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Sunday, September 03, 2006

Case Analysis- Harvard Business

Case Analysis: Merchant Card Services, Inc.
Harvard Business School

Introduction: The two principle parties in this case study include Glenn Romero of Starling Equity Group and Mitch Marlowe, CEO of Merchant Card Services Inc.. Starling Equity provided $5 million in funding to Merchant Card Services [hereafter referred to as MCS] in conjunction with co-investor Sterling Equity Group in exchange for shares of Series A Preferred Stock [convertible into common stock].

Key Points:
Series A Preferred Stock. Convertible at will into Common Stock. Starling declined conversion option in writing but retains option to convert ‘at will’. Stock remains preferred rather than common.
Stock will accrue dividends at 8% compounded annually with preference in liquidation to Common Stock. In the event of liquidation, holders of Series A Preferred Stock shall choose cash plus dividends.
Exit Rights: voting rights equal to 80% and right to elect 80% of BOD.
Other Rights: Preemptive rights, registration rights including two demand registrations, unlimited piggyback registrations and S-3 or equivalent rights; co-sale rights including pro-rata with Common Stock on rights of first refusal.
Under the demand registration rights, Starling has the right to force the company to register their securities with the SEC for sale to the public. According to the contract, Starling has two demand registrations available. Disclosure is an essential part of the registration process.
Piggyback rights entitle MCS to sell shares in an IPO [originally proposed].
BOD was never completed. Two Starling members serve on MCS BOD for total of six members. BOD has not met in a year.
Use of funds stipulated and met.

Financial/Transaction Overview:

Romero initially offered to invest $8 million at a pre-money valuation of $22.9 million based on two times MCS’s annualized monthly card processing revenues. MCS discovered a buyer bought another merchant acquirer based on a multiple of six times annualized monthly revenue, prompting MCS to demand a higher valuation. The final agreement resulted in a valuation of 2.67 times MCS’s annualized monthly merchant card processing revenues and a pre-money valuation of $31 million.

Liquidation rights equal to the greater of twice the initial investment or a 30% internal rate of return (IRR) on initial investment, with the right to convert from preferred to common stock representing a 20.5% ownership interest

Marlowe at the last minute insisted on accepting only $5 million rather than $8 million that the parties had previously agreed to. He also contractually limited Starling’s preferred interest to not more than 50% of the overall equity value. By reducing the capital raised to only $5 million, the preferred stock MCS issued to Starling would now have the right to convert into common stock representing a 13.9% ownership interest.

As noted below, MCS initially owned 74% of the company. Under the new valuation and less money invested by Starling, MCS now owned 84% and Starling dropped from 26% in the initial agreement to 13.9%.

Initial Agreement Final Agreement
$22.9 m Pre-Money Valuation

$31 m Pre-money Valuation





Anticipated vs. Potential Realized Return:
Under the Term Sheet for Starling’s investment with MCS, [numeral five paragraph three]; QUOTE NEEDS EDITING/Cleaned up

“In the event of a merger, consolidation, reorganization in which the company is not the surviving entity or resulting in a change of control o sale of all or substantially all of the Company’s assets, the holders of Series A preferred Stock (That is the case of Starling), unless previously converted into Common Stock, shall be entitled to received cash, prior and in preference to any distribution of any of the assets of the company to the holders Common Stock by reason of their ownership thereof, an amount (the “Liquidation Preference”) equal to the greater of (i) two times the initial issue price of the Series A Preferred Stock, and (ii) the amount required to achieve a 30% annualized internal rate on the initial issue price of the Series A Preferred Stock up to 50% of the Fair Market Value of the outstanding capital stock of the company”

If Starling signs the Proposed Shareholder Action by Written Consent and the Proposal Board Action by Written Consent, they would receive $9,718,208.99 [calculated by $70 m divided by 910,391 of Common Stock equals $76.89 per Preferred Stock multiply by 126,391 shares that Starling owns].

The amount Starling would receive according to the calculations above is much lower than anticipated under Starling’s Buyout Proposal Letter. The anticipated Buyout Price would be $13,581,535 [as calculated by $18,591,358 / (1+15%) ^ (820 days/365) under the Term Sheet]

Additionally is important to note that Romero in the Buyout proposal with Bank Service Corporation stated the “foregoing merely sets forth, on a non-biding basis, the terms on which they are currently willing to entertain discussion of the purchase of their Series A Preferred”. Romero also mentioned that until a definitive agreement is reached, all agreements governing their investment in MCS would remain in full force and effect.

MCS is requesting Starling to sign the two forms to close a deal with First Phoenix Financial Services Corp. But Starling has the right to execute numeral nine from the Term Sheet between MCS and Startling that states:
“Approval will be required from holders of Series A Preferred Stock (voting as a separate class) on matters affecting the value of the Series A Preferred Stock including, without limitation: (a) sale or merger, …”

Furthermore, in the Term Sheet between MCS and First Phoenix Financial Service Corp in numeral four (Closing Conditions”) it stated
“The execution and delivery of the definitive agreement relating to the acquisition would be subject to approval by the Board of Directors of Seller ( and the Shareholders of Seller if legally required) and the Board of Directors of Buyer”.

Starlings Potential Positions:
Because securities law restricts the right to sell these shares on the open market, exit strategies can take many forms. As noted above, Starling reserved numerous rights including the right to sell shares pursuant to registration rights on demand or a piggy-back basis, the right to sell to the new venture or assume voting control pending a sale.
If MCS wants to sell it has to agree to Starling terms or if First Phoenix Financial Services Corp wants to buy the company it needs to negotiate with Starling.


Critical Concerns:
By serving on the BOD, Starling is bound to a Fiduciary responsibility to MCS which must be adhered to in addition to acting upon personal interest or on behalf of Starling alone. Inherent to the Fiduciary responsibility includes:
Duty of Loyalty
Duty of Care
The MCS BOD is not in compliance with it’s own charter.
The BOD never secured the 7th member of the board
Have not held meetings for approximately one year
No communication forthcoming and improper communication. Not only has the board not met in a year but shareholder communication was not equal between minority and majority shareholders. The differential treatment of some shareholders against the interest of the company and managers is of concern.
Breech of confidentiality by calling friend to inquire about solvency/pricing of acquiring company. The obligation to maintain secrecy is also imposed upon the BOD as well as management.
The Fair Market Value [FMV] of shares has increased but an independent appraisal has not been submitted to the BOD for consideration.
Consider filing Sex 83B and recognizing income on the spread?
The proposed contract is not in compliance with the charter given a failure to obtain independent FMV and lack of sufficient notice/communication. By signing documents, Romero may be in breech of his Fiduciary Responsibility as a member of the MCS BOD and held personally responsible for failure to act in the best interest of the company or other shareholders. Potential issues involved include:
Failure to become informed
Conflict of interest
Risk of acting on the BOD arise from the fact that Romero may be considered an “affiliate” under securities law which could materially impair the right to sell the securities in an IPO [as originally intended by MCS and Starling].

Proposed Plan of Action:

Prior to signing or declining to sign any documents, Romero needs to become fully informed by requesting full disclosure, all pertinent documents and acting in his full capacity of BOD. At a minimum this would include:
Immediately discontinue communication of potentially confidential information with outside parties
Require MCS to have a BOD meeting with full participation by BOD members [including recruitment of 7th BOD] and bring all outstanding issues into compliance with it’s own corporate charter.
Require an independent appraisal of FMV of MCS in consideration of sale of MCS versus IPO or continued operation with buy-out.
If in compliance with above then consideration of sale can continue with recognition that it may be in the best interest of MCS as a corporation and their shareholders to sell. NEED CHART SHOWING POTENTIAL GAIN IN RE-EVALUATION OF MCS SHARES IF SOLD.
If valuation demonstrates shareholder benefit and best interest of MCS then approval for sale may be granted by Starling representation.
If sale proceeds then Starling would be entitled to XXX percentage of sale proceeds OR xxx percentage of new company [valuation table needs to be inserted here].

Based upon valuation model insert paragraph regarding Starlings decision to take profit from sale or continue with new company.

You will need to get references used from Nelson. Mine are as follows:

Case study itself
SEC website

Liabilities of General Partners of Venture Capital Funds: Old Legal Theories Create New Business Realities by James Topinka and Carol Kerr [article] No date on my copy.

“An Introduction to Registration Rights” 04/30/2002 Debevoise & Pimpton, Hong Kong

Venture Capital Primer online @

Review with Bierce & Kenerson, P.C. of 400 Madison Avenue 14th Floor NY NY 10017
Phone 212.840.0080


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