MiniDiscs Corporation Case

Brian Motley founded MiniDiscs Corporation at the end of 2005 with a $1 million investment. After nearly one year of develop- ment, the venture produced an optical storage disk (about the size of a silver dollar) that could store more than 500 megabytes of data, along with a mechanism allowing the device to be integrated into a variety of portable consumer electronic devices, including e-books, music discs, and video games.

In addition to Brian Motley's role as the venture's CEO, Susan Sharpe, with six years of prior financial management experience at two high-technology ventures, was hired as the CFO. The vice president of marketing was Steven Davis, and the vice president of operations was Sanjay Chavarti. Before being hired by MiniDiscs, Davis had twelve years of marketing experience in the tech- nology area. Chavarti worked in high-tech operations for eight years before pursuing the opportunity with MiniDiscs.

Leading electronic manufacturers were eager to incorporate the minidisc in their products. Brian Motley obtained $7 million in financing at the end of 2006 from venture investors in exchange for 43 percent of the stock in the venture. After this round of ven- ture financing, Brian retained 50 percent ownership in MiniDiscs, and the other three members of the management team (Sharpe, Davis, and Chavarti) owned 7 percent of the venture.

Over a four-year period (2007-2010), MiniDiscs moved quickly through its startup and survival stages and is now in the midst of its rapid-growth stage. Brian Motley has recently decided to harvest his investment by selling the firm. However, the other three members of the management team want to continue and proposed a leveraged buyout to Brian Motley. An external valuation firm estimated that $45 million represented a fair price for all of the equity in the MiniDiscs Corporation. An abbreviated balance sheet in thousands of dollars for year-end 2010 follows:

Current assets: $15,000

Fixed assets, net: 15,000

Total$30,000

Payables and accruals: $5,000

Long-term debt: 10,000

Common equity: 15,000

Total$30,000

It is the beginning of 2011, and the management team has $5 million of its own capital, including its share of the sales price, available to purchase all of the venture's existing equity capital. The intent is to retire all of the old stock and issue two million shares of common stock in the new venture to the management team. LBO financiers will put up $20 million in 8 percent, five- year subordinated debt funds plus 1.9 million warrants that can be converted into 1.9 million shares of common stock. A bank will also offer a $10 million, 14 percent interest rate, four-year fully amortized loan. To make the deal work, Brian Motley was asked to provide seller financing in the form of a below-market 10 percent, five-year seller's note. The amount of the note was to be for the difference between the $45 million selling price and the amount of funds raised from management, the LBO financiers, and the bank.

In exchange for the seller financing by Motley, the existing venture capitalists agreed to reduce their ownership rights from 43 to 40 percent. The management team also lowered its claim on the existing venture from 7 to 5 percent. Thus, as the result of agreeing to provide seller financing, Motley's percentage ownership of the $45 selling price was 55 percent. Motley estimated that the interest rate being paid on similar risk-subordinated seller loans was currently at 16 percent.

F.Assume that when MiniDiscs is sold at the end of 2015 for $60 million, the LBO financiers will have their debt retired and will sell their share of interest in the venture. What compound rate of return will the LBO financiers receive?