Diving into the Deep Sea World project – An attractive opportunity
Ion Mellsop originated an innovative “walk-through” aquarium concept: “a transparent walkway built into the floor which gave visitors the impression that they were under the sea”. Seen from several perspectives like novelty, market potential and competitive position, this opportunity seems very promising. First of all, the new “walk-through” aquarium has proven to be very successful in New Zealand which is similar in geography (island countries), demography and culture with Scotland. Furthermore, the large number of visitors attracted to less glamorous aquariums indicate a general interest in this type of attraction. The site in Edinburgh – where Deep Sea World would be situated – allowed the reuse of an old quarry that would keep construction time and costs down. Furthermore, it is located near major tourist attractions from which it can profit by tapping into this pool of visitors. Besides tourists, the aquarium would also provide an ideal leisure venue for 3 mio local people. Next to this, there is a lot of support from (local) government authorities. Last but not least, first-mover advantage can be obtained as no similar aquariums can be found in the UK. Sea Life, the only comparable one in the UK, was based on an older and obsolete model. Therefore, there is no strong competition currently. In short, it is reasonable to believe that the project is appealing for both investors and the Edinburgh community.
Fishing for finance – Fund raising pitfalls
The concept of a walk-through aquarium business has proven to be successful abroad but has never been developed in the UK before. This uncertainty already forms a first hurdle for possible investors. Furthermore, the total investment required for this hit or miss project is relatively high – about GBP 4.2 mio – although this is common for big construction projects which require a lot of CAPEX from day one. As Appendix I, Figure 1 shows, only funding of approximately GBP 3 mio was already committed, resulting in a funding gap of about GBP 1.1 mio that still had to be filled.
Second, the major project risks as described in Appendix II might scare off some investors. One important risk could be an overrun in construction time as this would lead to an opening after the holiday season. Another, is that higher than expected operating costs could put significant pressure on gross margins and narrow cash flows to a minimum level.
Third, before looking for equity financing Crane and McDonald already tried to finance their project with (bank) debt. Although they could sell the idea to non-senior bankers, they lacked the network to get final approval by senior management for this attractive but risky project.
Raising even more government grants or putting in more own capital will not be sufficient to fill the whole gap as no single party will probably want to bear the risk of losing a very high funding commitment. Getting venture capital at an acceptable hurdle rate means that management has to actively mitigate aforementioned risks and convince their VC partners of this.
Sharing the financing burden and returns – Our proposed deal
Appendix I, Figure 2 shows our proposal on how to fill the funding gap. Phil Crane and Mellsop & Davidson will have to put up an extra GBP 50k and GBP 175k respectively. Although this may seem a big hurdle for the management team, we feel their bargaining position is not very strong as they are already highly committed to the project. Furthermore, they need to get extra funding quickly to start construction. On top of this the proposed deal implies a concession towards Phil Crane as his proportion of committed funds in the total equity financing goes down and he is allowed to keep his minimum expected equity stake of 30% (see Appendix III).
For Mellsop & Davidson, we allow their high minimum expected equity stake of 12% in return for the higher financing commitment. We prefer this scenario over equity dilution because when management puts in extra funding they get even more involved and show their VC partners that they are willing to go the extra mile. As the VC syndicate, Dunedin and NVM will provide the bulk of the equity financing by investing GBP 623k additionally. Within this syndicate the equity stakes are allocated on the amount of funds invested by each party. A summary of the ownership structure is presented in Appendix I – Figure 3.
We assume that the remaining GBP 300k can be filled with venture debt. We believe this funding can be found by relying on the network of the VC syndicate. As there was already a high base rate of 8.3% and there are high risks involved, we assume a 20% interest rate.
To calculate the company’s value at exit we used the industry P/E of 16.5 in 1992, which we consider to be a good proxy for an assumed exit after 5 years. Appendix IV shows our assumptions about the earnings expectations for both management team and VC syndicate. Although we assumed a weighted average between the most-likely and pessimistic scenario for the VC’s point of view, we believe that the management team would only consider the most likely scenario together with an extra GBP 1 mio pre-tax profits, as mentioned in the case. This results in earning and exit value forecasts for 1997 that are more than 3 times as high as the VC syndicate. To increase the IRR for the VC syndicate we assume an annual preferred dividend pay-out scheme in preference to normal dividends that is shown in Appendix V.
Because of the very high exit valuation of the management team of about GBP 26,8 mio, Mellsop & Davidson will expect an IRR percentage of 73%. Phil Crane has a slightly lower but still very attractive IRR of 62%. For the VC syndicate we assume a lower expected exit value of about 8.9 mio. Their IRR is therefore approximately 43%, a hurdle rate that Norman can sell considering his confidence in the project. Scottish Enterprise Agency’s investment should be viewed more as a grant, reflected by their low equity stake as they value employment creation in Edinburgh highly. A summary of the pay-off expectations for each party can be found in Appendix VI.
The payoff diagram at exit in Appendix VII illustrates the liquidation preference of twice the initial investment for the Series A shareholders (i.e. VC syndicate) and the fact that capital gains below GBP 7.4 mio will be distributed to Series A on an as converted basis. In our proposal we include a weighted-average anti-dilution provision to be protected against possible future down-rounds and ask for drag-along rights so that the VC syndicate has the possibility to sell the company to a party of its choice. The management would retain a majority in the BOD, although important strategic decision would still need consent of the VC partners. A summary of all the funding sources, equity allocations and IRR’s is shown in Appendix VIII
Note: This is the class assignment from the course of Entrepreneurial Finance in Vlerick MFM program, rights reserved to the whole group inlcuding Feronia Budiman, Lang Dang, Vincent Gregoir, Sevn Heylen,Nicholas Vandermarliere and Xiaobin Huo