Publication

Fall 2006Published Article

Ethanol Producers at the Crossroads: Maximizing the Value of Your Company

Ethanol Producer Magazine

Ethanol has become the new darling of Wall Street. In the past year, ethanol producers are being embraced by investors including private equity firms, venture capital firms and hedge funds. Public ethanol companies recently have seen trading multiples in excess of $5.00 per gallon of estimated 2007 annualized ethanol production, 35x trailing twelve months' EBITDA and 1,000x trailing four quarters net income. Private ethanol producers are receiving unsolicited cash offers for smaller, but still very attractive valuations, especially compared to prior years. In this climate, producers are faced with a number of alternatives, all of which may sound attractive at first glance. In this bulletin, we summarize five of the most likely options for companies and the advantages and disadvantages of each: (i) status quo; (ii) selling; (iii) underwritten public offering; (iv) merger with a public shell company; and (v) private financing.

Status Quo

The last couple of years have been good for many ethanol companies; they have enjoyed record profits and dividends. The short-term appears to hold more of the same. As a result, continuing to operate your ethanol plant as is can appear to be an appealing option: the shareholders/members could continue to earn strong dividends with no dilution; the shareholder/members retain control; and the non-investment benefits of being able to secure a steady buyer for corn and development of the local economy will continue to exist.

Beyond the short term, however, there appears to be a storm on the horizon. Industry experts predict that there will be a consolidation wave across the ethanol industry in the next two years, followed possibly by the emergence of biodiesel and cellulosic fuel sources as the attention getters on Wall Street. There is the potential that larger operations will be able to attract better management talent, negotiate better sales agreements and develop greater economics of scale and operational efficiencies than smaller facilities. If that scenario occurs, the smaller ethanol companies could see their profit margins and valuations significantly squeezed. Companies should consider where they fit in this continuum and what their operations are likely to be following this projected consolidation.

Selling

If the consolidation wave occurs and if ethanol gives way to other bio-fuels, selling now may allow equity holders to take money off the table at a time when profits and valuations are higher than they may be in the future. Equity holders who also sell corn to the company might also consider entering long-term supply agreements prior to any sale. Private investors at most companies would probably receive returns on their capital in line with exit expectations.

The primary disadvantage of selling now is the loss of control. In addition, ethanol producers who are candidates for a public offering can currently achieve a greater valuation multiple in the public markets than the private markets. As a result, investors in these strong ethanol companies could miss out on the potential greater investment return.

One note of caution: If you decide to sell, consider carefully whether it is in your interests to receive cash for your company rather than publicly traded stock. If the goals are to have a liquidity event and minimize risk, receiving potentially overvalued public stock or illiquid private stock are not necessarily attractive alternatives to cash.

Underwritten Public Offering

An underwritten public offering involves engaging an underwriter to sell stock to institutional and individual investors and creating a strong trading market following the IPO. Going public probably offers the best platform for future growth, as well as the potential for the greatest returns. Some of the primary advantages include: the opportunity to obtain relatively cheap financing for future growth opportunities; the potential for liquidity for investors; and the availability of additional currency to fund acquisitions of other companies.

Of course, not all companies are viable candidates for IPO's. The strongest ethanol IPO candidates are those who have plans for significant expansion, via either acquisitions or the construction of new facilities. Public ethanol companies with the highest valuations have anticipated 2008 production capacity in excess of 400 million gallons of ethanol annually. In addition, an experienced management is a necessity for attractive valuations in public markets.

There are significant downsides to being a public company, including the significant expense (in time and money) and scrutiny of being a public company, the potential loss of control and dilution to existing investors. In addition, size matters for public investors. For example, while a company with a stand-alone 50 million gallon per year ethanol plant may pay handsome dividends to private investors today, it will not be a viable public offering candidate unless it has definitive plans to increase capacity significantly.

Merging With a Public Shell

One variation of doing an underwritten public offering is to do a "reverse merger" with a "shell" public company. In this transaction, a private company merges with a company that used to be a public company but has ceased operations and contains no material assets or liabilities but maintains its status as a public company. The primary advantage of a reverse shell merger is that it offers the potential to obtain the benefits of being a public company faster and cheaper than a traditional underwritten public offering.

The primary downsides of a reverse shell merger are that there is no initial liquidity or trading market, and generally no new capital is raised in the transaction. As such, post-reverse shell merger companies need to develop a trading market for their stock promptly following the transaction. Becoming eligible for exchange or Nasdaq listing also requires compliance with Securities Exchange Commission and Sarbanes Oxley guidance requirements which may result in significant investment in senior management and also require recruiting top-notch independent directors. If they are unsuccessful, they become subject to all of the downsides of being a public company (e.g. increased costs, public scrutiny, etc.), but receive none of the benefits. The current market environment seems receptive to reverse shell mergers involving ethanol companies. For example, Pacific Ethanol, Inc. (PEIX) is the product of a public shell merger and has been able to attract significant outside investment and a high degree of market liquidity.

Acquiring Additional Private Investment

In a professional private investment, a company seeks outside capital from professional investors such as private equity firms or hedge funds. The advantages of this transaction are that it provides a company with additional resources for future expansion and acquisitions, as well as making the company more attractive for a future potential liquidity event via sale or public offering. The disadvantages of a professional private placement is the fact that there is immediate dilution with no immediate liquidity, as well as a potential loss of control. It should be noted, however, that there are many ways to structure private equity investments so that existing equity holders retain significant influence over the company's activities and approval rights for all extraordinary corporate transactions.

Conclusion

There are a variety of challenges facing ethanol companies in the current environment, with many confusing solutions. To help companies sort through their options, we recommend two things. First, develop clearly defined long-term objectives. Second, carefully evaluate and understand all available options before recommending or deciding on specific actions or transactions. Shareholders of even small companies are filing suits for breach of fiduciary duty with increasing frequency.

It is a certainty that today's economics of ethanol will not last forever. However, today's choices made by ethanol companies in responding to market conditions will affect their members for a long time.

For more information, please contact Geoffrey R. Morgan at 414.225.2752, or grmorgan@michaelbest.com, or Gregory J. Lynch at 608.283.2240, or gjlynch@michaelbest.com.

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