Financial Capital: Types, Costs, and Harvesting

Posted on Sep 6, 2024 in Economy

Chapter 7: Types and Costs of Financial Capital

EXAM:

• Estimate the cost of publicly traded equity capital (exchange-listed common stocks)
• Explain how capital costs combine into the weighted average cost of capital (WACC)
• Understand venture investors’ target returns and their relation to capital costs.

Implicit vs. Explicit Financial Costs:

• Formal accounting includes explicit records of debt (interest & principal) & dividend capital costs.
• No provision is made to record the less tangible expense of equity capital (i.e., required capital gains to complement dividends).
  • Paper loss/gain vs. actual.
• IFRS (International Financial Reporting System)

Financial Markets:

• Public Financial Markets: For the creation, sale, and trade of liquid securities with standardized features (VERY LIQUID)
• Private Financial Markets: For the creation, sale, and trade of illiquid securities with less standardized, negotiated features (LESS LIQUID)

Costs of Debt Capital:

• Interest Rate: Price paid to borrow funds
• Default Risk: Risk that a borrower will not pay the interest and/or principal on a loan
• Nominal Interest Rate (rd): Observed/stated interest rate
• Real Interest Rate (RR): Interest one would face in the absence of inflation, risk, illiquidity, & other factors determining the appropriate interest
• Risk-free Interest Rate (Rf): Interest rate on debt that is virtually free of default risk (Government Bonds)
• Inflation: Rising prices not offset by increasing quality of goods or services being purchased. (Basket of Goods, Houses, Purchase Power Parity)
• Inflation Premium (IP): Average expected inflation rate over the life of a risk-free loan
• Default Risk Premium (DRP): Additional interest rate premium required to compensate the lender for the probability that a borrower will default on a loan (Bad history or increased leverage)
• Liquidity Premium (LP): Charged when a debt instrument cannot be converted to cash quickly at its existing value
• Maturity Premium (MP): Premium to reflect increased uncertainty associated with long-term debt. The longer the GIC, etc., the higher the return, because of decreased liquidity.
• Rf = RR + IP (Default-free borrowers – U.S. Government or Canadian)
• Rd = RR + IP + DRP + LP + MP (More complicated, risky debt securities & varying maturities & liquidities)
• Rd = rf + DRP + LP + MP
• Prime Rate: Interest rate charged by banks to their highest quality (lowest default risk) business customers
• Bond Rating: Reflects the default risk of a firm’s bonds as judged by a bond rating agency (Moody’s). This is a reflection of the probability of payment.
• Senior Debt: This is secured by a venture’s assets – PAID FIRST in a bankruptcy payout
• Subordinate Debt: Inferior claim (relative to senior debt) to venture assets
• Term Structure of Interest Rates: The longer the time to maturity, the higher the interest rate will be.
• Determining Market Interest Rates (EXAM)
  • Rd = RR + IP + DRP + LP + MP. Given numbers, you need to fill in the spots and do the math.
• Investment Risk: Chance or probability of financial loss from a venture investment
  • Debt, equity, and founding investors all assume investment risk.
  • A widely accepted measure of risk is the dispersion of possible outcomes around the expected return (average): the standard deviation of possible investment returns.
• Calculating Possible Return: (7-14)
  • % Rate of Return = (Cash flow + (End Value – Beginning Value)) / Beginning Value x 100
  • Expected Rate of Return: Probability-weighted average of all possible rate of return outcomes
    • Probability of occurrence * Rate of return = Components to Sum
  • Do this same thing for all different conditions, then add up the Components to Sum.
• Measuring Risk as Dispersion around an Average:
  • Outcome – Expected Return, THEN square the difference.
  • Multiply the difference squared by the probability of the outcome.
  • Equal to Components to Sum
  • Add components to the sum of each outcome to get the Variance (Sum)
  • Then, the square root of Variance (Sum) = Standard Deviation

Calculating Standard Deviation:

• Calculate the expected rate of return based on estimates of possible returns & probabilities.
• Subtract the expected return from each outcome to get deviations from expected.
• Square each difference/deviation.
• Multiply each squared deviation by the probability of getting the outcome.
  • Sum the weighted squared deviations to get the VARIANCE.
• Calculate the square root of the variance to get the standard deviation.
• A wider and flatter graph shows a higher probability of a wide range of outcomes.
• A tall and more focalized deviation shows a higher probability of a specific outcome.
• Coefficient of Variation: Shows the dispersion risk per unit of expected rate of return –
  • RATIO: RISK TO REWARD
  • Standard Deviation / Expected Return

FOCUS OF LECTURE:

Estimating the Cost of Equity Capital:

• Private Equity Investors: Owners of proprietorships, partners in partnerships, and owners in closely held corporations
• Closely Held Corporations: Corporations whose stock is not publicly traded
• Publicly Traded Stock Investors: Equity investors of firms whose stocks are traded publicly, like over the counter market or an organized securities exchange
• Organized Securities Exchange: Formally organized exchange typically having a physical location with a trading floor where trades take place under rules set by the exchange
• Over-the-Counter (OTC) Market: Network of brokers and dealers that interact electronically without having a formal location
• Market Capitalization (Market Cap) – Value: Determined by multiplying a firm’s current stock price by the number of shares outstanding.

Cost of Equity Capital for Public Corporations:

            Re = rf + IRP = RR + IP + IRP

• Re = Cost of common equity
• Rf = Risk-free interest rate
• RR = Real rate of interest
• IP = Inflation premium
• IRP: Equity investment risk premiums. Additional return expected by investors due to the risk of the publicly traded stock.

EXAM:

• Expected Return on Venture’s Equity (re) using the Security Market Line (SML):
  • Re = rf + [rm – rf] Beta
  • Rf = Risk-free
  • Rm = Expected annual rate of return on the stock market
  • Beta = Systematic RISK of the firm to the overall market.
    • Measure of how much faster/slower the stock will move in comparison to a market shift/swing
    • Will it be +/- with the market?
  • MRP: Market risk premium = Excess average annual return of common stock over long-term government bonds.
    • MRP = [rm – rf]

Cost of Equity Capital for Private Ventures:

• Venture Hubris: Optimism expressed in business plan projections that ignore the possibility of failure or underperformance
• What we do with such projections:
  • Rv = re + AP + LP + HPP
  • Rv = Rate of return for venture investors
  • Re = Cost of common equity
  • AP = Advisory premium
  • LP = Liquidity risk
  • HPP = Hubris projections premium (How much/little they put into the chance of failure – risk plan on forecasting, etc.)

EXAM. V.I.P.

• WACC: Weighted average cost of the individual components of interest-bearing debt and common equity capital
• After-tax WACC:
  • = (1 – Tax Rate) x (Debt Rate) x (Debt-to-Value) + Equity Rate x (1 – Debt-to-Value)
  • Is the investment worth it?
  • The average cost of capital
  • If the WACC = 3% and we make 8%, we are actually making 5%.
    • What’s our best indicator/investment choice?
• EXAMPLE!!!! DO IT. Slide 26.
  • INTEREST RATE IS TAX DEDUCTIBLE
  • When you calculate After-Tax WACC, there is a little less paid out for equity. This is because the interest expense is tax deductible.

Using WACC to Complete Calibration of EVA

• EVA: Economic Value Added – Measure if it’s worth taking the project on or comparing projects, etc.
• Net operating profit after taxes (NOPAT) – After-tax dollar cost of financial capital used
• NOPAT = EBIT(1 – Effective Tax Rate)
• After-tax dollar cost of financial capital used = Amount of financial capital x WACC
• EXAMPLE!!

Chapter 9: Valuing Early-Stage Ventures

Price Tag – What the Venture is Worth

• Terminal Value Cash Flows
• Required Cash & Surplus Cash
• Diff. Accounting & Equity Valuations

What’s the venture theoretically worth?

• Present Value (PV0): Value of all future cash flows discounted to the present at the investor’s required rate of return.
  • Investors pay for the future; entrepreneurs pay for the past.
  • No estimates, no valuation.
• Discounted Cash Flow (DCF): Valuation approach involving discounting future cash flows for risk and delay
• Explicit Forecast Period: 2-10 year period in which the venture’s financial statements are explicitly forecast
• Terminal (Horizon) Value: Value of the venture at the end of the explicit forecast period
• Stepping Stone Year: First year after the explicit forecast period.
  • Forecast revenues based on % sales, historical data, expectations of launch & prices, etc.
• Terminal Value at time T-1 = VCFt / (r(infinity) – g)
  • VCFt = Time T’s valuation cash flow
  • R(infinity) = Constant discount rate from time T-1 into the infinite future
  • G = Growth rate (sale each year)
  • The discount rate is equivalent to the WACC – the higher the WACC or the higher the weighted average cost of capital, the higher the denominator and the lower the terminal value of the company will be.
    • Similarly, the growth rate reduces this, so the higher the growth rate, the lower this denominator will be and, therefore, the higher the terminal cash value will be.
• PV = FV / x^t
• Capitalization (Cap) Rate: Spread between the discount rate and the growth rate of cash flow in the terminal value period (Rinfinit – g)
• Reversion Value: Present value of the terminal value
• Pre-Money Valuation: Present value of a venture prior to a new money investment
• Post-Money Valuation: Pre-money valuation of a venture plus money injected by a new investor
• Net Present Value (NPV): Present value of a set of future flows plus the current undiscounted flow
• Required Cash: Amount of cash needed to cover a venture’s day-to-day operations
• Surplus Cash: Cash remaining after required cash, all operating expenses, and reinvestments are made

Required Vs. Surplus Cash:

• Required Cash: The amount designated to be in the bank to ensure operations can run smoothly daily.
  • If they do not meet this value, they will need more financing to make up the difference.
  • If they exceed this value, the money is a “surplus.” It can be reinvested, paid as dividends, etc.
  • In the example, they borrowed money when they had a negative change in cash flow.
  • When they had a positive change in cash flow, they used the excess to pay off the debt they had previously taken out until it was paid down. Then, the additional amount was deemed to be cash surplus.
• Pseudo Dividend Approach:
  • Project PDC out five years, assuming that a “surplus cash” account “plugs” the balance sheet (catching all remaining cash).
  • Calculate the pseudo dividends by making sure that required investments in working capital do not include surplus cash.
  • Discount the resulting pseudo dividends to get a value for the venture’s equity ownership.
• Continued (VCFs) – Equity valuation cash flow
• Pseudo Dividend (Equity value cash flow)
  • = Net Income + Depreciation & Amortization Exp. – Change in Net Operating Working Capital (w/o surplus) – Capital Expenditures + Net Debt Issues
  • NOWC = Change in Assets – Change in Liabilities – Change in Cash Surplus
  • C.A. Now – Time 0 = Change in current assets
  • C.L. – Time 0 = Change in current liabilities
  • Same for cash surplus.
• After you have projected sales, base it on growth rates from sales of the previous year.
  • Then, once you have all the projected sales for the upcoming years…
  • Now, find the multiplication factor by the sales in history to get all the numbers, like COGS, etc.
  • This can then be multiplied by the sales value to find the values for the projected income statement.
• SAME with the projected balance sheet with retained surplus cash.
  • We create a “surplus cash” plug in the balance sheet to show where the surplus cash would go or to hold its place but not pay out as a dividend.
  • Get to the statement of cash flows with retained surplus cash: Look at the dividends and equity issues, and there are none (no equity because no more of the company is sold off for profit).
  • No more dividends because the money that could potentially be sent out here is being placed in cash surplus.
• Calculating the Pseudo Dividends (Equity VCFs) with for NOWC calculations.
  • Take the PV equity (excluding the current equity VCF) & ADD the Equity VCF to this to get the:
    • NPV Equity (including the current equity VCF)
• REAL Economics behind Pseudo Dividend Valuation:
  • They actually pay out all of the VCFs in dividends. You then discount all these values back to the present-day value of them, doing a terminal value of the final cash flow.
  • If there is PV calculated from all of the dividend payments or from all the changes in equity, a (+) being a payment out to owners, a (-) being a new issue of debt or getting more money from equity financing.
• Accounting Statement of Cash Flows:
  • Nets the impact of all other balance sheet & income statement accounts to FOCUS the cash account as the “collector” of all remaining cash flow.
• Equity Valuation Cash Flows:
  • Nets the cash impact of all other balance sheet and income accounts to focus on the EQUITY account as the repository of any remaining cash flow.

Chapter 13: Security Structures & Determining Enterprise Values

• Common Stock: Least senior claim on a venture’s assets (residual ownership)
  • Voting rights
  • Right to legal dividends
  • Preemptive Rights: Right for existing owners to buy sufficient shares to preserve their ownership share
• Preferred Stock: Equity claims senior to common stock: Provide preference on dividends and liquidation proceeds
  • Dividends as a % of par
  • Non-cumulative vs. cumulative
• Participating Preferred Stock: Preferred, with rights to participate in any dividends paid to common stockholders OR preferred stock with an investment repayment provision that must be met prior to the distribution of returns to common stockholders.
  • Option to receive common or preferred dividend payments if common > preferred or something along those lines
• Paid in Kind (PIK) Preferred Stock: Preferred stock that has the option of paying preferred dividends by issuing more preferred stock
• Redemption Feature: Preferred stock feature permitting the venture to redeem (buy back) the preferred security
• Convertible Preferred Stock: Preferred stock with the option to exchange into common stock
• Conversion ratio vs. conversion price
• Down (Rest) Round: Venture round (investment round) priced below the most recent previous price (Lot that was last sold at??)
• Conversion Price Formula (CPF)
  • New Conversion Price = (Shares Before Issue * Old Conversion Price + New Issue Price * New Shares) / Total Shares After Issue
• Market Price Formula (MPF)
  • New Conversion Price = Old Conversion Price * ((Shares Before Issue + (New Issue Price * New Shares / Share Value w/out New Shares)) / Total Shares After Issue)
• Convertible Debt: Debt that converts into common equity
  • Bankruptcy rights
  • Security interests in the venture’s assets SENIOR to preferred shareholders’ interests in the venture’s assets

OPTIONS:

• Option: Right to buy/sell additional shares of stock
• Call Option: Right, not an obligation, to purchase a specified asset at a specified price in the future
• Put Option: Right, not an obligation, to sell a specified asset at a specified price
• American-Style Option: Option exercised at any time until expiration
• European-Style Option: Can be exercised ONLY at expiration
• Bermuda-Style Option: Exercised only at a specific set of dates

Option Payoffs:

• Out of the Money Options: Not currently worth exercising
• At the Money Options: Breakeven
• In the Money Options: Profitable current exercise
  • CALL OPTION DIAGRAM SLIDE 10
  • So = Current stock price
  • St = Stock price at the exercise date
  • K = Exercise price
    • The lower the K compared to So, the better for the person.
• Similarly, the diagram for PUT options, though this one is in the opposite direction with a negative slope. The higher the K compared to So (current price) in this case, the better.

Volatile Value & Risk for Call Options:

• The fluctuations in stock prices are greater about the possible price, leading to greater risk but ALSO potentially greater reward on the stock.
• Warrants: Call option issued by a company granting the holder the right to buy common stock at a specific price for a specified period. Typically involves new shares, NO CHANGE IN MARKET PRICE (Give this to investors, like the Facebook ones, etc.).

Valuing Ventures with Complex Capital Structures:

• Enterprise (Entity) Method: Valuation for the entire financial capital structure, including interest-bearing debt.
  • Cash flows are distilled down to an amount that belongs to and must flow to the firm’s investors as a whole rather than a residual flow to equity.
  • Enterprise Valuation Cash Flow:
  • = EBIT (1 – Enterprise Tax Rate) + Dep & Amort Exp – Change NOWC (excluding surplus cash) – Capital Expenditures
    • Subtract the market value of debt from the enterprise value to get the equity value.
• PRACTICE QUESTIONS CH. 13 2/3/10/11 ???

Chapter 14: Harvesting the Business Venture Investment

M&A: Economies of scale, patents, to make more efficient.

Relative Valuation (Using Comparable Multiples) Provides Perspective:

• Compare the rates of return from what was invested and what they received.
  • Management Investors (paid out by value left in the company) & Venture Investors (guaranteed a rate of return)
• Harvesting: Process of exiting the privately held business venture to unlock the owners’ investment value

Methods of Harvesting/Exiting:

• Systematic distribution of assets directly to the owners
• Outright sale of the venture to others
• Two-step public equity registration/sale

Systematic Liquidation: Venture liquidates by distributing the venture’s cash flows to the owners (Other than when the venture is operating in a declining industry, it is difficult to think of cases where the advantage of liquidation outweighs the disadvantages).

Advantages:

• The entrepreneur maintains control throughout the harvest period.
• Harvesting of the venture can be spread out over several years.
• Time, effort, and costs of finding a buyer for the venture can be avoided.

Disadvantages:

• Liquidation proceeds are treated as ordinary income (rather than capital gains) – Lost tax benefit
• Difficult for the entrepreneur to maintain focus on a dying venture
• The value of the venture may decline more rapidly when competitors respond to the venture’s lack of investment.

Outright Sale: Venture sold to others, including: Family, managers, employees, outside (external) buyers

• Leveraged Buyout (LBO): Purchase price of a firm is financed largely with DEBT financial capital
• Management Buyout (MBO): Special LBO where the firm’s top management continues to run and has a substantial equity position in the reorganized firm

Outright Sale to Employees

• Leveraged Employee Stock Ownership Plan (ESOP) – West Jet?
• ESOP uses proceeds from the sale of debt to purchase venture equity (purchase equity through – private employees being to own parts of the company, want to be partners, etc.).
• Employees gain an ownership stake in the private venture.
• The ESOP strategy was made possible by an act of Congress (U.S. – anyone can invest in anything).

Sale to Outside Buyers:

• Control Premium: Amount typically applied to the base valuation to reflect the value of controlling the venture rather than just being a minority shareholder (PAY MORE)
• Illiquidity Discount: Amount typically applied to the base valuation to compensate for the difficulties in reselling private equity

Going Public:

• Initial Public Offering (IPO): Venture’s first offering of SEC-registered securities to the public
• Primary Offering: Sale of new securities
• Secondary Offering: Sale of used securities
  • Can buy in one and sell in another.

Investment Banking Role

• Investment Banking: Intermediary assisting in the creation, sale, and distribution of financial assets
  • Due to the extensive network of possible buyers for securities (affiliated brokerage and client services), investment bankers are considered to be experts in predicting the value of newly issued securities.
• Underwriting Spread: Difference between what the investment bank sets from selling securities to public investors and what they pay to the issuing firm
• Red Herring Disclaimer: Obligatory disclaimer disavowing any intent to act as an offer to sell or solicit an offer to buy securities. Filed with the SEC going to sell stocks – no price or issue size in the red herring – states – not trying to sell prior to SEC approval.
• Due Diligence: Process of ascertaining, to the extent possible, an issuing firm’s financial condition and investment intent
  • What is the appropriate value – will it increase or increase immediately or shortly after due to an efficient market?
• Firm Commitment: Type of agreement with an investment bank involving the investment bank’s underwritten purchase and resale of securities
• Best Efforts: Type of agreement with an investment bank employing only marketing and distribution efforts
• IPO Underpricing: Syndicate’s offering price with it is less than the market price immediately following the offering.
  • Shares left over/not sold the underwriter BUYS, or they sell at a discount to a large purchaser – mutual fund/hedge fund.
  • SEC investigates drops/increases SIGNIFICANTLY right away.

Aftermarket Security Trading:

• Market Order: Order to be executed as soon as possible at the prevailing market price
• Limit Order: Order that can be executed only at a specified price or better
• Stop Order: Order that converts to a market order once a certain price is achieved. Sell at a predetermined price.

Contemplating/Preparing for the IPO Process:

• Officers of a publicly traded corporation, MINIMAL personal privacy – public figures – lives are subject to scrutiny.
• A public company will quickly find out what they CANNOT say about the company (regulated).

Preparing for an IPO:

• Typical Steps to Follow:
  • Organization meeting and due diligence
  • Draft and attendant activities
  • Initial 30-day SEC review
  • Pre-marketing
  • Marketing
  • Pricing & closing
• WAY TO RAISE MONEY IPO??

Chapter 11: Professional Venture Capital

History:

• VCs: Individuals who join formal, organized firms to raise money and distribute venture capital to new and fast-growing ventures
• Pre-World War II: Most from wealthy people
• 1946: Beginning of professional VCs – formation of the American Research & Development (ARD). THEY started VCs.
  • ARD’s early performance: $3.5 million raised, poor performance for the first few years (1951 stock price down from $25-$19)
  • 1953: Small Business Administration (SBA) formed – Legislation permitted the Federal Government to actively engage in fostering new business formation.
  • 1958: SBA created Small Business Investment Companies (SBICs). Because of tax and leverage advantages, the SBIC became the primary vehicle for professionally managed venture capital.
  • Starting a new business, go to the government, and they will often invest in your business to help support and increase new ideas and growth within the country.
  • ARD’s later performance: Sold in 1972 for $813 per share (compound annual return of 14.7% because of DEC (Digital Equipment Company) – without it, they would have gotten 7.4%).
• Late 1960s–Early 1970s:
  • Boom-Bust Cycle: Many SBICs began having operating problems due to the mixing of risky venture investments & high financial leverage (debt service commitments).
• 1970s: Professional VC organizational structure changes, movement to private partnerships from public firms & volatile financial markets
• Dot-Com Bubble: People invested largely in several companies, but many of them failed, leading to a bursting. MASSIVE increase in VC investment followed shortly after by a MASSIVE decrease.

Professional VC Investing Cycle:

1. Determine objectives & policies.
2. Organize a new fund (usually a partnership).
3. Solicit investments for the new fund.
4. Obtain commitments for a series of capital calls – NO COMPETITION CLAUSE – DON’T SHOP AROUND.
5. Conduct due diligence and actively invest.
6. Arrange harvest/liquidation.
7. Distribute cash and securities process (as available), THEN START AGAIN.

Terms:

• Carried Interest: Portion of profits paid to the professional VC as incentive compensation
• Two & Twenty Shops: Investment management firms having a contract that gives them 2% of assets as an annual management fee and 20% carried interest.
  • 2% of the assets managed are charged AS WELL AS 20% of any profits made.

Organizing the Fund: VC Fund Placement Memorandum

• Frontmatter declarations
• State securities disclosures (shares disclosures)
• Offering summary
• Fund overview
• Executive summary
• Summary of terms
  • Compare the above to an insurance policy: Here is the coverage, the amount covered, summary, policies, summary of terms.

Soliciting Investments: Suppliers of Venture Capital – 25-Year Average

• Finance/Insurance 25%
• Pension Funds 42%
• Endowment Foundations 21%
• Individuals/Families 10%
• Corporate VC 2%

Obtain Commitments:

• Capital Call: When the venture fund calls upon the investors to deliver their investment funds.
  • Common to require subsequent investments consistent with the levels of investors’ initial contributions.
• Deal Flow: Flow of business plans and term sheets involved in the venture capital investment process (find the assets and where they lie, > what company? etc.)
• Due Diligence (in the venture investing context): Process of ascertaining the viability of a business plan

VC Screening Criteria:

1. Venture Capital Firm Requirements

• Cash-out potential (need to have ownership in the business, get money out)
• Equity share
• Familiarity with the technology/product/market
• Financial provisions for investors (debt vs. equity financing)
• Geographic location (more/less taxes)
• Investor control (who owns? Family – long time – around for longer)
• Investor group
• Rate of return
• Size of investment
• Stage of development

2. Characteristics of the Proposal

• Requirements for additional material – what the VC brings to the table – sees potential, also brings expertise to help by giving pertinent advice
• Need to give up a high % of ownership and put directors on the board.

3. Characteristics of the Entrepreneur/Team

• Ability to evaluate risk
• Articulate regarding the venture
• Background/experience – family-run/experience with it
• Capable of sustained effort – old man vs. young person, around for a long time, do they want in/out?
• Managerial capabilities – are they good? Good views on investments, where to grow?
• Management commitment – align with financial incentives? Fluff the books?
• References – Who’s done business with them? How do peers view them?
• Stake in the firm – If they don’t have a stake in their own firm???

4. Nature of the Proposed Industry

• Market attractiveness
• Potential size
• Technology
• Threat resistance: Patents, barriers, money in startup, etc.

5. Strategy of the Proposed Business

• Product differentiation (sets your product apart)
• Proprietary product (patents that distinguish)

Screening Outcomes:

1. Seek the lead investor position – want to have a controlling share
2. Seek a non-lead investor position – don’t want to have a controlling share
3. Refer the venture to more appropriate financial market participants
4. SLOR (standard letter of rejection) the venture

Structuring a VC Investment:

• Term Sheet: Summary of the investment terms and conditions accompanying an investment
• Typical Issues Addressed in a Term Sheet:
  • Valuation: What number growth they want, % linked companies that benefit
  • Ongoing funding needs: One-time shot? Or do they need stages?
  • Size & staging financing
  • Preemptive rights on new issues: Second-round investor – right to new funding offers first before new investors are brought into the picture
  • Commitments for future financing rounds & performance conditions: When projections/landmarks are hit, you get x amount of more money.
  • Form of security or investment: Actual shares
  • Redemption rights & responsibilities: First/second round going to be in the company for longer: Need to know what the redemption rights are: You can buy 30%, but you HAVE to keep for at least 5 years instead of being about to sell shares early, etc.
  • Dividend structure (number of VCs and outsiders)
  • Additional management
  • Conversion value protection (preferred to common stock)
  • Registration rights
  • Exit condition & strategy: Know what it is so you’re not “screwed.”
  • IPO-dictated events (e.g., conversion): We will take it public for financing, what is the structure for VCs, how long do they have to hold before they sell in the public market?
  • Co-sale rights (with founders)
  • Lock-up provisions
  • Employment contracts: Do they get paid higher or lower with stock options, etc.?
  • Incentive options
  • Founder employment conditions: Compensation, benefits, duties, firing conditions, repurchase of stock at termination, term of agreement, post-employment activities, and competition
  • Founder stock vesting: What are they doing with the stock? What are their options? Are they retaining control of the company?
  • Confidentiality agreements and protection for intellectual property: Patents, expire? Etc.

Chapter 12: Other Financing Alternatives

Other choices like GE, Sony, etc., that will fund people’s ventures or big banks.

Helping Start-Up Ventures Locate Funding:

• Facilitators
• Consultants
• Intermediaries

Commercial Vs. Venture Bank Lending:

·Commercial: traditional conservative measrues of borrower’s ability to repay and value of assets recovered in case of default

oBorrow on: balance sheet, income statement, CF- net income the same way treat net income person. Charge you an interest rate, and you set up a collateral.

·Venture Banks: Interest and principal represent only part of return to Venture lender

·WARRANTS (right to buy equity at a specific price) provide remainder of return

oWant to get paid as company grows, as a % of your company and its growth

oWARRANTS: call, put, option. In/out of money.

Five Cs of Credit Analysis:

·Capacity to repay – most critical

oBetter able to pay, the better interest rate (liquidity ratio)

·Capital – money you personally have invested in business; indication of extent of personal risk if business fails

·Collateral – additional forms of security or guarantees provided to lender (real estate, property/plant/equipment etc.)

·Conditions – focus on the intended purpose of the loan (focus of the loan)

·Character – general impression you make on the potential lender/investor. (not as much a reason to get it now, but can be a reason not to get credit).

Common Loan Restrictions:

·Maintenance of accurate records & Financial Statements

oUnauditted you will pay premium

·Limits on total debts

·Restrictions on dividends or other payments to owners and/or investors

·Restrictions on additional capital expenditures.

oGive you money for an asset, have to make sure you actually purchase the asset. Wont give to you, will give directly to the person you purchase item from.

·Restrictions on sale of fixed assets: selling key assets, not good view- might be trying to sell off the business soon- taking proceeds of loan

·Performance standards on financial ratios: Vs. industry average, make sure times interest earned is in line with industry standards.

·Current tax and insurance payments:

oNot current on taxes you will not be given the loan. You are likely to pay government first. Need recent NOA to show this.

Why Venture Might not get debt financing:

·Large portion of startup assets are intangible & provide no collateral

·Receivables either don’t yet exist or collection hx is inadequate

·Not economically plausible for bank to use management involvement in a defaulting new venture

·Risk characteristics not a good match to demand deposits or other bank liabilities.

Credit card financing:

·Ease of obtaining

·Potential low cost when rolling balance across various cards (low interest when roll all into one afterwards)

·Personal guarantees required on regular bank loans (personal money to guarantee it, money in bank account, or through value of your house etc.).

Small Business Administration (SBA):

·Created by an act of Congress for purpose of fostering the initiation and growth of small business (often help with incentives, not going to make you TONS of money but they will help along way.

·Provides capital and credit

·Guarantees general business loans

·Helps create new jobs in small business

·Facilitates investments through venture capital programs.

·Provides disaster loans

·Works with regulatory agencies

·Helps small firms obtain government business (on contract list, on list you will get more jobs/called more often)

·Provides management and technical assistance

·Implements asset sales programs (sell you old city equipment)

Small Business Administration Programs.

·Debt financing and other financing-related programs

·Surety bond program (helps to pay someone else if they cannot fulfill the duty that they said they would do for you – take back money for stuff not done properly.

·Federal procurement programs

·Research & Development

·Business counseling & Training (Grain of salt- waste money)

·Business information services: help tell how to get HST#, WSIB, who you see for accounting etc. one stop.

·Advocacy programs

·Disaster assistance

·Assistance for armed forces veterans

·Assistance for exporters

·Assistance for Native Americans

·Assistance for small and disadvantaged businesses (for marquee businesses, or social programs)

·Assistance for women.

SMA Sources financial capital:

·7(a) loan: commercial bank, credit union etc.

·504 Loan: commercial bank jointly with not for profit certified development company

·Microloan: Not for profit/government affiliated

·Venture capital: small businesses investment company (private for-profit organization)

Other Government Financing programs: Many State & municipal agencies that have been charged with supporting the formation and growth of small businesses.

·Factoring: selling receivables to a third party at a discount from their face value

·Receivables Lending: use of receivables as collateral for a loan.

o30/60/90 days, good use of payment in past, paperwork all lined up

Debt/Debt substitutes:

·Vendor financing: accounts payable and trade notes, terms like 2 in 10, net 30.

·Mortgage lending

·Venture leasing: leasing contracts where one component of the return to the lessor is a type of ownership in the venture usually through warrants.

Direct Public Offerings:

·Security offering made directly to a large number of investors- These have not been a significant challenge to traditional venture capital funding or investment banking services.

Chapter 15: Financially Troubled Ventures: Turnaround Opportunities

·Financial Distress: cashflow is insufficient to meet customer debt obligations

·Insolvent: Venture w/ negative book equity or net worth (balance sheet perspective), cashflow insufficient to meet current debt obligations (cash flow perspective

·Loan default: failure to meet interest or principal payments when due

·Protective clauses in case of default:

oAccelerated provisions: provides all future interest and principal obligations on loan become due immediately upon default

oCross-default provision: provides defaulting on one loan places all others in default

·Foreclosure: legal process used by creditors to try to collect amounts owed on loans in default

·Balance Sheet insolvency: Total debts > Total assets

oC.A + C.L.  (Loss shown as an addition to Total Debt)

oRetained Earnings is negative when a loss

oAdd C.S. to R.E. to get total equity, then total equity + debt to get that total as well.

·Cash Flow insolvency: exists when a venture’s cash flow is insufficient to meet is current contractual debt obligations ( C.A. & C.L.)

oSales – Operating Expense = EBITDA – Interest = EBIT

·Principal induced cash flow insolvency: we did this by taking on more debt, or paying more debt off etc.

·Resolving Financial Distress: There are 3 ways – individually or in combination – for resolving financial distress:

oOperations restructuring (day to day lower costs) Grow rev vs. costs/ cut costs relative revenues

§Revenue Expansion= Increase revenues, COGS increases proportional, but fixed cost stays same, make more money

§Drop fixed costs= sales/COGS same, decreases admin/general expenses, EBITDA increases

oFinancial restructuring (amortization, debt to equity etc.)

oAsset restructuring: Improving the working capital to sales relationship and/or selling off fixed assets

§Restructured working capital: decreased A/R & Inventories (just in time)- decrease working capital, Also can take LESS LOANS.

§DSO= Days sales outsanding                       ICP= Inventory Conversion Period

§Restructured Working Capital Scenario: Calculate the goal for Receivables and the goal for inventories:

· Receivables= (Revnues/365) * Target DSO

·Invetory= (COGS/365)*Target ICP

·Financial Restructuring: Changing the contractual terms of the existing debt obligations and/or the composition of existing debt claims against venture: consolidate/amortization,

·Debt Payment extension: postponing due dates for interest and principal payments on loans and payments on credit purchases- KEEP WRACKING UP INTEREST EXPENSES

·Debt Composition Change: When creditors reduce their contractual claims against the venture (hope to get something vs nothing).

Workouts & Liquidations:

·Private Workouts: voluntary agreement b/w venture’s owners and its creditors that provides for a financial restructuring of the venture’s outstanding debt

·Private Liquidations: Assignment: transfer of title to the venture’s assets to a third-party assignee or trustee. (The trustee does it for you)

Legal Bankruptcy Laws:

·Chapter 11: provides protection form creditors while a venture attempts to reorganize (GM aid Canada 1-3 years)

·Chapter 7: specifies the procedures to be followed when liquidating a venture. ALL OVER

·Bankrupt: occurs when a petition for bankruptcy is filed with a federal bankruptcy court

·Voluntary Bankruptcy Petition: petition for bankruptcy by the venture’s management

·Involuntary Bankruptcy Petition: petition for bankruptcy filed by the venture’s creditors

Reasons for Legal Reogranizations:

·Common pool problem: exists b/c individual creditors have incentive to foreclose on venture even though worth more as a going concern.

·Automatic Stay Provision: restricts the ability of individual creditors to foreclose to try to revocer individual claims.  (Pay app creditors, not just one foreclosing)

·Holdout Problem: exists when 1 or more creditors refuse to agree to the reorganization terms b/c of potential for a larger individual recovery.

·Cram Down Procedure: bankruptcy court accepts a reorganization plan for all creditors including dissenting creditor classes:

oDissenting Creditor Classes: those that don’t agree with the proposition

·Debtor-in-possession financing: Short term financing, made senior to all existing unsecured debt, to help meet liquidity needs during reorganization process.

·Prepackaged Bankruptcy: an initial private attempt to convince majority of the creditors to go along with a reorganization plan that will be proposed after the venture files under Chapter 11.

oUsually rejected, because they are not getting the best deal they could. Want to go to courts to figure out the seniority of debt and get as much money as possible.

Chapter 11: Legal reorganization process:

·Bankruptcy is filed with bankcrupty court for protection under Chapter 11 while firm attempts reorg.

·Bankruptcy judge accepts or rejects the petition. If accepted, time frame is set

·Firms management is given 120 days to submit a reorganization plan, with an additional 60 days allotted to get creditor and investor O.K.

·Creditor and stockholders are grouped into classes for voting process

·Accepted plan is implemented by the exchange of old creditor claims and securities for new ones

Chapter 7: Bankruptcy Liquidation Priority

·Absolute priority rule sets a hierarchial order for the payment of claims.

oAdministrative costs associated with the venture’s liquidation

oWages and other unpaid employee benefits

oSpecific customer claims

oTax claims

oSecured creditors

oUnfunded pension plan liabilities

oGeneral (unsecured) creditor claims

oPreferred stockholders claims

oCommon stockholder claims

o