How would you go about solving this case?

This case came up during a group practice session. I am interested to see how you guys would go about structuring the analysis. Any insight is appreciated!

Background: Two friends are thinking of starting a company that represents manufacturers who build rainwater harvesting packages. This type of company is known as a "rep" firm. These types of firms don't manufacture anything. Instead, they build relationships with clients and add value by increasing the amount of sales for the manufacturer. The manufacturer benefits because these rep firms take away the cost of having a sales force as well as the cost of having a large number of satellite offices.

Question: The two friends are thinking of asking an existing "rep" firm for an investment in their new company. This existing rep firm seems interested and willing to invest. What is a fair valuation for this new company, and what is a fair equity split between the existing "rep" firm and the two friends for this new company.

 
Best Response

This is one of the coolest posts I've seen on this site. I'm giving you a silver banana (whatever that is) and my best shot at an answer.

First I would want to clarify whether or not it is plausible for the two friends to start and run their business without the help of a "rep" firm. I would also want to know whether or not the two friends could hire the rep even without them making an equity investment. I am going to assume that they can start their business without the rep's investment, and that they may utilize or not utilize the rep for this (whether or not they take investment money).

So with that, I would think of the problem like this:

  1. Valuation of firm without rep's investment a. Revenue

- What kind of sales might they be able to obtain? In order to determine this I would want to look at the possible areas they could sell in, the quantities they could sell in each area, and prices they could sell for. - I would want this answer for both if they were to utilize the rep, and if they were to not utilize the rep.

b. Costs - What kind of costs would be required to start this business? I specifically would want cost of manufacturing/purchasing the product, and the costs of selling the products to each area outlined above. - I would want this answer for both if they were to utilize the rep, and if they were to not utilize the rep

c. Growth - I would make sure to think about how the above numbers would be expected to grow over the next X years.

From the above I would think a valuation would be possible from the cash flows using some kind of annuity equation/cost of capital

  1. Valuation of firm with rep's investment a. Incremental Revenue

- Could they obtain any additional sales if the rep was financially invested in their business? If the reps have an equity stake in the company, they would be incentivized to improve revenue. They might also obtain an advantage by being associated with the reps, as the reps are the ones that deal with customer's and likely have some brand recognition of their own, potentially meaning more sales or higher prices.

b. Incremental Costs - What happens to the business' costs if the rep invests? I would think cost savings in the company's spending on the reps services may be possible due to the rep's equity investment, however we need to keep in mind that the reps incur costs by performing services, so any kind of cost savings or advantageous investment would likely result in a higher equity stake for the rep.

c. Incremental Growth - Could the new business grow faster with the rep's equity investment?

If "Valuation with rep's investment" results in higher revenue, lower costs, or higher growth compared to "Valuation without rep's investment", then an equity investment by the reps is definitely a good idea for the two friend, and would result in a higher total valuation.

I would determine equity stakes as a function of how much the reps invest compared to the total valuation, in addition to how much value they add:

Minimum Rep's equity stake: (Equity Invested/Total Valuation) Maximum Rep's equity stake: (Equity Invested/Total Valuation) + (Value Added by Investment/Total Valuation) Potential "Fair" Rep's equity stake: (Equity Invested/Total Valuation) * [(Equity Invested/Total Valuation) * (Value Added by Investment/Total Valuation)]

I haven't done one of these in a long ass time, although I will say that it is a lot easier to type something like this out into a comment box than it is to do it verbally.

EDIT: BTW, if you have feedback I'd love to hear it, I haven't done a case in awhile and will be recruiting very soon.

 

I think MBBust really covered all the major points here in my opinion.

For me, I would really focus on their streams of revenue and to see if this is a product that is actually in demand with a large and underexposed market that could be taken advantage of.

-Are these products affordable? -How many units? -How long do these last and would consumers have to constantly replace/buy/upgrade?

Following those points, as MBBust covered, the growth potential. Are there any existing or upcoming competitors we should be aware about? How many and their respective market shares?

After getting down all this information and a firm understanding of the firm, product, and market I would really look into the benefits of having an additional investor. -Cost reduction? (Probably, but is it worth it?) -How big is this other investor/rep? -Could they merge or work as a partnership? -What exactly would they be providing? Is it just capital? -Will this allow us to reduce our prices to undercut competitors?

With this information, I would do a rough valuation to see how much more money we could be making and if we are overtaking our competitors. Then my equity split calculation would fall into place, similar to MBBust's but if this were a live case it probably wouldn't be as extensive as MBBust's but a more general and assumption based one.

Would also love to hear some feedback as well!

 

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