Opportunity Evaluation Allen Lane’s decision to acquire Plas-Tek Industries (PTI) is intriguing since the business appears to be a good match with Lane’s work experience and interest. As a manufacturer, PTI has been able to create large margins and high cash flow under Harry Elson’s leadership. However, significant risks are prevalent in acquiring PTI. First, more one-third of PTI’s sales originated from five companies and it is uncertain that without Harry Elson’s personal efforts if their patronage will continue.
Secondly, the bank valuation of PTI ($600K) appears inflated as the bank’s valuation is notably more than PTI’s book value ($292K), calculated with an inflated price/earnings multiple for a company with no proprietary assets and does not discount any contingent liabilities. Finally, it will be difficult for PTI to achieve long-term growth since PTI has no proprietary assets and that the company is in a mature industry in a slowing economy. Business Venture Status and Characteristics
As an established manufacturing company in a mature industry, Lane will have difficulty creating new growth through manufacturing a nonproprietary product, particularly in a slowing economy. However, the management vacuum created by Elson’s death provides opportunity to create new proprietary products that can grow the company. PTI has high cash flow and annual sales with relatively low labor costs as a nonunion company with both full and part time employees.
PTI created its competitive advantage in customer service, so it is important to keep key employees on to ensure that continues after Lane purchases PTI. However, Lane should make sure that he and the current part-time employees learn the job tasks and business knowledge that Bernie, Sarah and Eleanor have to ensure against a loss of intellectual capacity if one of them leaves. Additionally, PTI has demonstrated the ability to create significant cash flow under Elson’s leadership, but it is uncertain that will continue due to the customer relationship and management vacuum created by his death.
Finally, PTI does have $92K of land/buildings that they can collateralize for debt financing. Management PTI had been entirely dependent on Harry Elson to manage all strategic, financial, operational and marketing decisions. However, Lane’s Lane experience in managing finances, managing operations, leading teams and making strategic decisions in the manufacturing industry are the necessary hands-on skills to lead PTI after Elson’s death. However, it is questionable if Lane has either the necessary motivation or support team to operate PTI.
Having Dan Ray as a partner may be helpful due to Ray’s operations experience, but it is unclear how motivated Ray is in operating PTI. Lane will also need to rebuild existing customer relationships lost due to Elson’s death as well as build new relationships with new customers, which will take significant time and resources to accomplish. However, since this a nonunion company, Lane has the flexibility to make the necessary adjustments in personnel to fulfill the necessary strategic business needs as they occur.
Risks Two main risks need to be considered with this acquisition. The first risk is the contingent liabilities arising from Elson’s compensation and accumulated earnings from PTI’s interest-earning assets. Lane should provide the bank information on the accountant’s opinion on these contingent liabilities as rationale the bank’s valuation needs to discount them from their asking price. The second risk is the structure of PTI’s current customer base as a proportion of its sales.
PTI’s high concentration of sales to five customers is a cause for concern for PTI’s financial stability after an ownership transition. Lane can reduce this risk through building relationships with those customers as soon as possible and keeping key personnel like Eleanor to help maintain those relationships. At the same time, Lane should implement strategies to decrease the concentration of sales from PTI’s customer base. Financial Need According the bank, Lane needs $600K to submit a bid to acquire the PTI through a stock purchase.
However, the bank’s valuation is calculated using an inflated price/earnings multiple and does not account for the contingent liabilities. The P/E multiple that the bank used in its valuation is notably higher than expected for a company that does not have a proprietary product. Applying a market-based P/E multiple of 4X, the 20% cash sale discount and a $90K discount accounting for potential tax liability regarding Elson’s compensation (alternative 1), PTI should be worth $450K.
While this price is notably higher than PTI’s book value, it is more realistic than the bank’s valuation. Since Lane and partner Dan Ray personally will finance $200K of this transaction, they need $250K to complete the stock purchase. Therefore, the financial need is $275K. Debt? Considering that PTI currently has low liabilities and significant cash flow, Lane and Ray should seek debt financing. However, PTI is limited by having $92K in land/buildings and $150K in accounts receivable that it could be used as collateral.
Using accounts receivables as collateral is more expensive than term loans as well as directly affects customer service, PTI’s current competitive advantage. Therefore, PTI should seek to secure $92K needed to finance this acquisition through a fixed term loan using building/land as collateral. PTI’s cash flow should be able to pay off this loan, despite its 17% to 19% interest rate, over a short time period. Additionally, PTI’s cash flow should allow the remaining $183K to be financed through a mezzanine fund despite such financing requiring a 20%-30% interest rate. Equity?
Besides the $200K that Lane and Ray will use to buy PTI stock directly from the bank, the equity financing options for them are limited. PTI is in a mature industry that offers limited growth potential. Therefore, venture capital and angel investors are unlikely to see it creating the necessary high returns to merit investment. Since Lane had no close friends or family that would interested in financing that is not a viable option. However, if the bank insists that $600K be paid to acquire all PTI stock, Lane and Ray should negotiate a 3-year earnout to bridge the remaining $150K gap.