The sale of Krause parent F&W Publications, which was announced over a year ago (see 'Krause Parent Sold'), went through some pretty hairy litigation before all claims were settled this summer.  We missed it when it happened, but thought it was of sufficient interest to report it now.  Krause Publications publishes more than 40 hobby magazines, including Toy Shop, Comics Buyers Guide, and Scrye; has 750 books in print; and runs 10 hobby shows a year.

A suit filed less than three months after the sale closed alleged that Providence Equity Partners had fraudulently manipulated the records of F&W to obtain a sale price of $500 million, or $100 million more than the buyer (ABRY Partners) believed the company was worth.

According to Private Equity Week, the dispute between the two very large private equity companies was the largest of its kind based on dollar amount and firm size.

According to the documents from the Court of Chancery in Delaware in and for New Castle County, ABRY had agreed to pay ten times EBITDA (earnings before interest, taxes, depreciation, and amortization, a commonly used measure of cash flow) for the twelve months ending June 30, 2005.  F&W was purchased for $500 million in August 2005.

Shortly after the purchase, ABRY found what it said were irregularities in F&W's financial statements for the three quarters prior to the closing, which it said were manipulated to artificially increase earnings and the purchase price.

Court documents lay out the allegations: 

'With respect to the December 2004 financials statements, the Buyer alleges that the Company manipulated its earnings by overstating magazine revenues through a scheme known as 'backstarting,' which involves inflating revenues by providing new magazine subscribers with back issues of a magazine when they receive their first issue under the subscription.  This allows a publisher to report income earlier by using up more of a subscription in the first month.  The Buyer also argues that the Company misstated its performance by using outdated estimates rather than actual numbers to reflect newsstand revenue, failing to account for book returns correctly, and establishing inadequate reserves for obsolete inventory and uncollectible accounts receivable.  The Buyer contends that this resulted in overstated net revenues, which in turn inflated the Company's EBITDA.'

 

But wait, there's more in the discussion of the financials for the next quarter in the court documents.

'ABRY alleged that in the March 2005 financial statements, F&W fraudulently and intentionally reduced the Company's book return reserves by $500,000 in order to increase reported earnings.  Similarly, the Buyer also accuses the Company of 'channel stuffing' in order to inflate the quarterly revenues reflected in the March 2005 statements.  Channel stuffing, in this context, involved the Company offering higher-than-normal discounts to book retailers and discounts to more customers than normal, which artificially inflated revenues. ...[T]he Buyer contends that the Company failed adequately to account for the expected increase in returns.'

Court documents also report allegations of 'additional chicanery' in the June 2005 financial statements in order to improve the results for the quarter.  

'To that end, the Company: (1) extended by a week the quarterly reporting period of a subsidiary in the United Kingdom in order to increase the revenues and earnings depicted in the June 2005 statements; (2) shipped magazines in June that were scheduled to arrive in July; (3) manipulated its book club by moving a book club cycle from the second half of 2005 into June to inflate revenues; and (4) reported revenues related to a conference held in June 2005 but delayed reporting expenses from that same conference.'

The court documents also enumerate another dispute in addition to the allegedly fraudulent financial statements.  ABRY alleged that it was misled regarding the status of the implementation of a new book order fulfillment system called VISTA.  

'The failure of VISTA allegedly caused several customers, including Amazon.com, to stop ordering products from the Company.    The Buyer alleges that the problems with VISTA were so serious that they constituted a material adverse effect ('MAE') under the Stock Purchase Agreement.'

ABRY argued that the true value of the F&W was more like $400 million rather than $500 million and that it would never have closed had it known the true condition of the company.  ABRY had asked Providence to unwind the transaction and take back ownership of the company.  Providence had refused and the suit was filed.

In a ruling to settle the issue of whether Providence could limit its liability based on the purchase contract, the court ruled in February that 'the public policy of this State will not permit the Seller to insulate itself from the possibility that the sale would be rescinded if the Buyer can show either: 1) that the Seller knew that the Company's contractual representations and warranties were false; or 2) that the Seller itself lied to the Buyer about a contractual representation and warranty.'

Those questions of fact were never litigated, however, because ABRY and Providence reached a settlement in late May by which Providence agreed to invest an undisclosed amount to become a minority stake holder in F&W along with ABRY.  The result is that both the former and new owner of F&W now own shares of the company. 

Krause was a homegrown company built by founder Chet Krause title by title over decades in a small town in Wisconsin until its sale to F&W in 2002.  The alleged machinations by its owner certainly didn't fit with Krause's company culture, and it's good to see that the operations and people at Krause appear to be relatively unaffected by this unsightly mess.