Jordan-Williams, Incorporated (JWI), is a major publisher in selling to the corporate market and in delivery of content via of college textbooks focused on business education. At the Internet. the company's quarterly strategy meeting, senior management One of the companies JWI is considering as a partner is Netdecided to expand into business education materials aimed at Knowledge. NetKnowledge is an infrastructure and services comcorporations that require entry-level and mid-level managers to pany that supports corporate communication and training. The complete training courses to improve their business skills. For company has approximately 65 satellite-linked communication such training, content (in the opinion of JWI's senior manage- centers that corporations can use for live video conferencing or ment) is best delivered via the Internet since it has cost advantages training. NetKnowledge has also developed a platform to deliver and allows flexibility in scheduling employee training. prerecorded training to personal computers via the Internet. For JWI has existing content in almost all business areas, includ- clients that need help developing training materials, NetKnowling accounting, finance, marketing, management, and informa- edge has three production studios for designing and recording tion systems, as well as connections to authors who can develop content. new materials. However, the firm does not have experience A due diligence team from JWI has met with executives from delivering content over the Internet and does not have a sales NetKnowledge, viewed demonstrations of content delivered over force with experience selling to the corporate training market. the Internet using the NetKnowledge platform, and visited a NetGiven that JWI wants a rapid entry into this market, it plans to Knowledge production facility. The team is quite impressed with develop a strategic alliance with a company that has experience NetKnowledge and believes an alliance with the company would 568 CHAPTER 14 Analyzing Financial Statements: A Managerial Perspective be a great fit, since NetKnowledge does not specialize in develop- will be around in the foreseeable future to continue selling and ing content (it just assists companies with designing and record- delivering the materials to the corporate market. To assess the ing content), whereas JWI is a content expert. financial stability of NetKnowledge, the JWI due diligence team JWI is going to be investing heavily to modify its existing con- performed financial analyses and held discussions with various tent to make it more focused on the corporate training market executives at NetKnowledge. When finished with its investigaand to make it compatible with NetKnowledge's delivery plat- tion, the due diligence team prepared the following memo supform. Thus, it wants to gain some assurance that NetKnowledge porting a partnership with NetKnowledge. TO: Peter Gandrell (CEO), Christine Sayers (CFO), and Drew Marshall (Director of New Initiatives) FROM: Ted Chapman, lead manager, due diligence team investigating NetKnowledge SUBJECT: Report on Financial Condition of NetKnowledge In fiscal 2017/fiscal 2016, NetKnowledge (NK) suffered losses of $31,600,000/$21,200,000. In spite of these losses, the team recommends forming an alliance with NK. NK, like most companies in this space, is an early-stage company, and losses are not unexpected. The important questions to ask are: Does NK have a reasonable plan to become profitable? and Does NK have the cash to survive until profitability is achieved? We believe the answer to both questions is yes. In 2017, operating expenses increased substantially, resulting in an increased loss. However, per our discussions with executives at NK, the increased operating expenses are due in large part to a major advertising campaign and expansion of the sales force. The result is that NK achieved substantial brand recognition, and in 2017 revenue increased by approximately 20 percent. The company believes that, now that it has achieved its brand-recognition goals, it can cut operating expenditures (including advertising and sales force salaries) back to a level of 80 percent of the amounts in fiscal 2016 , or $29,520,000(80%36,900,000). With current revenue at $18,800,000, and assuming an ongoing revenue growth rate of 20 percent, the company will be profitable in three years (i.e., at the end of fiscal 2020 , revenue of $32,486,400 will exceed expenses of $29,520,000 ). Calculation of revenue estimate for year 3 : It appears to us that achieving profitability in 3 years is a very feasible goal. The company has expanded its web hosting options to a 24/7 basis and is now able to service clients with training demands around the world. In the fourth quarter of fiscal 2017 , the company signed contracts with three additional Fortune 500 clients to deliver services in 2018. The revenue from this prestigious group of clients is, of course, not reflected in the financial statements for 2017. Also, keep in mind that our partnership with NK will provide incremental revenue to the company. Of course, achieving profitability will be possible only if the company does not run out of cash. At the end of fiscal 2017 , NK had approximately $21,000,000 in cash and cash equivalents. The net decrease in cash and cash equivalents in fiscal 2017 was approximately $11,000,000. Thus, it appears that the company will be able to survive for at least 2 years (through fiscal 2019 ). At that point, assuming our net initiative is a success, we may want to make an equity investment in NK to provide the company with the cash it will need to survive a third year beyond 2019 (i.e., through fiscal 2020). Assuming an annual decrease in cash of $11,000,000, we would need to make an equity investment of approximately that amount. At the end of year 3 , as discussed above, NK will be profitable and likely able to fund itself internally. An investment of $12,000,000 would give us a substantial equity position in a firm that we predict will be successful. Furthermore, it would allow us to have a substantial say in the direction of NK, thus insuring that the company remains focused on our long-run needs in addition to the needs of its other clients. Alternatively, in light of the fact that the company will be only a year away from profitability at the end of fiscal 2019, if we decide not to make an equity investment, NK should be able to obtain additional debt or equity financing from creditors or investors. If you have any questions, please give me a call. I'll be in the rest of this week, and next week on Monday. After that, I'll be in Chicago working with the group from Balmer Consulting that is developing our new authors' website. Case 569 NetKnowledge Income Statements NetKnowledge Balance Sheets As of 12/31/17 As of 12/31/16 Assets Current assets: \begin{tabular}{lrr} Cash and cash equivalents & $21,300,000 & $32,100,000 \\ Accounts receivable & 3,100,000 & 3,900,000 \\ Prepaid expenses and other current assets & 300,000 & 600,000 \\ \cline { 2 - 3 } Total current assets & 24,700,000 & 36,600,000 \\ Property and equipment & 35,300,000 & 34,600,000 \\ Less accumulated depreciation & (13,400,000) & (9,100,000) \\ Total assets & $46,600,000 & $62,100,000 \\ Liabilities and stockholders' equity & \end{tabular} Current liabilities: \begin{tabular}{lrr} \multicolumn{1}{c}{ Accounts payable } & $5,800,000 & $5,000,000 \\ \multicolumn{1}{c}{ Other accrued liabilities } & 6,000,000 & 3,700,000 \\ Total current liabilities & 11,800,000 & 8,700,000 \\ Long-term debt & 26,900,000 & 13,900,000 \\ Total liabilities & 38,700,000 & 22,600,000 \\ Stockholders' equity & & \\ Common stock & 85,100,000 & 85,100,000 \\ Accumulated deficit & (77,200,000) & (45,600,000) \\ Total equity & 7,900,000 & 39,500,000 \\ Total liabilities and stockholders equity & $4600,000 & \end{tabular} NetKnowledge Statements of Cash Flows REQUIRED from Ted Chapman. Do you agree or disagree with his analysis The financial statements for NetKnowledge for fiscal 2017 and and conclusions? Would you recommend pursuing an alliance with NK ? fiscal 2016 are provided below. You should analyze them as you deem appropriate. Based on your work, comment on the memo Jordan-Williams, Incorporated (JWI), is a major publisher in selling to the corporate market and in delivery of content via of college textbooks focused on business education. At the Internet. the company's quarterly strategy meeting, senior management One of the companies JWI is considering as a partner is Netdecided to expand into business education materials aimed at Knowledge. NetKnowledge is an infrastructure and services comcorporations that require entry-level and mid-level managers to pany that supports corporate communication and training. The complete training courses to improve their business skills. For company has approximately 65 satellite-linked communication such training, content (in the opinion of JWI's senior manage- centers that corporations can use for live video conferencing or ment) is best delivered via the Internet since it has cost advantages training. NetKnowledge has also developed a platform to deliver and allows flexibility in scheduling employee training. prerecorded training to personal computers via the Internet. For JWI has existing content in almost all business areas, includ- clients that need help developing training materials, NetKnowling accounting, finance, marketing, management, and informa- edge has three production studios for designing and recording tion systems, as well as connections to authors who can develop content. new materials. However, the firm does not have experience A due diligence team from JWI has met with executives from delivering content over the Internet and does not have a sales NetKnowledge, viewed demonstrations of content delivered over force with experience selling to the corporate training market. the Internet using the NetKnowledge platform, and visited a NetGiven that JWI wants a rapid entry into this market, it plans to Knowledge production facility. The team is quite impressed with develop a strategic alliance with a company that has experience NetKnowledge and believes an alliance with the company would 568 CHAPTER 14 Analyzing Financial Statements: A Managerial Perspective be a great fit, since NetKnowledge does not specialize in develop- will be around in the foreseeable future to continue selling and ing content (it just assists companies with designing and record- delivering the materials to the corporate market. To assess the ing content), whereas JWI is a content expert. financial stability of NetKnowledge, the JWI due diligence team JWI is going to be investing heavily to modify its existing con- performed financial analyses and held discussions with various tent to make it more focused on the corporate training market executives at NetKnowledge. When finished with its investigaand to make it compatible with NetKnowledge's delivery plat- tion, the due diligence team prepared the following memo supform. Thus, it wants to gain some assurance that NetKnowledge porting a partnership with NetKnowledge. TO: Peter Gandrell (CEO), Christine Sayers (CFO), and Drew Marshall (Director of New Initiatives) FROM: Ted Chapman, lead manager, due diligence team investigating NetKnowledge SUBJECT: Report on Financial Condition of NetKnowledge In fiscal 2017/fiscal 2016, NetKnowledge (NK) suffered losses of $31,600,000/$21,200,000. In spite of these losses, the team recommends forming an alliance with NK. NK, like most companies in this space, is an early-stage company, and losses are not unexpected. The important questions to ask are: Does NK have a reasonable plan to become profitable? and Does NK have the cash to survive until profitability is achieved? We believe the answer to both questions is yes. In 2017, operating expenses increased substantially, resulting in an increased loss. However, per our discussions with executives at NK, the increased operating expenses are due in large part to a major advertising campaign and expansion of the sales force. The result is that NK achieved substantial brand recognition, and in 2017 revenue increased by approximately 20 percent. The company believes that, now that it has achieved its brand-recognition goals, it can cut operating expenditures (including advertising and sales force salaries) back to a level of 80 percent of the amounts in fiscal 2016 , or $29,520,000(80%36,900,000). With current revenue at $18,800,000, and assuming an ongoing revenue growth rate of 20 percent, the company will be profitable in three years (i.e., at the end of fiscal 2020 , revenue of $32,486,400 will exceed expenses of $29,520,000 ). Calculation of revenue estimate for year 3 : It appears to us that achieving profitability in 3 years is a very feasible goal. The company has expanded its web hosting options to a 24/7 basis and is now able to service clients with training demands around the world. In the fourth quarter of fiscal 2017 , the company signed contracts with three additional Fortune 500 clients to deliver services in 2018. The revenue from this prestigious group of clients is, of course, not reflected in the financial statements for 2017. Also, keep in mind that our partnership with NK will provide incremental revenue to the company. Of course, achieving profitability will be possible only if the company does not run out of cash. At the end of fiscal 2017 , NK had approximately $21,000,000 in cash and cash equivalents. The net decrease in cash and cash equivalents in fiscal 2017 was approximately $11,000,000. Thus, it appears that the company will be able to survive for at least 2 years (through fiscal 2019 ). At that point, assuming our net initiative is a success, we may want to make an equity investment in NK to provide the company with the cash it will need to survive a third year beyond 2019 (i.e., through fiscal 2020). Assuming an annual decrease in cash of $11,000,000, we would need to make an equity investment of approximately that amount. At the end of year 3 , as discussed above, NK will be profitable and likely able to fund itself internally. An investment of $12,000,000 would give us a substantial equity position in a firm that we predict will be successful. Furthermore, it would allow us to have a substantial say in the direction of NK, thus insuring that the company remains focused on our long-run needs in addition to the needs of its other clients. Alternatively, in light of the fact that the company will be only a year away from profitability at the end of fiscal 2019, if we decide not to make an equity investment, NK should be able to obtain additional debt or equity financing from creditors or investors. If you have any questions, please give me a call. I'll be in the rest of this week, and next week on Monday. After that, I'll be in Chicago working with the group from Balmer Consulting that is developing our new authors' website. Case 569 NetKnowledge Income Statements NetKnowledge Balance Sheets As of 12/31/17 As of 12/31/16 Assets Current assets: \begin{tabular}{lrr} Cash and cash equivalents & $21,300,000 & $32,100,000 \\ Accounts receivable & 3,100,000 & 3,900,000 \\ Prepaid expenses and other current assets & 300,000 & 600,000 \\ \cline { 2 - 3 } Total current assets & 24,700,000 & 36,600,000 \\ Property and equipment & 35,300,000 & 34,600,000 \\ Less accumulated depreciation & (13,400,000) & (9,100,000) \\ Total assets & $46,600,000 & $62,100,000 \\ Liabilities and stockholders' equity & \end{tabular} Current liabilities: \begin{tabular}{lrr} \multicolumn{1}{c}{ Accounts payable } & $5,800,000 & $5,000,000 \\ \multicolumn{1}{c}{ Other accrued liabilities } & 6,000,000 & 3,700,000 \\ Total current liabilities & 11,800,000 & 8,700,000 \\ Long-term debt & 26,900,000 & 13,900,000 \\ Total liabilities & 38,700,000 & 22,600,000 \\ Stockholders' equity & & \\ Common stock & 85,100,000 & 85,100,000 \\ Accumulated deficit & (77,200,000) & (45,600,000) \\ Total equity & 7,900,000 & 39,500,000 \\ Total liabilities and stockholders equity & $4600,000 & \end{tabular} NetKnowledge Statements of Cash Flows REQUIRED from Ted Chapman. Do you agree or disagree with his analysis The financial statements for NetKnowledge for fiscal 2017 and and conclusions? Would you recommend pursuing an alliance with NK ? fiscal 2016 are provided below. You should analyze them as you deem appropriate. Based on your work, comment on the memo