Question

Expanding Gregory’s – Greg and John has owned Gregory’s Greek Restaurant for over thirty years. The restaurant overlooks a river and offers visitors a lovely view of the countryside. Over the years, the restaurant’s popularity has grown through word-of-mouth advertising, and now guest often wait up to two hours on the weekend before being seated. Greg and John have been approached by Capstone Developers, which wants to use the Gregory’s Greek Restaurant concept in a mixed-use development it is putting together. It seems that one of Capstone’s managers ate at Gregory’s and loved the concept. Capstone Developers put together an investment proposal for Greg and Andy requesting to use their concept and cash equity for the deal.

The following are excerpts from the offer:
· Use of the Gregory Greek Restaurant name in exchange for limited partnership units in the new restaurant.
· A request for a 45% equity investment from Greg and John on the total project cost of $3,000,000. In return for their investment, they will receive 25% ownership and 25% of all cash flows, with Capstone reserving 75%.
· With an estimated $175,000 in cash flows in Year 1 and a 10% growth rate over the next decade, the return on equity looks very promising.
· Capstone Developers, as the general partner, will retain all operating rights, including the right to decide when the restaurant and property will be sold.

Analyze the structure of the equity proposal. If you were Greg and John, would you accept this offer as it stands? If not, what would you negotiate?

Answer 1

Answer:

Prima facie, the equity structure looks totally tilted in favour of Capstone Developers.

At equity contribution of 45% Greg and John are only getting 25% of the equity in the limited partnership.

Since the new project will be exploiting the benefit of the existing goodwill of Greg and John, the equity deal should have compensated for the that. Even in the cash flows, Greg and John are only getting 25% share. They need to realize that the cash projection of $175,000 and 10% increase afterwards is only because the brand name and goodwill they enjoy. They are bringing too much on the table (equity+goodwill) but aren't getting proportionate returns.

Further, all the operating and controlling rights are vested with Capstone Developers.

On the financial level:

IRR at the current level of cash flows is -9%.

Suggestion:

Greg and John should ask for least 50% stake in equity and cash flows for the firm so to compensate for 45% in equity contribution + 5% for goodwill and brand name. Also they should have equal control in operation and rights with respect of property.

The updated IRR post 50% share:

IRR became positive at 50% stake.

Note: Only 10 years are considered for the analysis. The project might generate more cash flows post 10 years.