ZOS KITCHEN CASE DISCUSSION 1. What has made Zos Kitchen successful so far? Briefly describe the key elements of Zos Kitchens business model that have contributed to its success.

2. From the point of view of Brentwood Associates, the PE firm that invested in Zos Kitchen, what are the main benefits of taking Zos Kitchen public? What are the main risks?

3. From the point of view Zos Kitchens management, what are the main benefits of taking Zos Kitchen public? What are the main risks? What, if anything, will management need to change if Zos Kitchen becomes a public company?

4. Please use the information and assumptions in the Zos Kitchen Exercise Excel file posted on Blackboard to estimate ranges for the potential payouts to Brentwood Associates under each of the following three exit scenarios: a. An IPO in early 2014 that values Zos Kitchen at a multiple of its 2013 Adjusted EBITDA. b. A sale to a strategic acquirer in early 2014 that values Zos Kitchen at a multiple of its 2013 Adjusted EBITDA. c. An IPO in early 2016 that values Zos Kitchen at a multiple of its projected 2015 Adjusted EBITDA. Please assume that Brentwood owns 100% of Zos Kitchens equity, and that Zos has no debt or excess cash at the time of exit.

5. In light of your prior answers, which of the following three options for Zos Kitchen should Brentwood pursue? Why? a. Brentwood should take Zos Kitchen public in 2014. b. Brentwood should sell Zos Kitchen to a strategic acquirer in 2014. c. Brentwood should continue to hold Zos Kitchen for at least two additional years, and reevaluate its exit options then. In order to compare options a (an IPO in 2014) and c (re-evaluate the exit options in 2016), you might find it helpful to compute the expected IRR for Brentwood of delaying the IPO from 2014 to 2016 based on the average payouts you have calculated in question 4; you can use the Zos Kitchen Exercise Excel file to do this In addition to considering the potential payouts to Brentwood calculated in question 4, please be sure to also take into account the risks associated with each of the exit options as well as any other factors you think are relevant to Brentwoods decision.

Rahul Aggarwal stared out of his office window at the rush-hour traffic snaking along the I-405 Freeway on a hot August day in 2013. Aggarwal was a managing director at the private equity firm Brentwood Associates (Brentwood) and a board director of Zos Kitchen (Zos), a small but rapidly growing restaurant chain serving fresh, Mediterranean-inspired fare. Zos had been a Brentwood portfolio company since October 2007. During the last few weeks, Aggarwal had been closely following the stock price movements of Noodles \& Co., one of Zos' competitors in the increasingly popular fast-casual restaurant industry. Since Noodles went public on June 28, 2013, its share price had increased 43% over its initial public offering (IPO) opening price. Having held Zos for almost six years, Brentwood was exploring exit alternatives for its investment. Noodles' successful IPO and post-IPO performance were a boon to Zos' own IPO prospects, given the similarity in growth profiles and industry positioning of the two companies. Despite being a much smaller company, Aggarwal believed that Zos' fundamentals were as strong as those of Noodles, if not stronger. Should Zos go public now? There was no doubt that if Brentwood was able to successfully take Zos public, this would be perceived as a "home run" by Brentwood's investors and would help cement Brentwood's track record in the eyes of its investor base. But could Zos pull it off? On the one hand, Zos' operating momentum had been nothing short of impressive. "In 2012 we had our third straight year of double-digit same-store sales growth. I've been doing this for 15 years and you just don't see performance like this, particularly as a company gets bigger," said Aggarwal. Importantly, the IPO market seemed to be finally gaining momentum after almost shutting down during the Great Recession, even though IPO activity in the U.S. still remained far from the levels reached during the 1990s (see Exhibit 1). Aggarwal was also particularly encouraged by the fact that six restaurant companies had gone public since late 2010 and a seventh one was about to do so (see Exhibit 2). On the other hand, there were many risks in executing an IPO. For one, preparing to go public would take substantial managerial time and resources, which risked derailing Zos' growth trajectory. If the IPO was successful, Zos would have to cope with the burdensome accounting and disclosure regulations required of a public company and would be subject to the constant scrutiny of investors and analysts. Was Zos ready for these challenges? Size was another key concern. If Zos were to go public in the coming months, it would be among the smallest restaurant IPOs in the last 15 years. Aggarwal worried that Zos may not generate enough interest among institutional investors, who might feel that the company was too small to be worth their time. Finally, there was the lingering question of just how long this "hot" IPO window might last. Brentwood and Zos could end up sinking a lot of time and money into IPO preparations only to have the window close before Zos could go public. How would a withdrawn IPO affect Zos' valuation in the private markets? How would it affect the morale and motivation of its management team, who would have built up expectations of sharing in the potentially large financial gains of an IPO? If Brentwood decided not to take Zos public, it could exit its investment by arranging a sale to a financial or a strategic buyer. Finally, there was always the option of waiting another two or three years before exiting the investment. Zos had revenues of nearly $80 million in 2012 and expected revenues of approximately $115 million in 2013 (by contrast, Noodles had revenues of $300 million in 2012). At a larger scale, Zos might attract interest from a wider array of investors in both the private and public markets. Aggarwal glanced over at his Outlook calendar: Zos' next board meeting would take place in a week. The question of what kind of exit to pursue would certainly be on the agenda. Both Brentwood and Zos had many issues to consider before a decision could be made. Compared with their venture counterparts, private equity firms typically invested in companies with proven business models that were more mature and could support greater amounts of leverage. However, the frontier between traditional PE and VC firms had become increasingly blurred in recent years as VC firms had started to focus on less risky, later stage investments, giving rise to a new investment category known as "growth equity." VC firms shared this growth equity category with PE firms that, like Brentwood, provided capital to established companies for the purpose of accelerating organic growth. Barnum described the typical company in which Brentwood invested as follows: We normally buy companies from entrepreneurs who started their businesses 15 to 25 years ago. Most entrepreneurs don't want a broad set of exit options with 35 different PE firms looking at their books, having meetings with them, and engaging in a bidding war. Instead, entrepreneurs want their banker or broker to find them three or four good buyers whose strategies match up with their businesses, so that they can interview them and pick the candidate they like the best. These entrepreneurs really care about who the buyer is and what it wants to do with their business. They have built a nice little business and they don't want someone to come in and do untoward things to it, even if they're selling. They typically still live in the community and really want you to take care of their company. Background on Zos Kitchen and Brentwood's Investment Decision Founded by Zo and Marcus Cassimus, Zos Kitchen opened its first restaurant in 1995 in Birmingham, Alabama. Zo Cassimus' Greek heritage and her mother's simple, fresh-from-thegarden cooking philosophy inspired the menu and ambiance of her restaurant. Within a short time, Zos Kitchen became synonymous with outstanding, fresh, and simple food served in an environment as comfortable and personal as Zo's own home kitchen. By 2007, the company was operating 19 restaurants, including three franchised locations, in eight southern states. Brentwood was introduced to the Zos Kitchen investment opportunity in early 2007 by a middlemarket investment bank. The bank had won the mandate to market Zos to a limited number of PE buyers with the relevant resources and expertise to help the company achieve its next stage of growth. At first glance, Zos' small size was a key concern for Brentwood when evaluating the investment. "We were concerned about all the headaches that come with having small scale, including lack of sophistication of the management team and its operating systems as well as questions around the concept's scalability, which ultimately represent more execution risk on the deal," said Aggarwal. At the same time, there were a number of reasons why Brentwood was interested in this opportunity. First, the restaurant industry, particularly the fast-casual segment, was attractive due to its strong growth profile, straightforward execution model, and low sensitivity to economic cycles and other risks common to consumer businesses, such as disintermediation from the Internet. Brentwood had made its first investment in the industry in 2004. By the time the Zos opportunity came across Aggarwal's desk, Brentwood had developed a relatively sophisticated level of industry expertise and strong connections with operating partners, and was actively looking to invest in other restaurant deals. Second, despite its small size, Zos had an exceptionally strong and consistent record of samestore sales growth over the previous four years. Only Chipotle, the best-in-class competitor in the Brentwood, this signaled that Zos was growing for idiosyncratic reasons and not just benefiting from a rising industry tide, a hypothesis Brentwood's customer due diligence supported. "We literally researched people in each of Zos' different markets and it really came through that customers were just incredibly enthusiastic about Zos. Having that strong connection with the customer and being able to validate it through third-party research is one of the key things that we look for across all our investments," noted Aggarwal. Regarding the concerns about Zos scalability, he explained: At the end of the day, the key question is: "Is there enough cash-on-cash return here to justify building more of these restaurants?" And the answer was yes. More importantly, even though there were only 19 restaurants, you could see that the concept was working in a lot of really different places, not just the home market of Birmingham and its surroundings. They had also gone to Houston, Dallas, Nashville, and Jacksonville. If you're in the industry, you know these are pretty different places, and they were having success in all of them. Third and perhaps most importantly, Zos was highly differentiated from its peers in the restaurant space. For Brentwood, differentiation was a key factor for sustaining growth. "If you're in a shopping mall and you want to have a bowl of frozen yogurt, you're just going to buy it from whichever store is there. You're not going to say, 'This frozen yogurt tastes different than the one that I like better, so I'm going to get in my car and drive to another place to buy that company's frozen yogurt," explained Aggarwal. Even if they served good food, these undifferentiated concepts risked becoming dependent on advantageous real estate selection for growth. As a fast-casual Mediterranean concept, Zos was really unique. "There really wasn't anything close to it in the restaurant space on a lot of levels." Mindful of the need to scale Zos and of the execution risks associated with its small size, Brentwood mitigated the deal's risk by doing an all-equity investment, although it did secure a $10 million line of credit from GE Capital at close. "It can be a double level of risk to take on a lot of financial risk and a lot of execution risk in a CAPEX-intensive strategy," explained Aggarwal. By choosing an all-equity capital structure, Brentwood ensured that Zos would have the financial flexibility needed to invest in growing and professionalizing the business without running the risk of violating debt covenants. Brentwood's all-cash offer also helped it win the sale process. On October 31, 2007, Brentwood and its affiliates closed on their majority investment in Zos Kitchen. Growing Zos Kitchen, 2007 - 2013 After closing the deal, two events took place that Brentwood had not anticipated: the onset of the Great Recession and the departure of Zos' CEO. It was under these difficult circumstances that then executive chairman and industry veteran Greg Dollarhyde became CEO of the company and, along with Brentwood, recruited current CEO Kevin Miles in a senior operating role (see Exhibit 4 for biographies). Miles recalled: What attracted me to the Zos opportunity was that it had private equity behind it, unlike my most recent company, Pollo Campero, which was all family-owned. I could see Brentwood had a strategy to grow Zos versus running the business through emotional family ties, which was what Campero was. Having had experience with PE owners through my prior positions at La Madeleine and Baia Fresh. I knew what I was getting into, though I didn't know the Brentwood folks at the time. So I met them and spent a lot of time with Rahul and Bill trying to get a good sense for what they were trying to accomplish at Zos. It really fit with my desire to work with a high growth, better-for-you concept that had a lot of potential with consumers. What was important to me was to have the financial acumen on the board and a PE partner that truly understood what it was going to take to turn what was a 20 unit chain at the time into a 100-plus unit chain. Miles joined Zos in March 2009 as executive vice president of operations and he and Dollarhyde quickly set out to work: We spent all of 2009 professionalizing the team, honing the concept, and building it into what we felt could be a national brand. We touched every surface of the restaurant. We added menu items. We added better lighting, better seating, better music (see Exhibit 5). We had to really build the dinner day-part and focus on how to build the business for long-term sustainability, and still give the customers what they were used to getting. Zos was a very profitable business and we took a lot of the profit out by what we added. Prior to these investments, our restaurants could make money at $800,000 in revenue per establishment; now they needed to reach $1.1 million to be profitable. You had to have the stomach to believe that what we were doing was the right thing for the long-term, particularly given the difficult economic environment that we were facing. I would say that it wasn't until 2011 that we started to see the fruit of all these changes. Miles and Dollarhyde also spent time deciding what should be Zos' geographic expansion strategy and ultimately selected a hub-and-spoke approach (see Exhibit 6). Miles recalled how his prior experience at Baja Fresh helped inform this decision: "Baja's struggles stemmed from the fact that we ran across the country and tried to put two, three, four stores in each of these very different cities to prove to Wall Street or a potential strategic buyer that the concept had legs. It was more about 'Did it have legs?' versus 'Did it make money and were we building a sustainable brand?' So we decided that we weren't going to do that at Zos." Zos adopted a highly analytical, technology-driven approach to many aspects of its operations and growth strategy, including real estate site selection, customer acquisition, and employee training. The company also decided to focus on building company-owned stores instead of pursuing franchising. Although franchising would allow Zos to grow its total unit count faster and required much less capital than a company-owned strategy, it also presented risks to the brand if the franchisees were not aligned with the company. "I don't believe in franchising if you're not going to do it properly. If you're going to franchise, you need to support franchisees, and you need to set up a franchise infrastructure in a way that it can enable them to be successful. Given Zos' size at the time, we didn't have enough resources to build the proper infrastructure, nor did we think it made economic sense for us to do so, particularly given how profitable our restaurants were," explained Aggarwal. By August 2013, Zos was on track to finish 2013 having grown its store count, revenues, and adjusted EBITDA to 102 units, \$116 million, and $11 million, respectively. This represented CAGRs of 34% in store count, 52% in revenues, and 42% in adjusted EBITDA over 2011 levels. The company was also planning to add another 30 restaurants in 2014. (Exhibit 7 summarizes Zos' historical performance since 2011 and compares it to two of its public competitors.) The Exit Decision In mid-2012, almost five years after its initial investment, Brentwood started to consider exit options for Zos. Given the growth nature of its investments, the average hold period of Brentwood's portfolio companies was about six and a half years, compared to three to five years for the typical PE firm. By summer 2013, Brentwood was debating between four potential courses of action: an IPO, a sale to a financial sponsor, a sale to a strategic buyer, or waiting two or three more years before exiting to give Zos time to gain additional scale. The IPO Process In an IPO, a firm transitions from being privately held by a relatively small number of investors to being a public company whose shares could be marketed to the general public and were traded on a major stock exchange (in the U.S., typically the NYSE or Nasdaq). The process to go public usually took six to nine months, though in certain instances it could take significantly longer. Once a company had decided to pursue an IPO, the first step usually involved the hiring of an investment bank that would act as the lead underwriter. The lead underwriter then put together a syndicate of underwriters which would jointly market the firms' shares. Underwriters played a key role in the IPO: they guided the issuing company through this unfamiliar process and used their reputation with investors to vouch for the quality of the issuer. The next step was to prepare the prospectus (Form S-1) that the company would use to register its securities with the U.S. Securities and Exchange Commission (SEC). In the prospectus, the firm described its business model, competitive position, and the planned use of the capital to be raised in the IPO. The company's audited financial statements also became part of the prospectus. Once completed, the prospectus was filed with the SEC, which reviewed the filing and responded with comments in approximately 30 days. The company and its advisors were responsible for addressing all the comments, a process that could take several weeks. Upon completion of the response, a revised S-1 was filed with the SEC for further review. This time-consuming review-and-comment process continued until the SEC had no additional comments. After the SEC cleared the prospectus, the underwriters and the management of the company embarked on a "roadshow" to present the company to potential investors, during which they tried to gauge and generate interest in the IPO. During the roadshow, underwriters typically disclosed a (non-binding) price range for the company's shares, and investors were asked to submit their requests for how many shares they wished to buy and at what price. Based on the feedback they received from the market, underwriters then adjusted the final offering price the day before the IPO. Virtually all IPOs were firm-commitment offerings, in which the underwriter guaranteed that the shares would be sold by buying them all from the issuer at the set offering price. Then, before the market opened on the first day of trading (also known as IPO day), the underwriter allocated blocks of shares at the offering price, mostly to institutional investors. The share allocation process could be complex, particularly if the offering was oversubscribed (i.e., investors requested more shares in total than were offered for sale). Because the allocation process presented the issuer with its only chance of influencing the make-up of its shareholder base, the underwriter took into account the reputations and investing styles of the investors in its allocation decisions. The underwriter strove to achieve an ideal balance between those different types of investors (e.g., long-term, short-term, domestic, foreign, etc.) that could best support the company going forward. underwriters typically provided price stabilization and liquidity to ensure that trading was smooth and, to the extent possible, to prevent price declines that could quickly taint the image of the newly public company. One of the main mechanisms underwriters had to provide this price stabilization was the so-called "greenshoe" or over-allotment option. It worked as follows. Underwriters initially oversold ("shorted") the offering by up to an additional 15% of the offering size. If during the first days of trading the share price fell below the IPO price, underwriters could buy back the extra 15% of shares in the market, thereby creating upward pressure on the stock price. The underwriters could do this without taking the market risk of actually owning this extra 15% of shares because they were simply closing out their short position; in such case, the greenshoe option was not exercised. When the offering was successful and the stock price remained above the offering price, the greenshoe option came into play. If the underwriters were to close their short position by purchasing shares in the open market, they would incur a loss by purchasing shares at a price above the price at which they shorted them (the offering price). To avoid incurring this loss, the underwriters exercised their greenshoe option to purchase an additional 15% of shares from the company at the original offering price, and they used these additional shares to close their short position without losing money. In addition to providing price stabilization during the early days of trading, underwriters often provided post-IPO analyst coverage, which was particularly valuable to small newly public companies that may have a hard time generating analyst interest. Also, many successful IPO firms returned to the market to do a secondary equity offering a few months after the IPO, and it was customary for the IPO underwriters to also lead these follow-on offerings. Should Zos Go Public? When Brentwood and Zos management began exploring the feasibility of an IPO in mid-2012, they first hired a third-party auditor to evaluate Zos' team and the robustness of its internal controls and financial reporting systems. "The questions we had in our mind were: Are we a year away or are we three years away from being ready? Should we even be considering an IPO now?" recalled Miles. The IPO readiness survey, which was completed in November 2012, revealed that while there were a few areas of weakness to be rectified, the company had many of the right systems in place to pursue an IPO in the coming months. During late 2012 and early 2013, Brentwood started to receive signs of strong interest in Zos from the investment banking and investing communities, who had been keeping tabs on the company's growth through industry conferences and other similar events. Following Zos' January 2013 presentation at ICR XChange, one of the largest investment conferences in the country where private companies were given the opportunity to present limited information about their businesses, Aggarwal was contacted by over 20 investment banks asking if Zos might be interested in going public: "When you get these many phone calls from investment banks, you have to really give some thought to what they're saying." The passage of the Jumpstart Our Business Startups (JOBS) Act in April 2012 also made the IPO option more attractive. The JOBS Act made it easier for emerging growth companies (EGCs, those with less than $1 billion in annual revenues) to "test the waters" by gauging investor interest in a potential IPO prior to publicly disclosing an IPO prospectus. The Act also allowed EGCs to submit a prospectus to the SEC for confidential review, provided that such submission and any subsequent amendments be publicly filed at least 21 days prior to the IPO roadshow. "Being able to file the initial S-1 confidentially gives us the option to test the possibility of going public without having our numbers out there for the world to see. You don't want your competitors to have that sort of information if you don't have to have it out there," said Aggarwal. In addition, the ability to test the waters and file confidentially preserved optionality for Zos in the event an IPO did not materialize. "If you try to go public and fail, your private valuation is hurt because you are seen as a tainted asset. It'll sow a seed of doubt in a future buyer. So if we ultimately decide against doing the IPO before we have to make our prospectus public, our valuation would not be permanently tarnished." The JOBS Act thus diminished the disclosure and reputational costs of a failed IPO. The JOBS Act notwithstanding, the IPO option was the costliest of all exit options and carried by far the most execution risk. First, there were the direct costs of an IPO. These included the underwriter fee (typically 5%7% of the gross IPO proceeds, and likely on the high end of that range for a small company like Zos); legal, auditing, and exchange listing fees; and one-time organizational costs to be compliant with regulations imposed by the Sarbanes-Oxley (SOX) Act of 2002. Based on industry reports, Aggarwal estimated that in Zos' case the direct expenses associated with an IPO would be in the order of $10 to $13 million (see Exhibit 8). In addition to the direct one-time costs of an IPO, there were ongoing costs of being a public company. These included incremental staffing costs (e.g., investor relations, internal audits, SEC reporting), and higher fees for accounting, legal services, and liability insurance. A company of Zos' size could expect to incur about $1 to $2 million annually in such recurring costs. While these expenses were important, particularly for a relatively small company like Zos on track to generate $11 million in EBITDA in 2013, Aggarwal was more concerned about the pressures that came with being a public company: We've been able to make long-term decisions while running Zos as a private company. Once you are a public company, having your quarterly numbers or the way you form a sentence in your investor conference call potentially influence the stock price imposes a very different mentality. There are things you can do in a business to increase short-term earnings that may not be the right thing for the long-term, like how you approach pricing or discounting. And you see some of our competitors doing aggressive discounting to make sure that they don't miss their sales number, even though it can have a longer term effect of making the customer think the product is less valuable. If we go public, we'll try to remain long-term oriented in our decision-making and not fall into any of these traps. But there is no way around the fact that quarterly earnings do matter, so these pressures would be an important concern. Miles added: "I believe we have a phenomenal brand. If we go public, my concerns really lie around how we ensure that we don't mess the concept up by whipsawing back and forth in an attempt to do everything that investors want." Brentwood spent considerable time probing whether Zos' management team was interested in running a public company. "Operating a public company is just a totally different ballgame from operating a private company. If you have a management team that does not want to go public, you can't force an IPO on them," said Aggarwal. In fact, Zos' management saw considerable benefits in becoming a public company. "Being a public company would increase our visibility with our customers and make it easier for us to attract and retain employees. From a financing standpoint, it would also provide us with a permanent source of capital to fund our rapid store growth," said Miles. However, Miles was also aware that if he became the CEO of a public company, then he would have to refine the way how he communicated with investors: My style as CEO-and really since my early career-has been very forthright, very transparent. When you are a private company and have a problem, you can simply call your PE investors and say "the business is doing well but we may miss the quarter, and here's why." I couldn't really do that if we were a public company. As a public company, there are many rules about investor communications and, with so many more investors to answer to, it would require more thought and challenging skills to communicate effectively with our investors. Partly because of the restrictions that its managers faced when communicating with investors, a public company's stock price could fluctuate wildly based on factors outside of the company's control, such as market conditions and the performance of competitors. "If one of your competitors reports a really bad quarter because of, say, higher than expected food costs, investors might assume that the other restaurant companies in their portfolio will report the same thing just because they are in the same industry," said Barnum. "So they sell your stock right away before you even have a chance to report your earnings and tell your story. And even if your story is different from the competitor's story, your stock doesn't recover necessarily." Should Zos suffer such a share price decline after its IPO, this decline could directly affect Brentwood, as most PE firms waited until several months after the IPO to sell their shares at the prevailing market price via secondary equity offerings. Sale to a Financial Sponsor or Strategic Buyer An alternative exit option would be to sell Zos to a financial buyer. Aggarwal had received inbound interest from a number of well-known private equity firms, all of whom had indicated a willingness to offer Brentwood an attractive valuation for Zos. Another possibility was to sell Zos to a strategic buyer who might be able to leverage synergies or superior financing abilities to pay a higher purchase price than a financial buyer. Recently, a family-owned restaurant holding company had expressed interest in taking over Zos. Should Brentwood decide to actively market Zos for sale, it could potentially attract many more financial and strategic bidders. The primary benefits of a competitive private sale process were speed and efficiency. A private sale could be completed in less than three months, and would not require as much management time and attention as an IPO. The direct costs to the seller would also be much smaller than in the IPO option, consisting primarily of a fee to an investment bank for running the sale process (typically 1.5% of the gross purchase price) and a fee to legal counsel (in the order of $1 million) for negotiating and reviewing the sale documents. Moreover, in a private sale the probability of a successful outcome would be far less dependent on the unpredictable performance of the public equity markets. The private sale option also provided greater certainty on exit returns by allowing Brentwood to exit its entire stake at once, something that rarely happened in an IPO. The main drawback of a private sale was that valuations tended to be lower in the private markets compared to the public markets. In a sample of restaurant M\&A transactions completed in the past three years, the average multiples paid by financial sponsors and strategic investors were 8x and 13x, respectively; this compared to an average current valuation of 21x trailing EBITDA for publicly traded fast-growth restaurant companies (see Exhibits 9 and 10). That being said, if Brentwood were able to orchestrate a competitive auction involving both financial and strategic bidders, it could still acquired Yard House, a 39-unit "gastropub" restaurant chain, at a 20x EBITDA valuation. If Brentwood could obtain a similar outcome for Zos, it could generate net-of-fees investment returns comparable to those of an IPO without having to endure the headaches and uncertainty of the IPO process. Another possibility was to pursue the sale of a minority stake in Zos to a financial sponsor, followed by an IPO in two to three years' time. This idea, which was raised by a couple of Zos' PE suitors, was not without its merits. A partial sale would allow Brentwood to recoup some of its investment now, while retaining upside on its remaining stake. It might also benefit Brentwood's current fundraising efforts as investors looked favorably on a PE firm's ability to realize proceeds on an investment. Aggarwal liked how this option allowed Brentwood to maintain control of Zos as it headed into an IPO. "It could turn out to be a 'have your cake and eat it too' outcome," he said. Wait and Gain Scale The final option would be to wait and gain scale before eventually exiting via an IPO or a private sale. After all, Zos had strong growth momentum and there were plenty of cities and states where it could still expand. It might be premature to "give away" that operating momentum to another buyer now. As a larger company, Zos' public offering would attract a larger pool of institutional investors, which would help mitigate the execution risk of an IPO. A bigger and more mature Zos would also attract larger PE firms that would not be interested in purchasing Zos now due to minimum investment size thresholds. "You don't gain anything by forcing an early exit," said Aggarwal. "If you can wait and still get a good exit outcome in two years, why not do so?" Zos could also solve its near-term capital needs by upsizing its credit facility with its lender. The company and Brentwood maintained a strong relationship with GE Capital, and Aggarwal felt reasonably confident that they could get yet another increase of Zos' credit line. But there was no denying that if Brentwood were able to successfully take Zos public in the coming months, this would provide a lasting solution to Zos financing needs and would greatly enhance Brentwood's reputation within the investment community. After all, it had been over eight years since Brentwood had taken Zumiez public, an action-sports goods retailer that was Brentwood's only IPO so far. At the same time, Aggarwal worried that a failed IPO could have longlasting negative consequences for both Brentwood and Zos. What kind of exit should Brentwood pursue for Zos? Should they follow the potentially more lucrative but riskier and costlier option of going public now? Should they prioritize speed and certainty of outcome by selling to a financial or a strategic buyer? Or should they wait for Zos to gain scale first before re-examining their exit options? Rahul Aggarwal stared out of his office window at the rush-hour traffic snaking along the I-405 Freeway on a hot August day in 2013. Aggarwal was a managing director at the private equity firm Brentwood Associates (Brentwood) and a board director of Zos Kitchen (Zos), a small but rapidly growing restaurant chain serving fresh, Mediterranean-inspired fare. Zos had been a Brentwood portfolio company since October 2007. During the last few weeks, Aggarwal had been closely following the stock price movements of Noodles \& Co., one of Zos' competitors in the increasingly popular fast-casual restaurant industry. Since Noodles went public on June 28, 2013, its share price had increased 43% over its initial public offering (IPO) opening price. Having held Zos for almost six years, Brentwood was exploring exit alternatives for its investment. Noodles' successful IPO and post-IPO performance were a boon to Zos' own IPO prospects, given the similarity in growth profiles and industry positioning of the two companies. Despite being a much smaller company, Aggarwal believed that Zos' fundamentals were as strong as those of Noodles, if not stronger. Should Zos go public now? There was no doubt that if Brentwood was able to successfully take Zos public, this would be perceived as a "home run" by Brentwood's investors and would help cement Brentwood's track record in the eyes of its investor base. But could Zos pull it off? On the one hand, Zos' operating momentum had been nothing short of impressive. "In 2012 we had our third straight year of double-digit same-store sales growth. I've been doing this for 15 years and you just don't see performance like this, particularly as a company gets bigger," said Aggarwal. Importantly, the IPO market seemed to be finally gaining momentum after almost shutting down during the Great Recession, even though IPO activity in the U.S. still remained far from the levels reached during the 1990s (see Exhibit 1). Aggarwal was also particularly encouraged by the fact that six restaurant companies had gone public since late 2010 and a seventh one was about to do so (see Exhibit 2). On the other hand, there were many risks in executing an IPO. For one, preparing to go public would take substantial managerial time and resources, which risked derailing Zos' growth trajectory. If the IPO was successful, Zos would have to cope with the burdensome accounting and disclosure regulations required of a public company and would be subject to the constant scrutiny of investors and analysts. Was Zos ready for these challenges? Size was another key concern. If Zos were to go public in the coming months, it would be among the smallest restaurant IPOs in the last 15 years. Aggarwal worried that Zos may not generate enough interest among institutional investors, who might feel that the company was too small to be worth their time. Finally, there was the lingering question of just how long this "hot" IPO window might last. Brentwood and Zos could end up sinking a lot of time and money into IPO preparations only to have the window close before Zos could go public. How would a withdrawn IPO affect Zos' valuation in the private markets? How would it affect the morale and motivation of its management team, who would have built up expectations of sharing in the potentially large financial gains of an IPO? If Brentwood decided not to take Zos public, it could exit its investment by arranging a sale to a financial or a strategic buyer. Finally, there was always the option of waiting another two or three years before exiting the investment. Zos had revenues of nearly $80 million in 2012 and expected revenues of approximately $115 million in 2013 (by contrast, Noodles had revenues of $300 million in 2012). At a larger scale, Zos might attract interest from a wider array of investors in both the private and public markets. Aggarwal glanced over at his Outlook calendar: Zos' next board meeting would take place in a week. The question of what kind of exit to pursue would certainly be on the agenda. Both Brentwood and Zos had many issues to consider before a decision could be made. Compared with their venture counterparts, private equity firms typically invested in companies with proven business models that were more mature and could support greater amounts of leverage. However, the frontier between traditional PE and VC firms had become increasingly blurred in recent years as VC firms had started to focus on less risky, later stage investments, giving rise to a new investment category known as "growth equity." VC firms shared this growth equity category with PE firms that, like Brentwood, provided capital to established companies for the purpose of accelerating organic growth. Barnum described the typical company in which Brentwood invested as follows: We normally buy companies from entrepreneurs who started their businesses 15 to 25 years ago. Most entrepreneurs don't want a broad set of exit options with 35 different PE firms looking at their books, having meetings with them, and engaging in a bidding war. Instead, entrepreneurs want their banker or broker to find them three or four good buyers whose strategies match up with their businesses, so that they can interview them and pick the candidate they like the best. These entrepreneurs really care about who the buyer is and what it wants to do with their business. They have built a nice little business and they don't want someone to come in and do untoward things to it, even if they're selling. They typically still live in the community and really want you to take care of their company. Background on Zos Kitchen and Brentwood's Investment Decision Founded by Zo and Marcus Cassimus, Zos Kitchen opened its first restaurant in 1995 in Birmingham, Alabama. Zo Cassimus' Greek heritage and her mother's simple, fresh-from-thegarden cooking philosophy inspired the menu and ambiance of her restaurant. Within a short time, Zos Kitchen became synonymous with outstanding, fresh, and simple food served in an environment as comfortable and personal as Zo's own home kitchen. By 2007, the company was operating 19 restaurants, including three franchised locations, in eight southern states. Brentwood was introduced to the Zos Kitchen investment opportunity in early 2007 by a middlemarket investment bank. The bank had won the mandate to market Zos to a limited number of PE buyers with the relevant resources and expertise to help the company achieve its next stage of growth. At first glance, Zos' small size was a key concern for Brentwood when evaluating the investment. "We were concerned about all the headaches that come with having small scale, including lack of sophistication of the management team and its operating systems as well as questions around the concept's scalability, which ultimately represent more execution risk on the deal," said Aggarwal. At the same time, there were a number of reasons why Brentwood was interested in this opportunity. First, the restaurant industry, particularly the fast-casual segment, was attractive due to its strong growth profile, straightforward execution model, and low sensitivity to economic cycles and other risks common to consumer businesses, such as disintermediation from the Internet. Brentwood had made its first investment in the industry in 2004. By the time the Zos opportunity came across Aggarwal's desk, Brentwood had developed a relatively sophisticated level of industry expertise and strong connections with operating partners, and was actively looking to invest in other restaurant deals. Second, despite its small size, Zos had an exceptionally strong and consistent record of samestore sales growth over the previous four years. Only Chipotle, the best-in-class competitor in the Brentwood, this signaled that Zos was growing for idiosyncratic reasons and not just benefiting from a rising industry tide, a hypothesis Brentwood's customer due diligence supported. "We literally researched people in each of Zos' different markets and it really came through that customers were just incredibly enthusiastic about Zos. Having that strong connection with the customer and being able to validate it through third-party research is one of the key things that we look for across all our investments," noted Aggarwal. Regarding the concerns about Zos scalability, he explained: At the end of the day, the key question is: "Is there enough cash-on-cash return here to justify building more of these restaurants?" And the answer was yes. More importantly, even though there were only 19 restaurants, you could see that the concept was working in a lot of really different places, not just the home market of Birmingham and its surroundings. They had also gone to Houston, Dallas, Nashville, and Jacksonville. If you're in the industry, you know these are pretty different places, and they were having success in all of them. Third and perhaps most importantly, Zos was highly differentiated from its peers in the restaurant space. For Brentwood, differentiation was a key factor for sustaining growth. "If you're in a shopping mall and you want to have a bowl of frozen yogurt, you're just going to buy it from whichever store is there. You're not going to say, 'This frozen yogurt tastes different than the one that I like better, so I'm going to get in my car and drive to another place to buy that company's frozen yogurt," explained Aggarwal. Even if they served good food, these undifferentiated concepts risked becoming dependent on advantageous real estate selection for growth. As a fast-casual Mediterranean concept, Zos was really unique. "There really wasn't anything close to it in the restaurant space on a lot of levels." Mindful of the need to scale Zos and of the execution risks associated with its small size, Brentwood mitigated the deal's risk by doing an all-equity investment, although it did secure a $10 million line of credit from GE Capital at close. "It can be a double level of risk to take on a lot of financial risk and a lot of execution risk in a CAPEX-intensive strategy," explained Aggarwal. By choosing an all-equity capital structure, Brentwood ensured that Zos would have the financial flexibility needed to invest in growing and professionalizing the business without running the risk of violating debt covenants. Brentwood's all-cash offer also helped it win the sale process. On October 31, 2007, Brentwood and its affiliates closed on their majority investment in Zos Kitchen. Growing Zos Kitchen, 2007 - 2013 After closing the deal, two events took place that Brentwood had not anticipated: the onset of the Great Recession and the departure of Zos' CEO. It was under these difficult circumstances that then executive chairman and industry veteran Greg Dollarhyde became CEO of the company and, along with Brentwood, recruited current CEO Kevin Miles in a senior operating role (see Exhibit 4 for biographies). Miles recalled: What attracted me to the Zos opportunity was that it had private equity behind it, unlike my most recent company, Pollo Campero, which was all family-owned. I could see Brentwood had a strategy to grow Zos versus running the business through emotional family ties, which was what Campero was. Having had experience with PE owners through my prior positions at La Madeleine and Baia Fresh. I knew what I was getting into, though I didn't know the Brentwood folks at the time. So I met them and spent a lot of time with Rahul and Bill trying to get a good sense for what they were trying to accomplish at Zos. It really fit with my desire to work with a high growth, better-for-you concept that had a lot of potential with consumers. What was important to me was to have the financial acumen on the board and a PE partner that truly understood what it was going to take to turn what was a 20 unit chain at the time into a 100-plus unit chain. Miles joined Zos in March 2009 as executive vice president of operations and he and Dollarhyde quickly set out to work: We spent all of 2009 professionalizing the team, honing the concept, and building it into what we felt could be a national brand. We touched every surface of the restaurant. We added menu items. We added better lighting, better seating, better music (see Exhibit 5). We had to really build the dinner day-part and focus on how to build the business for long-term sustainability, and still give the customers what they were used to getting. Zos was a very profitable business and we took a lot of the profit out by what we added. Prior to these investments, our restaurants could make money at $800,000 in revenue per establishment; now they needed to reach $1.1 million to be profitable. You had to have the stomach to believe that what we were doing was the right thing for the long-term, particularly given the difficult economic environment that we were facing. I would say that it wasn't until 2011 that we started to see the fruit of all these changes. Miles and Dollarhyde also spent time deciding what should be Zos' geographic expansion strategy and ultimately selected a hub-and-spoke approach (see Exhibit 6). Miles recalled how his prior experience at Baja Fresh helped inform this decision: "Baja's struggles stemmed from the fact that we ran across the country and tried to put two, three, four stores in each of these very different cities to prove to Wall Street or a potential strategic buyer that the concept had legs. It was more about 'Did it have legs?' versus 'Did it make money and were we building a sustainable brand?' So we decided that we weren't going to do that at Zos." Zos adopted a highly analytical, technology-driven approach to many aspects of its operations and growth strategy, including real estate site selection, customer acquisition, and employee training. The company also decided to focus on building company-owned stores instead of pursuing franchising. Although franchising would allow Zos to grow its total unit count faster and required much less capital than a company-owned strategy, it also presented risks to the brand if the franchisees were not aligned with the company. "I don't believe in franchising if you're not going to do it properly. If you're going to franchise, you need to support franchisees, and you need to set up a franchise infrastructure in a way that it can enable them to be successful. Given Zos' size at the time, we didn't have enough resources to build the proper infrastructure, nor did we think it made economic sense for us to do so, particularly given how profitable our restaurants were," explained Aggarwal. By August 2013, Zos was on track to finish 2013 having grown its store count, revenues, and adjusted EBITDA to 102 units, \$116 million, and $11 million, respectively. This represented CAGRs of 34% in store count, 52% in revenues, and 42% in adjusted EBITDA over 2011 levels. The company was also planning to add another 30 restaurants in 2014. (Exhibit 7 summarizes Zos' historical performance since 2011 and compares it to two of its public competitors.) The Exit Decision In mid-2012, almost five years after its initial investment, Brentwood started to consider exit options for Zos. Given the growth nature of its investments, the average hold period of Brentwood's portfolio companies was about six and a half years, compared to three to five years for the typical PE firm. By summer 2013, Brentwood was debating between four potential courses of action: an IPO, a sale to a financial sponsor, a sale to a strategic buyer, or waiting two or three more years before exiting to give Zos time to gain additional scale. The IPO Process In an IPO, a firm transitions from being privately held by a relatively small number of investors to being a public company whose shares could be marketed to the general public and were traded on a major stock exchange (in the U.S., typically the NYSE or Nasdaq). The process to go public usually took six to nine months, though in certain instances it could take significantly longer. Once a company had decided to pursue an IPO, the first step usually involved the hiring of an investment bank that would act as the lead underwriter. The lead underwriter then put together a syndicate of underwriters which would jointly market the firms' shares. Underwriters played a key role in the IPO: they guided the issuing company through this unfamiliar process and used their reputation with investors to vouch for the quality of the issuer. The next step was to prepare the prospectus (Form S-1) that the company would use to register its securities with the U.S. Securities and Exchange Commission (SEC). In the prospectus, the firm described its business model, competitive position, and the planned use of the capital to be raised in the IPO. The company's audited financial statements also became part of the prospectus. Once completed, the prospectus was filed with the SEC, which reviewed the filing and responded with comments in approximately 30 days. The company and its advisors were responsible for addressing all the comments, a process that could take several weeks. Upon completion of the response, a revised S-1 was filed with the SEC for further review. This time-consuming review-and-comment process continued until the SEC had no additional comments. After the SEC cleared the prospectus, the underwriters and the management of the company embarked on a "roadshow" to present the company to potential investors, during which they tried to gauge and generate interest in the IPO. During the roadshow, underwriters typically disclosed a (non-binding) price range for the company's shares, and investors were asked to submit their requests for how many shares they wished to buy and at what price. Based on the feedback they received from the market, underwriters then adjusted the final offering price the day before the IPO. Virtually all IPOs were firm-commitment offerings, in which the underwriter guaranteed that the shares would be sold by buying them all from the issuer at the set offering price. Then, before the market opened on the first day of trading (also known as IPO day), the underwriter allocated blocks of shares at the offering price, mostly to institutional investors. The share allocation process could be complex, particularly if the offering was oversubscribed (i.e., investors requested more shares in total than were offered for sale). Because the allocation process presented the issuer with its only chance of influencing the make-up of its shareholder base, the underwriter took into account the reputations and investing styles of the investors in its allocation decisions. The underwriter strove to achieve an ideal balance between those different types of investors (e.g., long-term, short-term, domestic, foreign, etc.) that could best support the company going forward. underwriters typically provided price stabilization and liquidity to ensure that trading was smooth and, to the extent possible, to prevent price declines that could quickly taint the image of the newly public company. One of the main mechanisms underwriters had to provide this price stabilization was the so-called "greenshoe" or over-allotment option. It worked as follows. Underwriters initially oversold ("shorted") the offering by up to an additional 15% of the offering size. If during the first days of trading the share price fell below the IPO price, underwriters could buy back the extra 15% of shares in the market, thereby creating upward pressure on the stock price. The underwriters could do this without taking the market risk of actually owning this extra 15% of shares because they were simply closing out their short position; in such case, the greenshoe option was not exercised. When the offering was successful and the stock price remained above the offering price, the greenshoe option came into play. If the underwriters were to close their short position by purchasing shares in the open market, they would incur a loss by purchasing shares at a price above the price at which they shorted them (the offering price). To avoid incurring this loss, the underwriters exercised their greenshoe option to purchase an additional 15% of shares from the company at the original offering price, and they used these additional shares to close their short position without losing money. In addition to providing price stabilization during the early days of trading, underwriters often provided post-IPO analyst coverage, which was particularly valuable to small newly public companies that may have a hard time generating analyst interest. Also, many successful IPO firms returned to the market to do a secondary equity offering a few months after the IPO, and it was customary for the IPO underwriters to also lead these follow-on offerings. Should Zos Go Public? When Brentwood and Zos management began exploring the feasibility of an IPO in mid-2012, they first hired a third-party auditor to evaluate Zos' team and the robustness of its internal controls and financial reporting systems. "The questions we had in our mind were: Are we a year away or are we three years away from being ready? Should we even be considering an IPO now?" recalled Miles. The IPO readiness survey, which was completed in November 2012, revealed that while there were a few areas of weakness to be rectified, the company had many of the right systems in place to pursue an IPO in the coming months. During late 2012 and early 2013, Brentwood started to receive signs of strong interest in Zos from the investment banking and investing communities, who had been keeping tabs on the company's growth through industry conferences and other similar events. Following Zos' January 2013 presentation at ICR XChange, one of the largest investment conferences in the country where private companies were given the opportunity to present limited information about their businesses, Aggarwal was contacted by over 20 investment banks asking if Zos might be interested in going public: "When you get these many phone calls from investment banks, you have to really give some thought to what they're saying." The passage of the Jumpstart Our Business Startups (JOBS) Act in April 2012 also made the IPO option more attractive. The JOBS Act made it easier for emerging growth companies (EGCs, those with less than $1 billion in annual revenues) to "test the waters" by gauging investor interest in a potential IPO prior to publicly disclosing an IPO prospectus. The Act also allowed EGCs to submit a prospectus to the SEC for confidential review, provided that such submission and any subsequent amendments be publicly filed at least 21 days prior to the IPO roadshow. "Being able to file the initial S-1 confidentially gives us the option to test the possibility of going public without having our numbers out there for the world to see. You don't want your competitors to have that sort of information if you don't have to have it out there," said Aggarwal. In addition, the ability to test the waters and file confidentially preserved optionality for Zos in the event an IPO did not materialize. "If you try to go public and fail, your private valuation is hurt because you are seen as a tainted asset. It'll sow a seed of doubt in a future buyer. So if we ultimately decide against doing the IPO before we have to make our prospectus public, our valuation would not be permanently tarnished." The JOBS Act thus diminished the disclosure and reputational costs of a failed IPO. The JOBS Act notwithstanding, the IPO option was the costliest of all exit options and carried by far the most execution risk. First, there were the direct costs of an IPO. These included the underwriter fee (typically 5%7% of the gross IPO proceeds, and likely on the high end of that range for a small company like Zos); legal, auditing, and exchange listing fees; and one-time organizational costs to be compliant with regulations imposed by the Sarbanes-Oxley (SOX) Act of 2002. Based on industry reports, Aggarwal estimated that in Zos' case the direct expenses associated with an IPO would be in the order of $10 to $13 million (see Exhibit 8). In addition to the direct one-time costs of an IPO, there were ongoing costs of being a public company. These included incremental staffing costs (e.g., investor relations, internal audits, SEC reporting), and higher fees for accounting, legal services, and liability insurance. A company of Zos' size could expect to incur about $1 to $2 million annually in such recurring costs. While these expenses were important, particularly for a relatively small company like Zos on track to generate $11 million in EBITDA in 2013, Aggarwal was more concerned about the pressures that came with being a public company: We've been able to make long-term decisions while running Zos as a private company. Once you are a public company, having your quarterly numbers or the way you form a sentence in your investor conference call potentially influence the stock price imposes a very different mentality. There are things you can do in a business to increase short-term earnings that may not be the right thing for the long-term, like how you approach pricing or discounting. And you see some of our competitors doing aggressive discounting to make sure that they don't miss their sales number, even though it can have a longer term effect of making the customer think the product is less valuable. If we go public, we'll try to remain long-term oriented in our decision-making and not fall into any of these traps. But there is no way around the fact that quarterly earnings do matter, so these pressures would be an important concern. Miles added: "I believe we have a phenomenal brand. If we go public, my concerns really lie around how we ensure that we don't mess the concept up by whipsawing back and forth in an attempt to do everything that investors want." Brentwood spent considerable time probing whether Zos' management team was interested in running a public company. "Operating a public company is just a totally different ballgame from operating a private company. If you have a management team that does not want to go public, you can't force an IPO on them," said Aggarwal. In fact, Zos' management saw considerable benefits in becoming a public company. "Being a public company would increase our visibility with our customers and make it easier for us to attract and retain employees. From a financing standpoint, it would also provide us with a permanent source of capital to fund our rapid store growth," said Miles. However, Miles was also aware that if he became the CEO of a public company, then he would have to refine the way how he communicated with investors: My style as CEO-and really since my early career-has been very forthright, very transparent. When you are a private company and have a problem, you can simply call your PE investors and say "the business is doing well but we may miss the quarter, and here's why." I couldn't really do that if we were a public company. As a public company, there are many rules about investor communications and, with so many more investors to answer to, it would require more thought and challenging skills to communicate effectively with our investors. Partly because of the restrictions that its managers faced when communicating with investors, a public company's stock price could fluctuate wildly based on factors outside of the company's control, such as market conditions and the performance of competitors. "If one of your competitors reports a really bad quarter because of, say, higher than expected food costs, investors might assume that the other restaurant companies in their portfolio will report the same thing just because they are in the same industry," said Barnum. "So they sell your stock right away before you even have a chance to report your earnings and tell your story. And even if your story is different from the competitor's story, your stock doesn't recover necessarily." Should Zos suffer such a share price decline after its IPO, this decline could directly affect Brentwood, as most PE firms waited until several months after the IPO to sell their shares at the prevailing market price via secondary equity offerings. Sale to a Financial Sponsor or Stra