The Financing Aspect of BabyCare Ltd anf Its Business Model - Case Study Example

 EXECUTIVE SUMMARY After having shown initial viability in its business operations, the management of BabyCare Ltd is at the third stage of venture capital financing negotiations, this time with Franklin Templeton Investments. The company employed a business model that required the selling of nutritional and vitamin supplements to mothers and expectant mothers in Chinese urban centers by holding training sessions and selling its products through the direct selling method. It was poised reach break even within several months when the need for additional financing arose. The company's board approved the need to raise $2.5 million of new to finance its working capital needs. While there were alternatives, the Templeton offer of convertible securities and a fixed rate note for a total of $3.5 looked good and did not undervalue the company or cause equity dilution. The questions with regard to the emphasis on the increase in the number of salespersons and average sales per salesperson was answered by the projected increase in customers membership and improved frequency of purchase generated by the training and counseling sessions with its customers. From the viewpoint of investors, BabyCare Ltd was a promising and attractive business and deserve capital and funding support for the following reasons: 1. Its founders showed true commitment to the business and were able to show good operational results after the first and second stage of venture capital financing. The prospects looked good. 2. The business concept is unique and shows sensitivity to the cultural and human relationship nuances of the environment where it has been operating. 3. The company followed government regulations and had no labor problems. It seems, however, that in the past the management had failed to exhaust its financing alternatives, particularly in terms of finding sources that could minimize dilution in the shares of existing owners. It is believed that the company will do well and be able to yield profitable returns for its shareholders because it has been proactive and sensitive to needs and peculiarities of its market. TABLE OF CONTENTS 1. China: Basic and relevant facts 1 2. Case facts: Highlights 1 3. The financing aspect 3 4. The revenue and sales aspect 4 5. Answers to Questions 4 5.1 Investing in BabyCare 4 5.2 BabyCare business model 5 5.3 Evaluation of BabyCare's funding opportunities. 6 Bibliography 7 CASE STUDY: BABY CARE LTD 1. China: basic and relevant facts. China today is one of fastest growing economies in the world with an double-digit Gross National Product (GDP) growth rate of 10.7 over the years, and showing an estimated of 11.9 percent in 2007. With a population of 1.33 billion people, its gross national product is $3.25 trillion (or $5,400 per capita) with a corresponding purchasing power parity of $7.1 trillion as of 2007. The purchasing power parity measures the amount of goods a dollar income can purchase within the economy. Annual inflation rate is a relatively low 4.8 per cent. China ranks 152nd (out of 211 countries) worldwide in terms of fertility rate with 1.75 child born per woman, slightly lower than that of Australia. The one-child per family policy of the Chinese government has limited the population growth to 0.61 percent annually, ranking 141st globally; however, because of its huge population it is estimated that over 22 million children are born in China every year. This is still a very significant figure for a business such as BabyCare Ltd. to take advantage of, particularly since the company aims to target the large cities with substantial urban population. 2. Case facts: highlights. The company was in the process of negotiating with Franklin Templeton Investments for an third-stage equity funding of $2.5 million. Mr. Seow, Templeton representative, had two questions: 1) How does the company reconcile its model based on revenue estimates derived from average sales per salesperson and and a growth in sales force, with the increase in the number of customers and the purchase rates? Were the revenue growth assumptions realistic? 2) Why did the company require working capital funding when it was on a cash basis? Despite these reservations on Mr. Seow's part, CFO Mumford and CEO Estes felt that they had successfully impressed upon the Templeton representative that they had shown that the business model was well adapted to the emerging market environment of China and that they had "capitalized" on the obstacles unique to China. Targeting the mother-and-child segment in China, they had proposed the business model whereby they would generate the sale of nutritional and vitamin supplements while at the same time providing training and health education to current and expectant mothers. They also sought to circumvent the problem of distribution channels by using direct selling and tight government regulations by redesigning their selling approach to conform to the domestic rules. This the company did by obtaining a license as a manufacturing entity so that the business did not appear similar to multi-level marketing model which the government had condemned as pyramid schemes. The salespersons or customer representatives were also mothers, a fact that made it possible to have enthusiasm in sharing advice and information during the training sessions with mothers and mothers-to-be. The business model also recognized the "emotional nature of this time in the woman's life and supported it by developing a trusting relationships that provided honest and accurate health advice." This writer would also like to add, in support of this business model, that since Chinese couples only have one child, parents want their only child to have a good start in life and invest on their only child very early in order to provide them with security in old age. It must also be emphasized that since couples do not have siblings themselves, there was a need to have good and trusting communication between the mother or expectant woman with the knowledgeable sales personnel of BabyCare Ltd. Another important consideration is the fact that China did not have a well-developed social security system, so that giving their only child a head start in terms of intellectual and emotional development and in terms of the best schooling possible, constituted their way of ensuring a secure future. 3. The financing aspect. BabyCare Ltd. was now on the third stage of venture capital financing. The first one, with Orchid, took eight months of negotiation, and the company was able to obtain only $6.25 million, with management providing the balance of $1.25 million. The management was also "coerced" into accepting some milestones conditions they had tried to avoid with the other Hong Kong-based arm of a US investment bank. The second round was negotiated with the Pacific Group Ltd, also based in Hong Kong, which invested $3 million at a pre-money valuation of $2.6, thereby diluting the shares of existing shareholders. Again the terms of this investment were not very favorable. Since that time, BabyCare Ltd achieved good results particularly at Dalian province and was on the way to breaking even in a period of six months, when management realized it needed additional cash of $2.5 million in order to reach the point when it could become self-liquidating. Liquid funds are needed to stock up inventories because of the long supply chain coupled with growing demand for its products. The board approved the need to raise $2.5 million based on an average of $25 (post-money) valuation (about 10 per cent). However, apparently the three options offered lower valuations, with two offering synergy opportunities. Franklin Templeton investments was contemplating a convertible security of $2.5 million with a conversion at a $22 million valuation plus an additional $1 million 12 percent fixed-rate note "to sweeten the deal." This offer was obviously within the parameters established by the board and therefore feasible and acceptable from the viewpoint of the management. 4. The revenue and sales aspect. Based on the membership and revenue data as of June 30, 2001, the company was able to obtain substantial figures in the matter of membership and continued support by members for the program. Considering both growth rates and attrition rates, management was confident that the top-line projections would generate membership growth that was in line with the projections. With regard to the revenue and net income projections, the management was also able to show a comparison of BabyCare Ltd with a typical consumer products company (Exhibit 4 of the case), which shows higher numbers for the company and profitability for both the manufacturing and selling operations. Because the products of the company were unique, this writer believes that the company stood to gain from the product differentiation, even if the prices were higher than average. The training programs for mothers and and mothers-to-be was an advantage that added value to what the company had to offer its customers. With regard to Templeton's reservations about the need for cash, it was known that although the company had no receivables, it had a long supply chain that needed inventory to meet demand quickly and on time. This was going to be overcome by the establishment of a local manufacturing plant at an estimated cost of $6 million in the future (2006). This would reduce production time significantly as well as prevent transportation and customs processing delays. It would also be able to obtain credit terms on its supplies in the future. 5. Answers to Questions: 5.1. Would you invest in BabyCare? Answer: If the question was addressed to Franklin Templeton Investments, the answer is that it was a done deal. The terms were generally within the framework of the board's decision, the amount of financing (convertible securities) was acceptable, and the existing shareholders were not expected to suffer a dilution in their shareholdings. If the question were addressed to me, the answer is Yes, for the following reasons: 1. The executives, Estes and Mumford, had demonstrated their commitment to the success of the business by committing their own funds to the company. For venture capitalists it is important that the managers "put their money where their mouth is" before they can be prompted to commit financing or equity participation in a business. 2. The business model presented by the BabyCare Ltd management was a unique one, addressed to the specific demographic characteristics of their prospective market. Their employment of mothers as sales representatives showed sensitivity to the culture and nuances of human relationships in that market. 3. The company had shown rising sales and no labor problems and was within striking distance to breaking even; and was nearly certain to break even, barring any force majeure, in the next six months or so. According to statistics (Brealey 1997), out of 10 new ventures only 2 or 3 are able to succeed, and only one can make it big. This unique business idea that BabyCare represents is poised to become one of those two or three successful enterprises, if not the one that can make it big, on the assumption that no major adversity can hit it. 4. The company conscientiously complied with government regulations, and there were no labor problems during the period covered by the case. 5.2. How is - or isn't -- BabyCare's business model tailored to the idiosyncrasies of an emerging market? According to the Small Business Encyclopedia, emerging markets are "those countries or geographic regions in which a previously untapped potential for U.S. exports or investment might be anticipated. Nations typically characterized under this banner are often developing countries, but they may also be economically formidable countries with markets that are increasingly open to exports." (emerging markets, Encyclopedia of Small Business, 2002). China is among the major emerging markets of the world with huge potential for growth owing to the thousands of corporations with foreign direct investments into that country in recent years, particularly after its entry into the World Trade Organization (WTO) in 2001. In the context of the question, the idiosyncrasies of an emerging market refers to those characteristics that emerging markets have in common, not necessarily those characteristics that pertain to China alone. An emerging market is one significant potential for growth. Because it has a small base to start with, it is bound to grow rapidly in the beginning and has a long way to move up economically before it reaches maturity that Western European countries, for example, have reached. A new investor from a foreign country needs to be adequately informed about the peculiarities of the culture, the laws and regulations, the political and economic environment, the demographic environment, and so on if it has to have a chance of succeeding. The management of BabyCare Ltd has no doubt taken all these aspects of the Chinese environment into account. In addition, it has fine-tuned its approach to the people, the authorities, and the market in the specific business environment where it has been operating. 5.3.. How would you evaluate BabyCare's funding opportunities? In financing growth companies, it is a normal expectation that a venture capitalist would try to protect its interests by requiring returns commensurate with the high risk involved, knowing as he does that the majority of new companies turn out to be failures It is not a surprise therefore that Franklin Templeton would offer convertible securities instead of outright equity participation in the business. Once the business is able to prove itself, only then would it convert its debt into equity and become part owner of the company. It is noted that the BabyCare Ltd. failed to explore other financing alternatives (or at least the case is silent about it) -- such as the use of bank loans. With a bank loan, the bank loan officer can keep track of the progress of the business and can adjust the terms of the loan depending on the operational results. The bank can also provide advice, can increase the loan, and make other adjustments as required to help nurture the business, while at the same time protecting the bank's exposure. This alternative, if feasible, would have caused less headache in terms of dilution of shares and repeated attempts to explore the uncertain market for equity funding. BIBLIOGRAPHY Brealey, RA, Myers, SC, Marcus, AJ. 1999 Fundamentals of corporate finance (2nd ed.). Boston:Irwin/ McGraw-Hill Cornell, C & Shapiro, AC 1993, 'Financing corporate growth," in Donald H. Chew, Jr. ed., McGraw-Hill: New York Hill, CWL 2001, Global business today, 2nd edn, Irwin/McGraw Hill, New York _________2005, International business: Competing in the global marketplace, McGraw-Hill, New York. Smith, C. 1993, ' Raising Capital' in Donald H. Chew, Jr., ed., McGraw-Hill: New York Home page. Viewed October 16, 2008 http://www.cia.gov/library/publications/the-world-factbook/index.html Home page. http://www.geographyiq.com/ranking/ranking_Population_growth_Rate_dall.htm Home page Viewed October 16, 2008 http://www.web2asia.com/2008/09/17/mommy-online-education-website-flying-high-in-china-yaolan-com/ Asia's hot growth companies. Viewed October 16, 2008 http://www.businessweek.com/magazine/content/05_46/b3959415.htm Babycare Ltd. Viewed October 16, 2008 http://www.quinstreetdss.com/aboutus/newsDetails-babycare.jsp Valuation. Viewed October 16, 2008 http://www.markpeterdavis.com/getventure/2008/06/venture-valuati.html Valuation. Viewed October 16, 2008 http://www.answers.com/topic/pre-money-valuation Emerging markets. Encyclopedia of Small Business 2002. Viewed October 16, 2008 http://www.answers.com/topic/emerging-markets Read More