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. What are the advantages and disadvantages of Rosetta Stone going...

. What are the advantages and disadvantages of Rosetta Stone going public?

2. What do you think the current value of a share of Rosetta Stone is (at the time of the case)?

Justify your valuation on a discounted-cash-flow basis and a market multiples basis.

Please note that we have discussed in class, and you have information in elc, about Business Valuations, Discounted Cash Flow Analysis, and Comparables (Market multiples).

3. At what price would you recommend that Rosetta Stone shares be sold, and why?

Some other things you will want to know to complete the case:

a) There is an Excel spreadsheet in elc for you to use for this case, and a PDF file which has the case. I have changed some of the numbers in Exhibit 7 of the provided Excel spreadsheet, so use the spreadsheet numbers for your DCF analysis even though they conflict with Exhibit 7 in the pdf file for the case.

b) Please use 10% for a WACC in your DCF analysis.

c) There is a rubric posted in elc. I will be using this rubric, subject to possible revisions, as I grade this.

d) For the sensitivity analysis referred to in the rubric, please determine how the estimated share price computed using the DCF analysis changes as WACC changes from the assigned 10% to a range of 6% to 14%, by whole percentages (i.e., you don't need to compute share price if WACC is 9.5%, just 6%, 7%, etc.). This is done most easily by using the Data Table function in Excel under "What-If Analysis"

2 Attachments
Rev. Apr. 2, 2013 This spreadsheet was prepa Foundation, Charlottesville, No part of this publication m —electronic, mechanical, ph
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20 pages
Rosetta Stone.pdf
For the exclusive use of K. Simpkins, 2015. UV3930
Rev. Mar. 25, 2011 ROSETTA STONE: PRICING THE 2009 IPO We are changing the way the world learns languages.
—Tom Adams It was mid-April 2009. Tom Adams, president and CEO of Rosetta Stone, Inc. (Rosetta
Stone), the language learning software company, reached for his iPhone to contact Phil Clough
of private equity fund ABS Capital. Adams and Clough had been discussing plans to take
Rosetta Stone public for some time. The wait was finally over.
In the wake of the 2008 financial crisis, the market for initial public offerings (IPOs)
evaporated. By early spring the market was showing its first encouraging signs. Just a week
prior, Chinese online videogame developer had listed on the NASDAQ at a price
to EBITDA of 6.5 times followed by a one-day jump of 25%, and the online college Bridgeport
Education was currently circulating its plans to go public at a range of 10 to 12 times EBITDA.
Having received preliminary approval of its registration filings with the U.S. Securities
and Exchange Commission (SEC), Rosetta Stone was authorized to sell 6.25 million shares, a
30% stake in the company. Exhibits 1 and 2 provide financial statements from Rosetta Stone’s
IPO prospectus, required by the SEC to inform investors about the details of the equity offering.
Half of the shares were to be new shares and the other half were shares to be sold by existing
shareholders. Rosetta Stone management had circulated an estimated price range of $15 to $17
per share, representing a price to EBITDA of about 8 times. Demand for the shares was strong,
and some analysts believed that Rosetta Stone was leaving money on the table. Yet with world
financial and product markets still in turmoil, there was a strong case to be made for prudence. Economic Conditions
The previous year had been a dramatic one for the world economy. Prices on global
credit and equity markets had been in free fall. The U.S. equity market was down over 50% from This case was written by Associate Professor Michael J. Schill with the assistance of Suprajj Papireddy (MBA ’10),
Tom Adams (Rosetta Stone), and Phil Clough (MBA ’90 and ABS Capital). It was written as a basis for class
discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright © 2009
by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies,
send an e-mail to [email protected] No part of this publication may be reproduced, stored in a
retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical,
photocopying, recording, or otherwise—without the permission of the Darden School Foundation. This document is authorized for use only by Kristy. Simpkins in 2015. For the exclusive use of K. Simpkins, 2015. -2- UV3930 its peak in October 2007 (see Exhibit 3 for details of the recent price history of U.S. equity
market returns in total and for select industries). The collapse of world financial markets had
preceded deterioration in economic activity worldwide, including dramatic shifts in real estate
values, unemployment levels, and discretionary consumer spending. The severity of economic
conditions had prompted massive intervention by world governments with dramatic policy
changes, particularly by the U.S. federal government. The economic and political conditions
were frequently compared with those of the Great Depression of the 1930s. With the crisis in full
swing, investors had flocked to U.S. Treasuries for security, pushing down yields on these
instruments to historic lows (see Exhibit 4). Heightened investor risk aversion had expanded the
risk premium for all securities. The general market risk premium was currently estimated at 6.5%
or 8.5%, respectively, depending on whether long-term or short-term government yields were
used in estimating the risk-free rate.
In February and March of 2009, there had been some evidence of improvement in
financial and economic conditions. Wholesale inventories were in decline. New-home sales were
beginning to rise. The equity market had experienced a rally of over 20% in recent weeks. Yet
many money managers and analysts worried that such economic green shoots were only a
temporary rally in a longer-running bear market. There was strong concern that the magnitude of
government spending would spur inflation in the U.S. dollar. GDP growth was still negative,
corporate bankruptcy rates and unemployment were at historic highs, and many believed the
economic void was just too big for a quick recovery to be feasible. A Wall Street Journal survey
of U.S. economists suggested that the economy was expected to generate positive growth in the
last half of 2009.1 In contrast, a survey of U.S. corporate executives stated that less than a third of
respondents expected to see an economic upturn in 2009.2 The debate regarding the economic
future of the world economy raged on. Rosetta Stone
In the 1980s, Allen Stoltzfus, an economics professor, real estate agent, and history buff,
was frustrated with his slow progress in mastering the Russian language. He was enrolled in a
conventional classroom Russian course but found it much less effective than the process he had
used to learn German while living in Germany years before. Seeking to produce a more natural
language learning method, Stoltzfus envisioned using computer technology to simulate the way
people learn their native language—with pictures and sounds in context. Rather than learning the
language by translating one language to another, his approach would be to use electronic
technology to encourage people to think in the target language from the beginning. He sought the
aid of his brother-in-law, John Fairfield, who had received graduate training in computer science.
Together they explored the concept of how a computer could be made to facilitate language
learning. Stoltzfus and Fairfield founded Fairfield Language Technologies in Harrisonburg,
Virginia, in 1992. The emergence of CD-ROM technology in the 1990s made the project
1 Phil Izzo, “Obama, Geithner Get Low Grades From Economists,” Wall Street Journal, March 11, 2009.
“Economic Conditions Snapshot, March 2009: McKinsey Global Survey Results,” McKinsey Quarterly,
March 2009.
2 This document is authorized for use only by Kristy. Simpkins in 2015. For the exclusive use of K. Simpkins, 2015. -3- UV3930 feasible. The company released its first retail language training software product in 1999 under
the name Rosetta Stone.3
The Rosetta Stone series of CD-ROMs provided users an effective way of learning new
languages. The software utilized a combination of images, text, and sound to teach various
vocabulary terms and grammatical functions intuitively by matching images with the spoken
word. Following the way children learn their first language, the company called this method of
teaching languages the Dynamic Immersion method: “dynamic” because digital technology and
the teaching method powerfully engaged the learner in an interactive learning process, and
“immersion” because learners anywhere, from any language background, started at the very
beginning and studied exclusively in the target language. A recent research study provided
scientific evidence that the language test scores of students that completed 55 hours of Rosetta
Stone training performed comparably to those who had completed an entire semester of a good
quality college language course.4 Rosetta Stone users were broadly satisfied with the experience
and regularly recommended the software to others.
After focusing initially on school and government sales, the company began aggressively
pursuing the retail market in 2001. Following the death of Stoltzfus in 2002, the company hired
an outsider, 31-year-old Tom Adams, as chief executive. Adams brought an international
dimension to the small-town, rural company: A native of Sweden who had grown up in England
and France, he was fluent in Swedish, English, and French. He had studied history at Bristol
University in the United Kingdom and had earned an MBA from INSEAD in France. Prior to
arriving in Harrisonburg, Adams had been a commodity merchant in Europe and China.
Adams got right to work by entering new markets and scaling up the current business;
from 2004 to 2005, the revenues of the company nearly doubled, from $25 million to $48
million. Acknowledging the need for capital and professional support as the company expanded,
Adams solicited a capital infusion from the private equity market. In 2006, two firms, ABS
Capital Partners and Norwest Equity Partners, made major equity investments in the company.
As part of the recapitalization, the name of the company was changed from Fairfield Language
Technologies to Rosetta Stone, Inc., to match the signature product. Over the ensuing two years,
revenue continued to expand aggressively, rising to $81 million in 2006, $137 million in 2007,
and $210 million in 2008. Since Adams’s arrival, the compound annual growth rates of Rosetta
Stone’s revenue and operating profit were at 70% and 98%, respectively, and the company
employed over 1,200 people. By early 2009, Rosetta Stone was the most recognized language
learning software brand in the world. Millions of language learners in more than 150 countries
were using the Rosetta Stone software. The company offered self-study language learning
solutions in 31 languages to its customers. (Exhibit 5 lists the language training software
currently offered by the company.) In 2008, approximately 80% of Rosetta Stone revenue was
3 The name Rosetta Stone referred to a black basalt tablet discovered in 1799 by a French engineer in
Napoleon’s army near the Egyptian town of Rosetta. The tablet contained an inscription of a single text in three
languages—two Egyptian scripts (hieroglyphic and demotic) and ancient Greek—thus enabling 19th century
scholars to decipher Egyptian scripts conclusively for the first time.
Roumen Vesselinov, “Measuring the effectiveness of Rosetta Stone,” working paper, City University of New
York, January 2009. This document is authorized for use only by Kristy. Simpkins in 2015. For the exclusive use of K. Simpkins, 2015. -4- UV3930 accounted for by retail consumers, 20% by institutions. Institutional customers included
educational institutions, government and military institutions, commercial institutions, and notfor-profit institutions.
In a few short years, Rosetta Stone had successfully developed a strong brand; its kiosks
with bright yellow boxes had become an institution in U.S. airports, and its print advertising in
travel publications included a popular print ad of a young farm boy holding a Rosetta Stone box,
the copy reading, “He was a hardworking farm boy. She was an Italian supermodel. He knew he
would have just one chance to impress her.” The unaided awareness of the Rosetta Stone brand
was over seven times that of any other language learning company in the United States.
Leveraging a strong brand, steady customer base, and diverse retail network, Rosetta Stone had
maintained positive profitability in 2008 despite the severe economic downturn and, in both
average orders of bundled products and services and in units sold, even had experienced
The company expanded its product line by increasing the number of languages and levels
offered and broadened the language learning experience by introducing Rosetta Studio and
Rosetta World. Rosetta Studio allowed each Rosetta Stone learner to schedule time to chat with
other learners and with a native-speaking coach to facilitate language practice, motivation, and
confidence. Rosetta World connected a virtual community of language learners to practice their
skills through a collection of games and other dynamic conversation opportunities. Adams
envisioned a substantial growth trajectory for the company with a multitude of ways to leverage
its novel learning technology and expand its geographic reach. With a fixed development cost,
Adams expected the strategy to continue to increase company operating margins and expand
revenue, but he recognized that, as the company continued to show strong profit and growth, the
incentive for competition to attempt to gain market share would intensify. Exhibit 6 provides
three video excerpts of an interview with Adams in which he describes the future of Rosetta
Stone. Industry Overview
The worldwide language learning industry was valued at more than $83 billion, of which
more than $32 billion was for self-study learning, according to a Nielsen survey. The U.S.
market, from which Rosetta Stone generated 95% of its revenue, was estimated to be more than
$5 billion for total language learning and $2 billion for self-study learning. The total language
learning market was expected to expand as proficiency in multiple languages was becoming
increasingly important due to trends in globalization and immigration. The self-study market,
particularly through electronic delivery, was expected to dominate the industry expansion given
that self-study was increasingly accepted by language learning and travel enthusiasts.
The language learning industry had historically been dominated by specialized language
schools that taught languages through conventional classroom methods. The largest player in the
market was privately held Berlitz International. Berlitz taught languages in its classrooms using This document is authorized for use only by Kristy. Simpkins in 2015. For the exclusive use of K. Simpkins, 2015. -5- UV3930 the Berlitz Method of Language Instruction, which advocated immersion in the target language,
among other things, and according to company literature, offered programs and services through
more than 470 centers in over 70 countries. Auralog, a French company, was another important
competitor in the industry. Both Berlitz and Auralog offered electronic software packages that
provided quality language training software.
As had the Rosetta World product, businesses such as LiveMocha, Babalah, and Palabea
had also adopted a social media approach, connecting language learners through the Internet, but
these sites tended to be secondary enrichment sources for language learners.
Major software companies with deep pockets represented the most important potential
threat. Although the novelty of Rosetta Stone’s approach shielded it from many of the existing
players in the industry, the entry of a company such as Apple or Microsoft into the language
learning market had the potential to thwart Rosetta Stone’s aspiration of dominating global
language learning.
The IPO Process5
The process of going public—selling publicly traded equity for the first time—was an
arduous undertaking that, at a minimum, required about three months. (Table 1 provides a
timetable for the typical IPO. Exhibit 6 links to video of Adams describing the specific ways
Rosetta Stone management prepared the company to go public.)
Before initiating the equity-issuance process, private firms needed to fulfill a number of
prerequisites: generate a credible business plan; gather a qualified management team; create an
outside board of directors; prepare audited financial statements, performance measures, and
projections; and develop relationships with investment bankers, lawyers, and accountants.
Frequently, firms held “bake-off” meetings to discuss the equity-issuance process with various
investment banks before selecting a lead underwriter. Important characteristics of an underwriter
included the proposed compensation package, track record, analyst research support, distribution
capabilities, and aftermarket market-making support.
After the firm satisfied the prerequisites, the equity-issuance process began with a
meeting of all the key participants (management, underwriters, accountants, and legal counsel for
both the underwriters and the issuing firm) to plan the process and reach agreement on specific
terms. Throughout the process, additional meetings could be called to discuss problems and
review progress. 5 This section draws from Michael C. Bernstein and Lester Wolosoff, Raising Capital: The Grant Thornton
Guide for Entrepreneurs (Chicago: Irwin Professional Publishing, 1995); Frederick Lipman, Going Public
(Roseville, CA: Prima, 1994); Coopers and Lybrand, A Guide to Going Public 2nd edition (New York: Coopers &
Lybrand, 1997); and Craig G. Dunbar, “The Effect of Information Asymmetries on the Choice of Underwriter
Compensation Contracts in IPOs” (PhD diss., University of Rochester, n.d.). This document is authorized for use only by Kristy. Simpkins in 2015. For the exclusive use of K. Simpkins, 2015. -6- UV3930 Following the initiation of the equity-issuance process, the SEC prohibited the company
from publishing information outside the prospectus. The company could continue established,
normal advertising activities, but any increased publicity designed to raise awareness of the
company’s name, products, or geographical presence in order to create a favorable attitude
toward the company’s securities could be considered illegal. This requirement was known as the
quiet period.
Table 1. Timetable for typical U.S. IPO (in days).
Prior to Day 1:
Organizational “all-hands” meeting 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 45: Registration (announcement) 43 44 45 46 47 48 50: Prospectus (red herring) 50 51 52 53 54 55 57 58 59 60 61 62 64 65 66 67 68 69 49 45–75: SEC review period
SEC auditor reviews
56 for compliance with
SEC regulations.
Underwriter assembles
63 syndicate and initiates
road show.
70 71 72 73 74 75 76 76–89: 78
Letters of comment received from
SEC; amendments filed with SEC.
90: Effective date; shares offered 85 79 80 81 82 83 86 87 88 89 90 77 76–89: Road show
Preliminary price range set. Under84 writers, issuing firm’s management
present deal to institutional investors,
build book of purchase orders.
91 91: Trading begins 92 93 94 95 96 97 98 98: Settlement 15–44: Due diligence
Underwriter interviews
management, suppliers, and
customers; reviews financial
statements; drafts preliminary
registration statement. Senior
management of underwriter
gives OK on issue. 1–14: Quiet period Source: Created by case writer based on industry standards. The underwriter’s counsel generally prepared a letter of intent that provided most of the
terms of the underwriting agreement but was not legally binding. The underwriting agreement
described the securities to be sold, set forth the rights and obligations of the various parties, and
established the underwriter’s compensation. Because the underwriting agreement was not signed
until the offering price was determined (just before distribution began), both the firm and the
underwriter were free to pull out of the agreement any time before the offering date. If the firm
did withdraw the offer, the letter of intent generally required the firm to reimburse the
underwriter for direct expenses. This document is authorized for use only by Kristy. Simpkins in 2015. For the exclusive use of K. Simpkins, 2015. -7- UV3930 The SEC required that firms selling equity in a public market solicit the market’s
approval. The filing process called for preparation of the prospectus (Part I of the registration
statement), answers to specific questions, copies of the underwriting contract, company charter
and bylaws, and a specimen of the security (all included in Part II of the registration statement),
all of which required the full attention of all parties on the offering firm’s team.
One of the important features of the registration process was the performance of duediligence procedures. Due diligence referred to the process of providing reasonable grounds that
there was nothing in the registration statement that was significantly untrue or misleading and
was motivated by the liability of all parties to the registration statement for any material
misstatements or omissions. Due-diligence procedures involved such things as reviewing
company documents, contracts, and tax returns; visiting company offices and facilities; soliciting
“comfort letters” from company auditors; and interviewing company and industry personnel.
During this period, the lead underwriter began to form the underwriting syndicate, which
comprised a number of investment banks that agreed to buy portions of the offering at the offer
price less the underwriting discount. In addition to the syndicate members, dealers were enlisted
to sell a certain number of shares on a “best-efforts” basis. The dealers received a fixed
reallowance, or concession, for each share sold. The selling agreement provided the contract to
members of the syndicate, granted power of attorney to the lead underwriter, and stipulated (a)
the management fee that each syndicate member was required to pay the lead underwriter, (b) the
share allocations, and (c) the dealer reallowances or concessions. Because the exact terms of the
agreement were not specified until approximately 48 hours before selling began, the agreement
would not become binding until just before the offering. The original contract specified a range
of expected compensation levels; the selling agreement was structured so that the contract
became binding when it was orally approved via telephone by the syndicate members after the
effective date.
The SEC review process started when the registration statement was filed and the
statement was assigned to a branch chief of the Division of Corporate Finance. As part of the
SEC review, the statement was given to accountants, attorneys, analysts, and industry specialists.
The SEC review process was laid out in the Securities Act of 1933, which according to its
preamble aspired to “provide full and fair disclosure of the character of securities sold in
interstate commerce.” Under the Securities Act, the registration statement became effective 20
days after the filing date. If, however, the SEC found anything in the registration statement that
was regarded as materially untrue, incomplete, or misleading, the branch chief sent the registrant
a letter of comment detailing the deficiencies. Following a letter of comment, the issuing firm
was required to correct and return the amended statement to the SEC. Unless an acceleration was
granted by the SEC, the amended statement restarted the 20-day waiting period.
While the SEC was reviewing the registration statement, the underwriter was engaged in
“book-building” activities, which involved surveying potential investors to construct a schedule
of investor demand for the new issue. To generate investor interest, the preliminary offering
prospectus or “red herring” (so called because the prospectus was required to have the words This document is authorized for use only by Kristy. Simpkins in 2015. For the exclusive use of K. Simpkins, 2015. -8- UV3930 preliminary prospectus on the cover in red ink) was printed and offered to potential investors.
During this period, underwriters generally organized a one- to two-week “road show” tour,
which enabled managers to discuss their investment plans, display their management potential,
and answer questions from financial analysts, brokers, and institutional investors in locations
across the country or abroad. Finally, companies could place “tombstone ads” in various
financial periodicals announcing the offering and listing the members of the underwriting
By the time the registration statement was ready to become effective, the underwriter and
the offering firm’s management negotiated the final offering price and the underwriting discount.
The negotiated price depended on perceived investor demand and current market conditions
(e.g., price multiples of comparable companies, previous offering experience of industry peers).
Once the underwriter and the management agreed on the offering price and discount, the
underwriting agreement was signed, and the final registration amendment was filed with the
SEC. The company and the underwriter generally asked the SEC to accelerate the final pricing
amendment, which was usually granted immediately by phone. The offering was now ready for
public sale. The final pricing and acceleration of the registration statement typically happened
within a few hours.
During the morning of the effective day, the lead underwriter confirmed the selling
agreement with the members of the syndicate. Following confirmation of the selling agreement,
selling began. Members of the syndicate sold shares of the offering through oral solicitations to
potential investors. Because investors were required to receive a final copy of the prospectus
with the confirmation of sale, and the law allowed investors to back out of purchase orders upon
receipt of the final prospectus, the offering sale was not realized until underwriters actually
received payment...
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