Stratos Corporation is a privately held tablet semiconductor technology firm with bright growth prospects.The past 5 years have seen the firm evolve from a pure startup to a profitable firm with $30mm in annual revenues. The company's executive team is currently focused on how to finance the next phase of the company's growth strategy, specifically expansion into a new complementary smartphone circuit board design and expansion into the European OEM market.
Key financial considerations are as follow:
- Smartphone expansion will cost an estimated $15mm in investment capital and an additional $10mm of net working capital investment (primarily component and finished product inventory as well as some receivables). These funds will be required evenly in two stages over the 2-year launch period. This venture is expected to add $6mm/yr in annual after-tax gross marginand $0.5mm in additional annual costs beginning in two years. This venture is expected to have a 10 year life. Assume that the present value of the depreciation tax shield is $2mm.
- European expansion is expected to require $15mm in working capital primarily to finance new receivables and inventory. This capital will need to be available upfront in order to ensure that marketing efforts are not wasted and orders are unfulfilled. This opportunity would double the revenue of the current operations though incremental profit margins would be lower as a cost of entry to the tune of GM% at only 70% of the core business. This venture would be perpetual.
- Current operations generate $3mm in annual after-tax cash flow (assume capex = depreciation and no incremental working capital) and are expected to grow at a 15% compounded rate for the next five years with no incremental investment. Fixed non-manufacturing costs for the business are $8mm/yr and consist primarily of employee compensation, facilities costs, etc.
- The company is currently owned 40% by its management team, 40% by external investors (mainly VCs with a smattering of angel capital) and 20% is owned by an ESOP which is held in trust (though in practice controlled by management). The CEOhas a piggyback clause tied to VC exit which allows her to cash out her 10% ownership position, if desired, upon VC liquidation.
- Stratos currently has no long-term debt but does maintain a $10mm line of credit which generally remains drawn upon only during peak periods to the tune of $3-4mm.
- The VC investors wish to exit their investment within 3 years at the latest. The angel investors have no clear expectations in re: time to harvest.The IPO market is currently depressed with deal flow / valuations at multi-year lowsis but expected to recover within 2-3 years.
- Discussions with investment bankers have set the long-term debt target rate at 8% and set the existing business value at $125mm excluding any value associated with the new ventures.
- Marginal tax rate is 30%, cost of equity is 15% and current credit facility interest rate is 5%.