Grace Bioremediation Technologies: An Investment Analysis for Covington Capital, Study Guides, Projects, Research of Business Finance

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Group Assignment Grace Bioremediation Technologies Case Report FNCE 4037 EL 01: Entreprenurial Finance Dr. Wang Dec. 14th

Contents

• Executive summary……………………………………………………………………
• Introduction…………………………………………………………………………....
  • Investment goals and investment strategy test…………………………………. Management Analysis
  • Examine Buisness Model……………………………………………………….
  • Opportunities & Risks…………………………………………………………..
  • Risk avoidance and risk minimization………………………………………….
• Investment instruments Analysis……………………………………………………. - A. Common equity………………………………………………………... Investment instruments - B. Convertible preferred ………………………………………………….. - C. Debt instrument with zero cost warrants……………………………….
  • Final Decisions…………………………………………………………………. - Comparison among three financing strategies…………………………. - Aggrements and Key clauses…………………………………………...
• Appendix……………………………………………………………………………….

Management Analysis

Covington Capital Covington Capital is a leading venture capital firm located in Toronto, Ontario. The fund has 11-member investment team that acted as the investment manager to five Ontario- based Labour Sponsored investment funds, with total assets of approximately $465 million. To implement an investment, the Fund managers have considered several factors. Investment goals and strategy test First is the industry diversification in which no more than 35% of the Fund’s total assets at the time of investment could be invested in an industry without approval of the board of directors of the Fund. To finance the management buyout of GBT, it will only need a very small amount of money from the Fund. Therefore, buying GBT does not have any effect on the industry diversification. Second factor is the geographic diversification. Covington Capital is trying to diversify their investment throughout Canada. GBT is a provider of bioremediation technologies for the environmental remediation industry, which has expanded its technique to the U.S. and international markets, and it has already been a international business. Therefore, the buyout of GBT has met Covington’s geographic strategy. Moving on the strategy of size of investment, the ideal investing size for Covington is in the range of 3 and 5 million dollars. So regarding the fact that GBT is looking for a financial aid of $4.35 million. It is in the range of 3 and 5 million dollars. Therefore, GBT is the ideal investment target of Covington Capital. For the management team, Covington Fund has set a requirement that the target management team must have high cohesiveness and rich experience to operate the business. In addition, the management team must also have demonstrated a cooperative attitude, and be

open to give up control. The management team at GBT had operated on a relatively independent basis from W.R. Grace, and having negotiated all agreements with the contractors and consultants. The team has significant experience in the bioremediation industry and has been key to increase awareness among clients about the benefits of the technologies. Also the management team had clearly dedicated that it could meet the requirements dictated by its customers as well as by the environmental regulatory bodies. Although the management team of GBT wants to have voting control of the company, the fact is that they only have a small amount of capital turnover. They are willing to give up the control of the company. The target company size of Covington is to invest in companies that have less than $50 million in assets. GBT has much less assets than $50 million. Also, for the target return, Covington’s goal is to invest a company that has an annual return of at least 20%. So according to the projected income statement from 2002-2006 that is given, the annual return of GBT has reached over 30%. Therefore, investing in GBT could be a good opportunity. Another important factor that Covington Fund has considered is that the Fund tend to invest some potential companies. Since the last century, public awareness of the potential harmful effects of hazardous and toxic wastes on the environment and public health had led to the implementation of extensive regulation of waste management activities in the U.S. and internationally. The remediation industry had evolved in response to the increasingly stringent regulatory environment. In the remediation technologies of the soil and water marketplace, for those using biological methods, the systems developed by GBT, promised the greatest opportunity to provide treatment that was environmentally benign, cost-efficient and reliable. On the other hand, GBT had developed a highly reliable patented process that surmounted the technological obstacles that so many other bioremediation companies experienced in their product development efforts. Furthermore, the market for viable

For the industry, the market for viable bioremediation solutions was expected to grow significantly over the upcoming several years. According to expectations, the global bioremediation market size is $1,176 million. This is a high level for the market size. This date in 2000 was $698 million. The growth rate is 11%. This is an average level. Although GBT's market share is low (The net sale for GBT in 2000 was $1,197 thousands). But GBT had established a well-known and respected presence in its markets, and GBT had emerged as the most cost-efficient alternative in the market. That’s means GBT has certain competitiveness in the market. The management team at GBT had significant experience in the bioremediation industry. A management team with expertise and experience, with intact networking connections in the proposed industry. But since the company’s history was only operated as a division of Grace Canada, and It never has a full executive team. The management team has few of the functional areas covered. This is a challenge for the company's future development. The management has established long-term supply relationships with three companies in the United States and two companies in Europe. And the company intends to build more relationships with other manufacturers. This ensures that the company has a good supply channel. The company can also reduce capital expenditures by entrusting its product manufacturing requirements to external experts. The company’s net sales in 2001 were significantly higher than those in 2000. The net sale in 2000 was $1,197 thousand, and in 2001 was $1,671 thousand. That increased in 39.6%. The gross margins still increased in 2001, and it was 49.9%. This margin figure was almost twice as high as the industry average. The company's net income turned into a profit in 2001. The net income in 2001 was $47 thousand, and by further increasing sales and reducing expenses (like sell expenses, administrative expenses), the company expects the net

income in 2002 to reach $427 thousand. The after-tax margins in 2001 was 2.8% and is expected to increase to 18.9% in 2002. If this goal is achieved, and this is a high level in the industry. The company’s asset turnover in 2001 was 0.4 times. The asset turnover rate reflects the operational capacity of the company's overall assets. The company's asset turnover rate is low, indicating that the company's operating capacity is poor. Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. The company’s ROA in 2001 was 1.04%. That means the company's profitability is poor in 2001. But if the goal in 2002 is achieved, the ROA will increase to 10.4%. This is an average level in industry. All of all, the financially performed for GBT in 2000 and 2001 is not good. But we must also note that GBT’s business capabilities are also increasing year by year. Opportunities & Risks - The positive aspects of the opportunity with the buyout financing The remediation industry had evolved in response to the increasingly stringent regulatory environment. In the environmental remediation industry, two of the chief market sectors were soil remediation and water remediation. Since 1996 GBT provided a family of unique proprietary soil and water bioremediation technologies to U.S. and international markets. Compared to other companies in the industry, DARAMEND is sold at a much lower price than competitors. The technology provided by GBT has become the mainstream technology in the market. GBT with headquarters located in Mississauga, Ontario. GBT also had executive offices in Delray Beach, Florida and in Penticton, British Columbia.GBT has been well developed in the North American market. Management had established long-term supply relationships with three companies in the United States and one in Europe to manufacture the components of the DARAMEND products.Not only that, GBT’s clients primarily consisted of established companies, environmental remediation contractors, other remediation

follow the following principles when determining the financing structure: first, to minimize the cost of capital; second, to maintain an appropriate proportion of debt capital and equity capital; and third, to reasonably match short-term debt capital with long-term debt capital.

Investment Instruments Analysis

Covington Capital limited its investment instruments to common stock, preferred stock and debt with zero cost warrants. The followings are our analysis about the advantages and disadvantages of these three methods. A. Common Equity: Common equity is the amount that all common shareholders have invested in a company. Advantages (a) As a holder of the venture’s common stock, stockholders have the traditional rights of participation in dividends. (b) Common stockholders have the right to maintain their percent ownership through subsequent financings. Such preemptive rights allow existing owners to buy sufficient shares in each round of financing so that their ownership is not automatically diluted. (c) Common stockholder is the only one who have the ownership voting rights regardless how many shares of company stock she or he owns, including those needed to appoint a board of directors. (d) Common stockholders can sell their shares back to the company and held as treasury shares. (e) When a business chooses to liquidate, all of the company assets are sold, shareholders have claims on its assets. A larger asset balance, and a large amount of shares that

shareholder have means that shareholders are more likely to receive some assets during the liquidation. Disadvantages (a) Compared to debt holders or preferred stockholders, common stockholder is the least senior claim on a venture’ asset. (b) The common stockholders ownership percentage will be diluted through future round financings. (c) It is possible that shareholders do not receive any value, such as a bankruptcy situation when a company is forced into liquidation. B. Convertible preferred stock ：Convertible preferred stock is the preferred stock with option to exchange it into common stock at any time before the expiration date. Advantages (a) Compared with common stocks, convertible preferred stocks have fewer risks. When the venture is at its startup stage or in bad operation, the preferred status places the preferred shareholders above common shareholders in fixed dividends and any liquidation proceeds. And when the venture takes off, the preferred shareholders have the opportunity to convert their preferred into common stocks which has the equal right as common stockholders to participate in the growth of the venture. (b) If the company was mismanaged and faced liquidation, the preferred shareholders had the priority to be paid before common shareholders. Disadvantages (a) Compared to common stocks, preferred stocks do not have the voting rights. (b) Compared to long-term debt, the right of liquidity is after the debt-holders when the venture goes bankruptcy. And the rate of dividends is lower than long-term debt.

common stock shareholders should take highest risk to exchange for a 30% return. But its capital gain depends on this venture’s growth rate. While the convertible preferred stock shareholders and the creditors can have fixed annually dividend or interest fee. Since the risk for preferred stock shareholders and debt holders are lower than common stock shareholders, they ask for relevantly lower rate of return (25% and 20% respectively). Assuming this venture has a sustainable growth rate, Covington could use the debt tool to have an appreciation at the end of 2006 by using the warrant. B.Aggrements and Key clauses After the analysis above, we decide to choose the last one – debt with zero cost warrants as our investing form for the highest PV among three instruments. The next question is to stipulate relevant clauses to guarantee the safety and income of the subsequent investment. After consulting textbooks and the internet, we think the following terms and restrictions are appropriate : (a)Submit financial reports regularly. To guarantee the safety of the investment and capacity to repay, the best way is to inspect financial statements, knowing the operating, financing and investing performance. If there are any signals, such as insufficient cash flow or unreasonable expenditure, the investors can call a meeting for solving this. After all, they are not only investors but also the creditors, the board directors and “shareholders” in the future. They deserve the rights to know and make decisions. (b)Restrictions on proceeds. The annual income from operating ought to be restricted use. The proceeds should pay the interest at first, then being allocated as dividends. Given there are no other shareholders but management teams at the year 0-5, this dividend number should not be large. Otherwise, it is unfair for the investors who just receive fixed interests every year but invested much more than managers. Besides, proceeds cannot be spent on personal

use. It should be prevented that some managers would use companies money to make luxury purchases. (c) Limits on total debts and shares. Due to the form of investment, for the purpose of controlling asset-liabilities ratio and leverage ratio, the total amount should not be excessive otherwise the debt paying ability would be greatly weakened. And considering the “shareholders” role in the exit year, the number of shareholders should be limited for preventing from being diluted. (d)Limits on capital expenditure. Because the income generated from fixed assets cannot be recovered immediately, this type of investment can be seen as an occupation of the working capital. On the other hand, if GBT went bankruptcy in future, the fixed asset cannot be transferred into cash right away and would cause some value loss when transferring. Keeping a healthy cash flow is the recipe for the successful venture, one method of which is to control the capital expenditure. (e) Withdraw of funds. Once the investors find that the venture has defaulted above terms, they have rights to withdraw their principals and interest immediately on account of safety. And their subsequent ownership should be discounted to this year in presupposed rate and the venture has the obligation to buy these shares back at the specific price.

% for Covington 60% 50% 40% Expected rate 30% 25% 20% Value of equity at exit ( assume P/E ratio= 15 times )

x 15times

==$1,669,000 x 15times

=$1,435,000 x 15times Present value $5462,510 $4585,580 $5,983, IRR 43% 32% 34%