Dwayne Clarke and Fred Munk were sitting in their weekly sales meeting with their new manager (GM) Bruce Hunter. The local pet supply company, ACME Pets, for which they both had worked more than six years, had recently been acquired by a large national company, GC Pet Supplies (GCPS). This was their 4th such meeting with the entire sales team. Dwayne and Fred had caught eyes when their Machiavellian boss (Bruce) had just announced another day and route change for delivery to a particular area. Bruce defended the change with the comment, ‘who are the customers going to get their supplies from if they don’t like it?’ GCPS had not only purchased ACME but also their only significant competitor, attaining a virtual monopoly in the region. Independently, Dwayne and Fred both thought that perhaps ‘I should be the one that the customer can go to.’ After the sales meeting Dwayne and Fred privately shared their thoughts with each other.
Dwayne had worked for ACME Pets for nine years, starting as a warehouse labourer while he finished college. Upon graduation, the owner approached him about taking over a sales route for a departing rep. The position was perfect for him. His warm genuine personality quickly won over his customers and eventually Dwayne grew his territory to over $2 million in annual sales, one third of that office’s total.
Fred had started six years earlier as a buyer and had built a strong relationship with over one hundred vendors from whom they purchased products. Fred’s philosophy was that his city was a small, expensive stop for most vendor sales reps; therefore, he was keen to give them time and listen to their presentations when they visited. He wasn’t an easy mark but he gave everyone an honest shake. Fred worked hard and simultaneously pursued an advanced management degree. His efforts paid off and he moved up the company ladder rapidly and at the time that GCPS bought ACME, he was the General Manager. As such, Fred had ample opportunity to build relationships with many of the customers and vendors that worked with ACME. However, Fred rarely had contact with Dwayne’s customers as they were already being serviced beyond company expectations.
Status Quo or New Venture?
As Dwayne and Fred pondered the possibility of starting a new pet supply company, they grappled with the ethics of performing any due diligence while staying employed with their eventual competitor. They decided to ask some questions and do the underlying research over the coming months. Ultimately, they had to determine at what point to terminate their employment if they felt the opportunity was worth pursuing.
After 7 months, the preliminary research looked promising. They determined that the potential enterprise had merit. However, the required financing was a significant roadblock. Both were dissatisfied with their jobs at GCPS but, as creatures of comfort, Fred and Dwayne wondered if they really wanted to leave the security that they had in their current employment. Years later, they admitted that they probably would not have acted if their hand had not been forced.
GCPS senior management had heard rumours that Fred had already started a competitive venture. Thus, they decided to fire Fred. Shortly thereafter, Dwayne resigned his position so that he could partner with Fred in the new venture. Fortuitously, Dwayne and Fred found a mutual friend who offered to help fund their new business. Out of work and armed with a new hope for resources, Fred and Dwayne developed a plan for Qualco Pet Supply.
GCPS was obviously not happy about the potential competition and it attempted to flex its muscles and discourage suppliers from selling to the budding competitor. However, suppliers and customers were quite keen about the new pet supply distributor in the area and Qualco was reasonably successful at securing commitments. In fact, the number one supplier in the industry sold and shipped product to Qualco three months before their planned opening. This provided legitimacy for Qualco that Fred and Dwayne were able to leverage. The fact that they had already procured a significant amount of product from the industry’s top supplier opened doors at many other suppliers. Fred and Dwayne were able to dramatically enlarge their product offerings.
GCPS became increasingly distressed by the competitive threat and practiced open retribution on suppliers that sold to Qualco. The effect, however, was the opposite of what they intended. GCPS’s tactics generated a wave of support among suppliers for Qualco, both overtly and covertly.
Preparation for Launch
While Dwayne was shoring up support from customers for the projected launch, Fred was working feverishly on business plans and projections. Fred was familiar with inventory turn rates and gross margins in the industry, being 4 and 30% respectively. He felt certain that that they could increase the turn rates but he used the more conservative industry standards in his forecasts. Based on discussions with potential customers, Fred and Dwayne projected that they could capture approximately one sixth of the six million dollar market in their first year ($1,000,000). They determined that it would ultimately take three hundred thousand dollars in inventory to offer a full line of products, which would be vital to achieve their long-term market share goals. However, they could not justify that many dollars in inventory for the initial launch. Thus, Fred calculated the bare minimum level of inventory that he believed would be needed to get started. If Qualco could start with $175,000 of inventory, with a 30% gross margin, they would be able to generate $250,000 in sales in a quarter. With 4 turns, they would achieve their goal of $1 million in sales during the first year.
In addition to the inventory costs, Fred anticipated that Qualco would need $85,000 for other start-up costs. He felt that they would need to attain funding of at least $300,000 in order to cover inventory and other start-up costs, with a small cushion for operational losses and an accounts receivable balance. Monthly operational expenses were expected to be approximately $18,000. Plus they would have to account for principle and interest payments on the $300,000 note. They planned to push any spare monies into additional inventory. Fred knew that finances would be tight but he believed that the plan was attainable.
Rather than providing funding for the venture, their friend opted to help Fred and Dwayne secure a bank loan that would be personally guaranteed by each of the three of them. The loan would be collateralized with the value of their homes. With the assistance of their friend, Fred and Dwayne were approved for a $300,000 loan from a branch office of a large regional bank called Zinc’s. The pieces were falling into place and Fred and Dwayne were well prepared for the launch of Qualco Pet Supply (or so they thought).
Always Expect the Unexpected
Armed with formal bank approval, Dwayne and Fred borrowed some short term money from friends to pay for their first few product orders and to cover some of their start-up expenses. They leased warehouse space (personal guarantees) and hired a couple of key employees. They also used personally guaranteed loans to purchased trucks to be used for delivery.
Finally, the big day to close on the loan arrived. The much needed money would be used to pay off the short term loans and acquire the additional inventory they needed to finally open the doors. All three partners, and their wives, travelled to Zinc’s to “sign their lives and homes away.” As they entered the bank, they were greeted by a nervous loan officer who informed them that a “committee” had met that morning and revised their previously approved loan down from $300,000 to $175,000. The bank was unyielding, even with the threat of a lender liability suit.
Given the start-up expenses already incurred, that left Qualco with half the needed money for inventory and nothing for operational losses or accounts receivable. Dwayne and Fred were literally sick! They had run the numbers a million times and could not see how the business could survive with the amount of money that was available. They had already spent tens of thousands of dollars and had committed to tens of thousands more. There just was not enough money for inventories to get the job done.
Please demonstrate the validity of Dwayne and Fred’s original financial assumptions by preparing the appropriate financial statements and answering the following questions using the assumptions below. State any additional assumptions you make:
1. Was $300,000 enough to start this business? What was their peak cash need (it will be $300k + or – their cash shortage or overage)? Did they need more or less than $300k or less? If so how much more or less did they need?
2. In what month did their peak cash need come?
3. In what month did they achieve operational break-even (GM >, = Operating expenses)?
4. What was the first year’s net income?
5. What was the cash balance at the end of the first year?
6. Is this company worth pursuing? Why?
· The first month they were only going to be open for two weeks so sales were predicted at $20k, the second month would come in at 40k, the remaining months increase at 15% per month with the 12th month sales adjusted to $167,851 so that the year end sales total $1,000,000
· 30% GM
· Monthly Operating Expenses do not need to be broken down, they are $18k
· Of $85K, $25k should be booked as start-up expenses in the first month on the income statement
· The remaining start-up expenses of $60k should be booked as PPE on the balance sheet (assume no depreciation)
· Ignore taxes and depreciation
· There are no disbursements to owners
· Assume the beginning inventory of $175k was paid for at the time it was received. Assume instant replenishment and hold the inventory constant from month to month (so all 12 months will show $175K in inventory).
· AR – Invoices are not collected for an average of 30 days
· AP – For reorders, vendors are not paid for 30 days
· Calculate the loan of $300,000 at 6% interest over 10 years; insert loan and the amortization on the balance sheet and the interest payments on the income statement.
· There was no capital contribution from the owners (no initial equity)
· If cash is negative there is no need to show additional financing, just show the shortage