FENCHEL LAMPSHADE COMPANY

ENTREPRENEURIAL FINANCE
Maria Chekulaeva Corina Fendrihan Chris Kleijne Rodica Timotin Lionel Uijttenhove

SUMMARY OF FACTS
TRANSACTION
Fenchel Family Fenchel Lampshade Company Steve & Michele Rogers

Emotional deal from both the seller and the buyer sides
Fenchel family (Ken, his uncle and aunt) Founded by Kens uncle in 1926 Operated by Ken alone for the past 5 years Desire to retire but no real pressure
Discussion starts

SELLER

BUYER

Successful HBS MBA graduates Dream of owning a business Experienced a couple of unsuccessful attempts in acquiring a company

TIMELINE OF THE DEAL

350 325 300 275 250 225 200

Black Monday

Deal breaks

Negotiations restore

S&P 500

Aug 20, 1987

May 27, 1987

Sep 11, 1987

Feb 6, 1987

Apr 13, 1987

Dec 7, 1987

Apr 15, 1988

May 27, 1988

Oct 23, 1987

May 5, 1987

Oct 2, 1987

Jan 16, 1987

Jun 17, 1987

Mar 23, 1987

Jan 20, 1988

Nov 13, 1987

Dec 29, 1987

Feb 10, 1988

Mar 24, 1988

May 6, 1988

Jul 30, 1987

Mar 2, 1987

Jul 9, 1987

Mar 3, 1988

FENCHEL LAMPSHADE COMPANY

Premium quality segment ($20 million) Strong cash flows
total market $70 million in 1985 growing at 5% p.a. since 1972 turnover of approximately $1 million cash flow margins of 15% to 30% low growth rate (1.3% p.a.) because of no aggressive strategy 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 18 ethically diversified employees (13 are African American) 10 employees are older than 50 years old

SUMMARY OF FACTS

Loyal and diversified customer base

Experienced and dedicated employees

Low competition

Fenchel management will continue their positions

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

Q1. THE FINANCING PLAN

OVERVIEW
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 Maturity (years) 5 5 5 Principal Repayment $20 000 $10 000 $15 000 $45 000 Equity stake 15% 25% 85% 75%

DEBT FINANCING Principal SBA Loan (government agency) City of Chicago State of Illinois Fenchel Family (note) Fenchel Trade Debt TOTAL DEBT EQUITY FINANCING Amount MESBIC/SBIC (Preferred Stock) Steve and Michele Rogers TOTAL EQUITY $115 000 $50 000 $165 000 Redemption Dividend Rate period after 3 years 9.00% Annual Dividend $10 350 $300 000 $100 000 $50 000 $75 000 $105 000 $630 000 Interest Rate Annual Interest 10.33% 6.25% 5.00% 10.00% $30 990 $6 248 $2 500 $7 500 $47 238

$10 350

Q1. THE FINANCING PLAN

SHORT-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 Scenario $230 000 $330 000 $430 000 $230 000 $330 000 $430 000 EBIT 4.87 6.99 9.10 3.99 5.73 7.47 ICR 6.99 5.73 2,49 3.58 4.66 2.24 3.22 1.98 DSR 3.58 2.48 WORST Case Scenario WORST Case Scenario $159 000 $168 000 $177 000 $159 000 $168 000 $177 000 EBIT 3.37 3.56 3.75 2.76 2.92 3.07 ICR 3.56 2.92 1.72 1.82 1.92 1.55 1.64 0.81 DSR 1.82 1.33 1984 1985 1986 1987 HISTORICAL Ratios -$20 771 -$9 291 $19 379 $108 366 EBIT -0.44 -0.20 0.41 2.29 ICR -0.23 -0.10 0.21 1.17 DSR

Q1. THE FINANCING PLAN

LONG-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 Scenario 1987 1988F 1987 1989F 1990F 1988F 1989F 1990F EBIT (pro forma) Debt payments (estimated) Net income Dividends Equity Reinvestment Rate Implied growth rate in Net Income $159 000 $92 238 $122 426 $66 762 $10 350 84% 35% $168 000 $92 238 $75 762 $10 350 86% 36% $177 000 $230 000 $330 000 $430 000 $92 238 $92 238 $92 238 $92 238 $84 762 $122 426 $137 762 $237 762 $337 762 $10 350 $10 350 $10 350 $10 350 88% 36% 92% 38% 96% 39% 97% 40%

Growth rate in net income

Implied ROE ROE 1986 ROE 1987 Average ROE 1986-1987

-45%
-54% 27% 55% 41%

13%
16%

12%
14%

13%
14%

73%
76%

42%
43%

Q2. SMALL BUSINESS ASSOCIATION (SBA) LOAN

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

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

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

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 companys 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: Companys 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 1984-1987 9% Projected growth Best case scenario 1988 1989 1990 57% 33% 25% Average Historical Growth 1984 - 1987 9% Projected growth Worst case scenario 1988 1989 1990 15% 9% 8%

Q3. FINANCIAL STATEMENT COMPONENTS AS % OF SALES

In the Income Statement
Historical Best case Worst case average scenario scenario Cash/sales Accounts receivable/sales Merchandise inventories/sales Accounts payable/sales Other expenses/sales

In the Balance Sheet

Historical average 4% 9% 7% 7% 6% Best Worst case case scenario scenario 1% 9% 7% 7% 5% 1% 9% 7% 9% 5%

Materials/sales Direct labor/sales Other costs/ sales

Total expenses/sales Owners' salary/sales Operating profit/sales

38% 13% 3%
32% 12% 2%

37% 13% 4%
27% 3% 16%

37% 13% 4%
27% 5% 14%

Q3. KEY GROWTH DRIVERS

Streamlining the advertising methods

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

Increasing demand
(current and anticipated expansion of their biggest client -Marshall Fields department store)

Expanding the customer base

Q3. KEY GROWTH DRIVERS

new accounts unexploited accounts in the Midwest new categories of customers

Types

Expanding the customer base

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)

Strategy

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)

Debt overhang
Restrictions on cash flows, and therefore on investments Difficulty in raising additional funds needed for the aggressive growth 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 familys strategy 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 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

Family business

Employees

Competition

Q3. MAJOR RISKS (2)

Management Know-how 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 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 its a small, old family-owned business 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 Even though Steve and Michele have long term plans regarding this investment, they should still have in mind an exit strategy in case they didnt factor in some potential risks; the two dont seem to have thought about it 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

Information risk

Macroeconomic risk Exit strategy

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) Fenchel Lampshade Average in manufacturing industry
Barry Wright Bush Industries

Market to Book 3.59 1.98

1.37 2.69

PE ratio 41.02 20.30

18.70 13.49

Debt/Assets 82.89% 27%

4.39% 55.61%

GF Corp
Knoll International Newell Companies Shelby Williams INDS Hillenbrand Industries Interlake Group Tab Products Virco Manufacturing

0.64
1.88 1.56 3.33 3.14 1.78 2.20 1.25

58.33
20.95 12.44 18.89 18.27 14.36 17.50 10.04

33.38%
42.86% 18.98% 26.13% 24.05% 22.75% 1.37% 39.81%

Q4.2 MANAGEMENT KNOWLEDGE

Steves 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 Partners' salaries/Income before partners' salaries Profit margin * Profit margin
*Income before partners' salaries

1984

1985

1986

1987

14% 12% 10% 8%

Income before partners' salaries Partners' salaries

220000

128%
10% -1%

111%
11% -0.02%

83%
14% 3%

46%
21% 13%

170000

Fenchel
Industry average

Profit margin (Manufacturing Barry Wright Bush Industries GF Corp Knoll International Newell Companies Shelby Williams INDS Hillenbrand Industries Interlake Group Tab Products Virco Manufacturing Industry average

Industry) 5% 4% 0.3% 6% 5% 7% 6% 3% 5% 2% 5%

4% 4% 1% -3% 6% 7% 8% 4% 6% 2% 3.8%

4% 6% -3% 1% 5% 6% 8% 7% 5% -2% 3.7%

120000

6%
4% 2% 0% 1984 -2% 1985 1986 1987 -30000 70000

20000