tim98404_ch14.qxd

Case Questions (each answer should be roughly 1 page double spaced, 4 pages total):

1. 1. Evaluate the business opportunity for the franchisee and the franchisor. How do they make money in this business?
2. 2. Evaluate the company?s growth and financial strategy. What have been the consequences?
3. 3. Evaluate the current strategy, both for growth and for financing. How much money is needed and when?
4. 4. What should Hindman do?

tim98404_ch14.qxd 3/19/03 12:36 PM Page 491 Chapter 14 Obtaining Venture and Growth Captital 491 Case Hindman & Company Preparation Questions 1. 2. 3. 4. Evaluate the business opportunity for the franchisee and the franchisor. How do they make money in this business? Evaluate the company's growth and financial strategy. What have been the consequences? Evaluate the current strategy, both for growth and for financing. How much money is needed and when? What should Hindman do? Dismal Friday It is March 10, 1983, another \"Dismal Friday\" for Jiffy Lube, Inc., and Jim Hindman, president and founder. Today's layoffs are the latest in a series of cutbacks that have reduced Jiffy Lube's payroll by over 40 percent since the beginning of February. The layoffs and other cost reductions are painful, but Hindman realizes that things can still get worse. Jim Hindman founded Jiffy Lube in 1979. Now, in March 1983, it is the largest franchisor of quick oil change and lubrication service centers in the United States. Jiffy Lube service centers perform a \"14 point fluid maintenance program\" on automobiles in approximately 10 minutes. Customers pay $18-$20 for the basic service (optional services also are provided for an additional charge). Background After graduating from the University of Minnesota with a master's degree in health care administration, Hindman worked 10 years as a hospital administrator. In 1967, he started his own health care business, Hindman & Associates. The company built 32 nursing homes and eventually diversified into several unrelated businesses. By the mid-1970s, Hindman's ownership interests in these ventures were worth several million dollars, and he was bored and looking for new challenges. In the early 1970s, Hindman began coaching football in his free time, eventually taking over as head coach of Western Maryland College in 1977. By 1979, Hindman was again restless and looking for new business opportunities. One of the factors that prompted Hindman to start another business was a comment made by one of his students, who claimed that: \"There are no opportunities left. You couldn't make a million dollars in America today.\" \"I was really perplexed at how in the hell he could come away from college believing that,\" recalls Hind- man. \"That really was a major, triggering, emotional event that caused me to start looking around for a new business.\" Joining him were Ed Kelley and Steve Spinelli. Kelley had worked for Hindman in the health care business and was an assistant coach at Western Maryland. The fast oil change business quickly caught Hindman's attention. Research revealed that in the prior 10 years, the number of full-service gas stations had been reduced by almost half. Most had been replaced by selfservice stations, which didn't do oil changes or other minor maintenance. Hindman's brother-in-law knew a man who operated a \"Jiffy Lube\" franchise (part of a chain of oil change centers headquartered in Utah). After several meetings with Jiffy Lube's owner in Utah, Hindman purchased the Jiffy Lube trademark and the rights to seven franchises. Early Strategy Jim Hindman describes Jiffy Lube's early progress after acquiring the first seven units in May 1979: We spent most of the first year putting together a formal policy and procedure manual for the franchises and developing a standard design for the service centers. E&W assisted us in the development of our franchise audit program and in setting up our accounting system. We also did a complete market study; we were trying to develop a system that would be responsive to the customer. Jiffy Lube's early strategy is summarized in excerpts from a business plan prepared in the first year of operation (see Exhibit A). Ed Kelley sums up their early strategy: Our goal was to get to 100 units as quickly as possible. We were trying to reach a level of respectability. That would allow us to go out and do some of the things we needed to do, which was primarily to attract capital, and attract people to buy our franchises. Expansion . . . and Losses The Jiffy Lube network of service centers has grown rapidly from its original seven units (Exhibit B). The growth has come from the acquisition of four small chains of service centers (approximately 30 units in total), the acquisition of individual centers, and the sale of new franchises. Jiffy Lube has successfully expanded its network of service centers, but it has incurred cumulative losses of more than $5 million since inception (Exhibit C ). The tim98404_ch14.qxd 3/19/03 12:36 PM Page 492 492 Part IV Financing Entrepreneurial Ventures EXHIBIT A Business Plan Over 100 Jiffy Lube Service centers will be in operation by the end of 1982. Expansion will be accomplished through: 1. Sales of new franchises. 2. Acquisition of existing service centers or small franchise chains that meet the company's specifications. Franchising will be used as the primary means of expanding the Jiffy Lube network. Franchising will attract qualified managers to each individual center because of the ownership opportunity offered them. Franchising will also accelerate growth because it eliminates many of the managerial and financial requirements that would be necessary to develop and maintain a large network of company-operated centers. Franchises will be positioned to create blocks of service centers in targeted cities. \"Clustering\" these centers in large blocks will build name recognition and make advertising cost-effective. The overall image of Jiffy Lube is not yet at the point where all franchisees will be willing to pay up front the $250K-$300K required to purchase land and develop a new center. In many situations it may be necessary for Jiffy Lube to provide the real estate development financing. Reaching 100 units by the end of 1982 will require the sale of 40 to 60 new franchises (depending on the number of units acquired from existing chains). The company may find it necessary to provide real estate financing for half, or 20 to 30, of these units. Based on a cost of $300K per unit, Jiffy Lube will need to obtain real estate financing of $6 million to $9 million to achieve the projected level of new franchise sales. EXHIBIT B Jiffy Lube Service Center Network (includes statistics for both franchised and company-owned centers) Year Ending March 31 Total gross sales for network (millions) Total centers in operation: Franchised Company owned 1980 1981 1982 1983 (projected) $1.5 $2.5 $7.1 $15.6 7 19 40 96 1 10 30 0 EXHIBIT C Jiffy Lube, Inc., Operating Results Year Ended March 31 (in millions) 1980 Revenues Net loss See Exhibit G for projected 1983 financial statements. 1981 1982 1983 (projected) $.2 $2.0 $3.5 $5.5 $(0.4) $(0.7) $(1.4) $(2.6) tim98404_ch14.qxd 3/19/03 12:36 PM Page 493 Chapter 14 Obtaining Venture and Growth Captital entire network of service centers is projected to generate over $15 million in sales for fiscal 1983. However, as the franchisor, Jiffy Lube shares in only a portion of this total. Jiffy Lube's revenues are made up of the following: Royalty fees from franchisees (approximately 5 percent of each franchisee's gross sales). Rental income on property leased or subleased to franchisees. Initial fees from new franchises (approximately $20,000 per new service center). Sales by company-owned centers (however, as described in a later section, all company-owned centers were disposed of in fiscal 1983). The majority of franchisees are individuals who operate one or two franchises. Early Financing Jiffy Lube was financed during its startup and first several years of growth largely through Jim Hindman's personal resources. During the first three years of operation Hindman contributed over $1.5 million in the form of cash, assumptions of debt, and forgiveness of personal loans made to Jiffy Lube. Hindman also personally guaranteed certain transactions Jiffy Lube entered into, including lines of credit with banks, loans relating to the purchase or development of service centers, and real estate lease obligations. Ernst & Whinney provided introductions to several banks and, at Hindman's request, participated in key meetings with the bankers. Financing also was obtained through the sale of stock to directors, officers, employees, and other investors. 493 The most significant sale was a private placement of $530K in preferred stock, the majority of which was sold to a small group of Midwest investors. In addition, Jiffy Lube used its common stock in several acquisitions, the largest being the purchase of Speedy Lube, a franchisor and operator of seven oil change centers. In addition to the above, the need for real estate financing outlined in Jiffy Lube's business plan resulted in the company's most significant financing transaction to date, its 1981 agreement with Pennzoil. Pennzoil Agreement In December 1980, Hindman and Kelley attended a trade meeting put on by Pennzoil for its regional sales people and major distributors. Pennzoil was the oil supplier for the majority of Jiffy Lube centers and believed that the quick oil change business could become a new major distribution channel for oil products. Pennzoil saw the quick change industry as an opportunity to gain market share from Quaker State, the leading oil distributor in the eastern United States. Pennzoil's national sales manager told Hindman that the oil company planned on building 100 quick oil change centers in the East. Hindman spent the night writing a proposal to convince Pennzoil to work with Jiffy Lube, rather than compete against it. In October 1981, the two companies signed an agreement (Exhibit D). For $1 million Jiffy Lube sold convertible preferred stock representing 29 percent of the company to Pennzoil. The agreement allowed Pennzoil to place four members on Jiffy Lube's board of directors. Pennzoil agreed to guarantee $6.3 million of real estate financing. Service centers developed with the financing guaranteed by Pennzoil were EXHIBIT D Pennzoil Agreement Pennzoil will purchase 10,000 shares of Jiffy Lube Convertible Preferred Stock for $1,000,000. Cumulative dividends of $12 per preferred share are payable quarterly. Any deficiency must be paid or declared before setting aside any funds for any junior stock. These shares are redeemable by Jiffy Lube at any time after November 17, 1985, upon payment in cash of $110 per share plus an amount equal to all accrued dividends. They can be converted at the option of Pennzoil into common stock at a conversion price of $0.553 per share of each $1.00 Preferred Stock value. Pennzoil shall have the option of electing the greater of 3 or 30 percent of the members of the board of directors of Jiffy Lube. Jiffy Lube agrees to furnish Pennzoil certain financial information, including audited financial statements within 150 days after the close of each fiscal year, and unaudited statements within 45 days after the close of the first three fiscal quarters. Jim Hindman, and then Jiffy Lube, shall have the right of first refusal should Pennzoil desire to sell any of its shares of Jiffy Lube stock. Pennzoil has the right of first refusal should Jim Hindman decide to sell any of his shares of Jiffy Lube stock. Pennzoil agrees to issue a commitment to guarantee $6,250,000 worth of indebtedness to be incurred in connection with the financing of real estate site acquisition and construction cost in connection with the erection of Jiffy Lube centers. These units are to be built east of the Mississippi River and generally along the eastern seaboard. Pennzoil agrees to guarantee an additional $1,000,000 in order to finance Jiffy Lube's purchase from Pennzoil of four units which Pennzoil has financed under its \"Build to Suit\" program. Any units built using financing guaranteed by Pennzoil will be required to enter into a Lube Center Sales Agreement and to execute a Pennzoil Sign Agreement. Pennzoil will have the right to approve the selection of new sites to be financed under this agreement. tim98404_ch14.qxd 3/19/03 12:36 PM Page 494 494 Part IV Financing Entrepreneurial Ventures required to purchase the majority of their oil products from Pennzoil. Pennzoil's financing allowed Jiffy Lube to initiate its aggressive expansion plan. The agreement also strengthened Jiffy Lube's financial credibility, and enabled it to increase its bank line of credit from $300K to over $1.2 million. The relationship with Pennzoil was far from perfect, however. The two companies apparently had different objectives, which resulted in different strategies for Jiffy Lube's expansion. Jiffy Lube's business plan emphasized \"clustering\" and \"franchising\"; Pennzoil advocated \"wide coverage\" and \"assured distribution channel\" (company-owned service centers). Jiffy Lube quickly discovered that Pennzoil's \"right to approve the selection of new sites\" as outlined in the agreement really meant that the oil company would select the new sites. Pennzoil used a \"scattergun\" approach to site selection. To create maximum exposure for the Pennzoil name, the oil company wanted service centers to be developed in as many markets as possible. \"It seemed like we had one center in every major city from Miami to Boston,\" recalls Hindman. In addition, Pennzoil did not believe that franchising should be relied on to provide all of the growth. Jim Hindman: As soon as we signed the agreement and walked out of their corporate offices, they took me by the hand and got us involved in the acquisition of service centers which we were to operate. This was despite the fact that our business plan specifically stated that we were going to go out and franchise. Under Pennzoil's direction, Jiffy Lube acquired three chains of oil change centers (23 units in total) in late 1981 and early 1982. Hindman felt that Pennzoil's strategy ran counter to Jiffy Lube's own strategy and that \"our business plan had been trashed. We were not capitalized to operate these centers, and we didn't have the management team.\" Why did Jiffy Lube go along? \"They were supplying the money. I felt that we just got married to these guys; we've got to go along to get along.\" The acquired stores quickly became a burden to Jiffy Lube. By the end of fiscal 1982, 30 of the 70 Jiffy Lube centers were owned and operated by the company. These required a large commitment of Jiffy Lube's managerial and financial resources and resulted in significant overhead costs. And sales at many of the new centers were not growing as fast as expected. \"Every market where we had just one unit we were dying,\" recalls Hindman. Jiffy Lube lost $1.4 million in the year ended March 31, 1982, and was expected to lose $2.6 million for fiscal 1983. By April 1982 Hindman made three major decisions: 1. 2. All company-owned centers would be sold to franchisees. Hindman was going to buy Pennzoil's Jiffy Lube stock. 3. Jiffy Lube would have to find other sources of financing to continue its growth plans. Between May 1982 and February 1983, Jiffy Lube sold all of its company-owned centers to franchisees. In most cases, to expedite the sale, Jiffy Lube retained ownership of the service center's real estate and sold only the rights to operate the franchise. The real estate was then leased to the franchisee. Hindman had also tried to resolve the conflict with Pennzoil: We tried to convince Pennzoil that (1) we had to cluster and (2) we had to have a different relationship. They were a giant and they took too long. They had 10 committees, and everything required 10 sign-offs. We needed to move fast to get back to our original strategy. Our only solution was to buy them out. We had to move carefully, though. We wanted to end up with a good relationship with Pennzoil. Even if they sold us the stock back, they were still our largest supplier, and had guaranteed over $5 million in real estate financing for us. From October 1982 to February 1983, I didn't put any money into the company even though we were hurting. I knew that if I started putting money in, it would just give Pennzoil an incentive to want to keep their stock. So we let our payables build up and let a large part of our staff go. In February 1983, Pennzoil agreed to sell Hindman its stock for $435K. Jiffy Lube's worsening financial status during fiscal 1983 made it easier for Hindman to buy out Pennzoil: \"They wanted out. Maybe they thought we were going bankrupt, and they could pick up the service centers after we went under.\" The split with Pennzoil was reasonably amicable. Hindman: They recognized that the arrangement wasn't working. Pennzoil still believed in the concept of quick oil change centers, though. They believed that regardless of whether we survived or not, a large amount of oil was going to be sold through the quick change centers. Pennzoil kept their real estate guarantees in place. Current Situation: 1983 Now, in 1983, Jiffy Lube feels that it is well positioned for the future, despite the past losses and current cash crises. Jiffy Lube has 96 units and is the largest franchisor of quick oil change centers in the United States. The company has reached a respectable size and feels it can take advantage of the name recognition being generated in some areas. In addition, the company has gotten back to its original strategy of franchising, rather than operating service centers. The sale of all company-owned stores has cut costs and freed management to spend more time selecting and selling new franchise sites. The company expects tim98404_ch14.qxd 3/19/03 12:36 PM Page 495 Chapter 14 Obtaining Venture and Growth Captital 495 EXHIBIT E Financial Characteristics of Typical Jiffy Lube Franchise Real estate requirements 15,000 square feet of land (building interior covers 2,500 square feet) Cost of land and building $300,000 Startup costs (equipment, etc.) $100,000 Monthly fixed costs $8,000 Variable costs 57% of sales Breakeven car count/day 28-35 cars Typical months to breakeven 7-8 months A \"typical\" mature unit (approximately two years old) will service between 60-70 cars per day, producing annual revenues of about $400,000-$500,000 and $75,000-$100,000 of pretax income. Depending on whether the franchisee owns or leases the real estate, the monthly fixed costs include a charge for either: 1. Rent ($3,000-$4,000) paid to Jiffy Lube or to a 3rd party lessor, or 2. A similar charge for mortgage interest. The 96 franchises currently in operation have the following real estate arrangements: Real estate owned by Jiffy Lube and rented to the franchisee 20 Real estate owned by Jiffy Lube and subleased to the franchisee 4 Real estate owned or leased by the franchisee. (Approximately 30 of these were part of chains to which Jiffy Lube acquired the franchise rights. In these cases the franchisees already had their own real estate arrangements before Jiffy Lube became involved.) 72 EXHIBIT F Management's Analysis of Future Operations Management has made the following projections of future operations: Service Centers in Operation Fiscal Year At Year End On Average during the Year Total Gross Sales for Network 1983 96 83 $16 million (based on 11 months of actual operations) 1984 125 111 $28 million 1985 200 163 $49 million 1986 300 250 $75 million In addition to projecting the future revenues, management has reviewed current expenditures and made the following prognosis for the upcoming year: 1. All expenses related to the company-operated centers have been eliminated. 2. Management believes that because of the recent restructuring, selling, general, and administrative expenses can be held to approximately $2.1 million during fiscal 1984. To achieve the growth projected for fiscal 1985 and 1986, it is anticipated that selling, general, and administrative (S, G, & A) expenses will have to increase to $2.6 million and $3.1 million respectively. 3. The only other significant expenses expected are interest on the outstanding debt and real estate lease commitments. to open at least 25 new franchises in the coming year. Jiffy Lube also expects improvements in the units it recently sold, as franchised centers have historically outperformed the company-owned centers. Exhibit E summarizes the financial characteristics of the typical franchise. Fiscal 1983 is coming to a close, and management's analysis of future operations has been prepared, along with projected financial statements based on the first 11 months of operation (Exhibits F, G, H, I, and J ). Jiffy Lube is now dependent on franchise tim98404_ch14.qxd 3/19/03 12:36 PM Page 496 496 Part IV Financing Entrepreneurial Ventures royalties and rental income, because of the sale of the company stores. Because of its dependence on franchise royalties, Jiffy Lube needs to quickly increase the number of franchises. Much of the growth to date has come through the acquisition of existing chains. Franchise agreements for new units are typically made with individuals for one or two service centers. Experience to date has proven that the sale and development of new franchises can be accelerated when Jiffy Lube offers to provide or arrange for real estate and construction financing. Possible Alternatives Hindman has already used the majority of his liquid assets in his prior contributions to Jiffy Lube and in the pur- chase of the Pennzoil stock. His major remaining assets are his interests in W. James Hindman, Ltd. (75 percent ownership), and several other nursing home partnerships (these might be worth as much as $3 million). Hindman has considered disposing of his partnership interests to provide cash for Jiffy Lube. However, Hindman's tax basis in these (approximately $200K) is far less than the current market value, and he views the outright sale of them as a last resort because of the tax consequences. Several other investors in W. James Hindman, Ltd., are also shareholders in Jiffy Lube and seem willing to use their investments to raise cash for Jiffy Lube. Another source Jiffy Lube has considered is a second private placement with existing shareholders. Specific terms haven't been discussed, and it is unknown how much these investors would be willing to contribute. EXHIBIT G Projected Statement of Operations and Balance Sheet Projected Statement of Operations Year Ended March 31, 1983 (projected) Revenues: Sales by company-operated units Initial franchise fees Franchise royalties Rental income from franchisees Net gain on sales of company-operated units Miscellaneous Total revenues Expenses: Company-operated units: Cost of products sold Salaries and wages Depreciation and amortization Interest Rent Other Total units expenses Commissions Selling, general, and administrative expenses Interest expense Total expenses Net loss $3,877,000 685,000 542,000 276,000 40,000 41,000 5,461,000 1,300,000 1,090,000 180,000 258,000 308,000 1,250,000 4,386,000 136,000 2,749,000 762,000 8,033,000 $(2,572,000) tim98404_ch14.qxd 3/19/03 12:36 PM Page 497 Chapter 14 EXHIBIT G Obtaining Venture and Growth Captital 497 (concluded) Projected Balance Sheet March 31, 1983 (projected) Assets Current assets: Cash Accounts receivable Prepaid expenses Total current assets Accounts receivable from future franchises Property and equipment: Land Buildings and improvements Automobiles, furniture, and equipment $139,000 962,000 23,000 1,124,000 636,000 2,372,000 3,913,000 255,000 Construction in progress Intangible assetstrademarks, franchise rights, and deferred finance costs Deferred franchise costs Other assets 682,000 7,222,000 203,000 7,019,000 815,000 199,000 103,000 Total assets $9,896,000 Less allowances for depreciation Liabilities and Stockholders' Equity Current liabilities: Accounts payable and accrued expenses Due to officers, directors, and employees Notes payable Current portion of long-term debt Current portion of capital lease obligations Total current liabilities Long-term debt, less current portion Capital lease obligations, less current portion Deferred franchise fees Stockholders' equity: Series A 12% cumulative convertible preferred stock $12.00 cumulative convertible preferred stock Common stock Capital in excess of par value Retained-earnings deficit Less cost of common stock held in treasury Total stockholders' equity Total liabilities and stockholders' equity $1,252,000 696,000 2,211,000 86,000 4,000 4,249,000 6,577,000 359,000 1,143,000 1,307,000 1,000,000 166,000 880,000 (5,238,000) (1,885,000) (547,000) (2,432,000) $9,896,000 tim98404_ch14.qxd 3/19/03 12:36 PM Page 498 498 Part IV Financing Entrepreneurial Ventures EXHIBIT H Long-Term Debt/Rent Commitments at March 1983 Description Payment Terms/ Comments March 1983 Balance Interest Rate $5,372,000 16.5% 524,000 Prime Notes relating to acquisitions of service center chains: Benchmark/Archeo Browns Quick Lube Joe Wilkerson Stock repurchaseJohn Lindholm 250,000 117,000 117,000 104,000 Prime \u0001 1% 13% 13% Prime Others 179,000 Vary from 12% to 18% Construction loans: NA mortgage Maryland National Bank Monthly payments of approximately $75,000 are required in fiscal 1984. Requires increasing monthly payments for interest and maturity through February 1994. Guaranteed by Pennzoil. Monthly payments of approximately $7,000, varying based on the prime interest rate. Due 6/85 Due 2/87 Due 2/87 Annual payments of approximately $50,000. Mature at various times through 1987. $6,663,000 Rent commitments: Fiscal 1984 commitments payable under capital and operating leases ($150K represents real estate subleased to franchisees; the remainder is office building, etc., included in S, G & A) Rentals receivable in fiscal 1984 from franchises already in operation, land, buildings, and improvements rented to franchisees $ 230,000 $ 775,000 EXHIBIT I Notes Payable and Amounts Due to Officers, Directors, and Employees at March 1983 Description Notes payable: Bank lines of credit: Maryland National Bank Savings Bank 1st National Jiffy Lube International Partnership #1 Notes to four accounts payable vendors March 1983 Balance $499,000 500,000 250,000 Interest Rate Prime \u0001 1% Prime \u0001 1% Prime \u0001 1% 675,000 Prime \u0001 1/2% 287,000 0-10% Payment Terms/Comments Minimum interest rate of 12%. The notes become payable at various times between 6/83 and 3/84. Jiffy Lube has drawn the full amount of each line. Due on demand. Hindman owns 27% of partnership. Another 56% is owned by four individuals who are directors (or former directors) of Jiffy Lube. All due by 6/83. $2,211,000 Due to officers, directors, and employees: Jim Hindman Others $550,000 146,000 $696,000 Prime \u0001 1% Due on demand. Majority are noninterest-bearing demand notes to J. Hindman. tim98404_ch14.qxd 3/19/03 12:36 PM Page 499 Chapter 14 Obtaining Venture and Growth Captital 499 EXHIBIT J Ownership at March 1983 Common stock Jim Hindman, president/CEO Gilbert Campbell, director Others (less than 5%) Series A 12% cumulative preferred stock: Jim Hindman Others (less than 5%) (Convertible at the option of the holders into approximately 1,568,000 shares of common stock.) $12.00 cumulative convertible preferred stock: Jim Hindman (Convertible at the option of the holders into approximately 1,808,000 shares of common stock.) Shares Percent 2,133,333 285,710 675,775 3,094,818 69% 9 22 100% 7,255 5,815 13,070 66% 44 100% 10,000 100%