners of a minority small businness.

“Small Business Act (SBA) (section 8a) is seeking set aside requirements and competitive procurements and competitive procurement opportunities on

behalf of Illinios minority small businness”

Q2. CONDITIONS

Pros:

• The loan has the highest interest rate (10.33%)• The loan is classified as senior debt, while other

loans are subordinated• Up to 85% of the loan is guaranteed by the

state, so the risk is significantly diminished• Fenchel family stays committed to the company

due to their loan of $75,000 to the company. This loan is classified as lowest subordinated loan to the company

• The City of Chicago and the State of Illinois provide a subordinated loan with interest rates below the prime rate

• Collateral: Assets of Fenchel Lampshade Company and personal guarantee of company’s new owners, Steven and Michele Rogers

Cons:

• No maturity known or principal repayment scheme (website: “once certified, a firm is approved for program participation for nine years following notificationof approval”)

• Leverage of the company is very high! Equity is only 17% of total assets (See ‘leverage’)

• Collateral: Company’s assets suitable as collateral are lower than loan. Projected fixed assets + merchandise inventories = $155,000. while there is no information available regarding the personal capital of Steven and Michele

• The projections realized by the buyers are highly optimistic

Q2. CONCLUSION UPON SBA LOAN

SBA would agree to provide the loan to the

Fenchel Lampshade Company

Cons are not extraordinary for people who start

having their own business

Steven and Michele qualify for a minority

advancement plan

Q3. GROWTH ASSUMPTIONS USED FOR FINANCIAL PROJECTIONS

• Only assumption used for the projections is growth in Net Sales, which is

then linked to the elements of the Income Statement/ Balance Sheet to get

projected values for all elements

• Even though they accounted for “best” and so-called “worst” case

scenarios, the best case – highly optimistic, the worst case – still more

optimistic than historical values

Average Historical

Growth Projected growth

Best case scenario

1984-1987 1988 1989 19909% 57% 33% 25%

Average Historical Growth

Projected growth Worst case scenario

1984 - 1987 1988 1989 19909% 15% 9% 8%

Q3. FINANCIAL STATEMENT COMPONENTS AS % OF SALES

• In the Income Statement • In the Balance Sheet

   Historical average

Best case scenario

Worst case scenario

Materials/sales 38% 37% 37%Direct labor/sales 13% 13% 13%Other costs/ sales 3% 4% 4%

Total expenses/sales 32% 27% 27%Owners' salary/sales 12% 3% 5%Operating profit/sales 2% 16% 14%

 Historical average

Best case

scenario

Worst case scenario

Cash/sales 4% 1% 1%Accounts receivable/sales 9% 9% 9%Merchandise inventories/sales 7% 7% 7%

Accounts payable/sales 7% 7% 9%Other expenses/sales 6% 5% 5%

Q3. KEY GROWTH DRIVERS

Streamlining the advertising methods

(specialized trade shows, product catalog, advertising program with department stores, advertising in

specific journals)

Expanding the customer base

Increasing demand

(current and anticipated expansion of their biggest

client -Marshall Field’s department store)

Q3. KEY GROWTH DRIVERS

Expanding the

customer base

Types

new accounts

unexploited accounts in the Midwest

new categories of customers

Strategy

contracts with high end hotels, colleges, hospitals, the government, interior design companies, mail order

catalogs

Hiring and training more manufacturing representatives=> ↑ in independent lamp and lampshade retail stores and

lighting showrooms(2 groups of customers with high growth in wealthy suburbs)

collaboration with premium lamp manufactures (industry with sales > $2 billion, only 2 lamp manufacturers make their own lampshades)

minority supplier programs: sell to corporations that are looking to buy from minority-owned

businesses

the Set Aside Program: sell to local, state and government agencies

minority vendor programs: sell to more department stores (with the help of the Black Retailers Action

Group)

Q3. MAJOR RISKS (1)

• Restrictions on cash flows, and therefore on investments• Difficulty in raising additional funds needed for the aggressive growth

Debt overhang

• The sellers are highly emotional• A reason for the customers’ loyalty could be the long term relationship with the

family• Customers might mostly associate the company with the family’s strategy

Family business

•The focus of the company is on high quality products, i.e. high dependency on specialized personnel•The employees might have a stronger commitment to the family than to the company itself•Since there are only 18 employees (67% over 40 years and soon to be retired) there is a high probability of soon needing new personnel, which can be costly

Employees

• The non-compete clause expires in five years, period during which the company will be focused on repaying its debt

• Though the chance of new entrance in the Midwest region is small and the threat of the NY/NJ manufacturers is small due to the high transportation costs, the previous owners could use their life-long established business relations and knowhow to found/help found a competing company

Competition

Q3. MAJOR RISKS (2)

• It is possible for two HBS graduates not to have enough experience for running a small manufacturing company

• Steven and Michele might be too eager to own a company, so they underestimate their managerial capacity

Management Know-how

• There is always the risk of adverse selection considering that the insiders have better information about the company than the buyers

• Due to this bias, the projections made by Steve and Michele can be overoptimistic

• The risk is especially big considering the fact that it’s a small, old family-owned business

Information risk

•Since most of the interest rates on the loans the company raised are anchored to the prime rate, any volatility in the latter constitutes a risk to the company

Macroeconomic risk

• Even though Steve and Michele have long term plans regarding this investment, they should still have in mind an exit strategy in case they didn’t factor in some potential risks; the two don’t seem to have thought about it

Exit strategy

• Largest orders come from a limited customer base (large department stores): if one/more of their major clients would end the contract or they take part in a consolidation process, it would lead to large decrease in sales

Customers

Q3. MITIGATING RISKS

Smoothen the management transfer- it will maintain customers’ and employees’ loyalty

Run a thorough Due Diligence- It will decrease the information risk

Keep family involved- It will reduce information risk and facilitate attracting

financiers

Consider an exist strategy- In case of a true worst case scenario, the two should consider how they can recover part of their investment

Q4. QUESTIONS FOR DISCUSSION

1. Is $795,000 a reasonable price for Fenchel Lampshade?

2. Can Steve and Michele be good managers in a small company in a sector they do not know considering their lack of experience?

3. What do you think of the losses Fenchel made in 1984 and 1985?

Q4.1 PRICE OF THE DEAL - MULTIPLES

(1986) Market to Book PE ratio Debt/Assets

Fenchel Lampshade 3.59 41.02 82.89%Average in manufacturing industry 1.98 20.30 27%       

Barry Wright 1.37 18.70 4.39%

Bush Industries 2.69 13.49 55.61%

GF Corp 0.64 58.33 33.38%

Knoll International 1.88 20.95 42.86%

Newell Companies 1.56 12.44 18.98%

Shelby Williams INDS 3.33 18.89 26.13%

Hillenbrand Industries 3.14 18.27 24.05%

Interlake Group 1.78 14.36 22.75%

Tab Products 2.20 17.50 1.37%

Virco Manufacturing 1.25 10.04 39.81%

Q4.2 MANAGEMENT KNOWLEDGE

Steve’s Background

• Work experience as a manager, business analyst purchasing agent and consultant therefore having experience in negotiations and financial analysis

• He managed eight unionized employees• While working for Bain and Company, he worked for

consulting assignments in the manufacturing industry• He developed and implemented performance

improvement strategies

Q4.3 LOSSES IN 1984-1985

Fenchel 1984 1985 1986 1987Partners' salaries/Income before partners' salaries

128% 111% 83% 46%

Profit margin * 10% 11% 14% 21%Profit margin -1% -0.02% 3% 13%*Income before partners' salaries        Profit margin (Manufacturing Industry)    Barry Wright - 5% 4% 4%Bush Industries - 4% 4% 6%GF Corp - 0.3% 1% -3%Knoll International - 6% -3% 1%Newell Companies - 5% 6% 5%Shelby Williams INDS - 7% 7% 6%Hillenbrand Industries - 6% 8% 8%Interlake Group - 3% 4% 7%Tab Products - 5% 6% 5%Virco Manufacturing -  2% 2% -2%Industry average - 5% 3.8% 3.7%

1984 1985 1986 1987

-2%

0%

2%

4%

6%

8%

10%

12%

14%

-30000

20000

70000

120000

170000

220000

Income before partners' salaries

Partners' salaries

Fenchel

Industry av-erage