Venture Capital, Leveraged Finance, and Distressed Investing
VC Method: Pre-Money and Post-Money Valuation
Pre-money value is before the addition of investor’s capital. Post-money value is pre-money value plus investor’s capital.
Post-Money Value Calculation
Fully diluted shares before investment = Sum of current shares + options + warrants outstanding
New number of fully diluted shares = Sum of current shares + options + warrants outstanding + amount invested in the round
Percent of total shares investor purchases = Total number of new shares purchased / new fully diluted shares
Post-money value = Amount invested in this round / Percent of total shares investor purchases
We can also say:
The post-money value is the present value (PV) of the exit value of the firm, using the investors’ target return as the discount rate.
- The earlier the investment in the company’s life, the higher the target rate will usually be.
Ex: PV of exit value = $50 / (1 + .5)5 = $6.58. If investors invest $1.5 today, they will need to own $1.5 / $6.58 = 22.78% of the firm to get the return they want.
The PV of the exit value is called the post-money value = $6.58. The pre-money value is $6.58 – $1.5 = $5.08 million
New shares could also be found to be:
Old shares x (% new stake / (1 – % new stake)) = 500,000 x (.2278 / (1 – .2278) = 147,501. At post-money value of $6.58 million / 647,501 = $10.17 per share.
New Shares = 147,501 Total Shares = 500,000 + 147,501 = 647,501
Assuming 250,000 option shares in pool not yet granted to employees.
With a pre-close valuation of $6.58 million, if the shares are included in the outstanding shares, the beginning shares are 750,000 rather than 500,000.
New shares = N / (N + 750,000) = .2278 = 221,251
Total shares now equals = 750,000 + 221,251 = 971,251
$6.58 million / 971,251 = $6.78 per share. It is better for the entrepreneur to not include the options, but better for the investor to have the options included.
Early-stage companies often go through several rounds of investment before an IPO or sale. Unless VCs continue investing on a pro-rata basis in later rounds, dilution of their equity stake is likely to occur. Anti-dilution provisions and liquidation preferences help, but dilution is a VC’s greatest enemy.
Series A investors would need to own 22.78% of the firm’s equity at exit to achieve their 50% return per year. Series A investors should anticipate additional rounds of financing and negotiate a higher ownership percentage in order to be left with 22.78% at exit. Using historical averages, the firm would sell 25% in Round B and 20% in round C. This is cumulatively 45% of the company sold in B and C rounds.
The retention ratio for any round i = 1 – Cumulative share of equity sold in future rounds after round i. The retention ratio is the percentage of equity that all prior-round investors retain after the additional rounds of financing are completed.
The Series A investor would have a retention ratio of 1 – 25% – 20% = 55%. Therefore, to have 22.78% ownership stake at exit, the Series A investor would need .22.78 / .55 = 41.42% ownership at the end of Series A.
A Series A stake of 41.42% would be diluted to 41.42% x 55% = 22.78% at exit and give the Series A investor a 50% return. The dilution example is somewhat simplified but highlights the need for investors to: 1) Estimate the number, timing, and size of later rounds of financing 2) Estimate the required final ownership percentages that they and later investors will likely demand 3) Future management and key employees will be granted 4) The ownership that will be sold in the IPO
Sum-of-the-Parts (SOTP) Valuation
SOTP = Enterprise ValueSegmentA + Enterprise ValueSegmentB + … – Net Debt – non-operating assets and liabilities
The term Fully Distributed means a value as if the company were already a publicly traded company. To find fully distributed values for a company, you should use Forward Multiples. Fully distributed equity value is calculated by subtracting net debt, adding cash, and adding primary offering proceeds, which are treated as cash. An underpricing “sweetener” discount of 10-15% is applied to get the offering price.
Leveraged Finance
Leveraged Finance: financing of investments using very high levels of debt, as opposed to equity. Funds raised for: Leveraged buyouts (LBOs), Mergers and Acquisitions, Recapitalization – borrow to pay dividend or share buyback, Refinancing of old debt. Speculative-grade debt comes in two types: Loans – Term-Loans and revolvers that are issued by banks and institutional investors. These speculative loans are called levered loans or leveraged loans. & Bonds – Fixed-coupon paying publicly registered with the SEC that are traded by institutions. Speculative bonds are called “junk” or “high yield” bonds.
Syndicated loans are a type of financing that is offered by a group of lenders to a single borrower. Often offered when the loan size or risk is too great for one bank/lender alone. However, not all syndicated loans are levered loans.
Speculative-Grade Bonds
Typical Characteristics: 1) Interest Payment: Fixed coupon paid semiannually 2) Term: 5-10 years 3) Principal Amortization: No principal paydown until maturity 4) Collateral: Unsecured 5) Public Debt: Bonds are public debt requiring registration with the SEC
Senior vs Subordinated Bonds
Bonds can be classified as senior or subordinate to another bond.
This means that senior unsecured bonds are senior to other bonds, but are still behind secured bonds in bankruptcy priority.
In general, senior bonds do usually recover more in bankruptcy than subordinated bonds.
Default rates are way higher for speculative grade.
Speculative Loans
Leveraged Loans – Term loans that are often packaged with a revolving credit facility and are syndicated by an investment bank to commercial banks and institutional investors. Traditionally called Senior Secured Leveraged Loans.
Typical Characteristics: 1) Principal Amortization 2) Secured (1st or 2nd lien) by the firm’s assets 3) Floating rate – Payments set at a spread over a benchmark rate, such as LIBOR, but now Secured Overnight Financing Rate (SOFR.) 4) Term: Shorter maturity than bonds 5) Covenants: More restrictive covenants (require regular compliance with financial ratios) 6) Private: Not registered with SEC 7) Prepayment is typically allowed without penalty 8) Over time, banks have become less comfortable with speculative-grade companies, and institutional investors now make up a larger proportion of the market for leveraged loans.
Covenant-Lite Leveraged Loans
Sometimes called “cov-lite” Leveraged Loans. Contain looser “incurrence covenants” which require compliance with credit ratios only when taking specific actions (issuing debt, dividend payments, making acquisitions.) Overtaking high-yield bonds, due to borrower flexibility and the lack of SEC registration.
Mezzanine Debt
Mezzanine debt describes financing between senior, secured debt and equity. This would include debt such as 2nd lien debt, senior and subordinated bonds. However, unfortunately, the term “Mezzanine Debt,” is often used by practitioners to refer to securities with both debt and equity features, which sits between traditional loans and bonds, but above common equity. 1) Convertible debt 2) Bonds with warrants (long-term option to buy stock) 3) Convertible preferred stock 4) Preferred stock with warrants. Primarily used to fund leveraged buyouts, when financial sponsors want more debt in the capital structure than conventional leveraged loans and bonds offer.
Hedge funds and mezzanine funds are the primary mezzanine investors. Unsecured: usually unsecured with few or no covenants. Target return of 10%-20%. Private transaction, so liquidity is lower than high-yield bonds.
Mezzanine investors often want to increase returns by 1-2% by adding an “equity kicker,” which is an option to participate in the equity upside of the business. There are three options: Warrants: Warrants act like employee stock options, where investors can convert them into common stock. Co-investing: Mezzanine investors are given the right to co-invest equity alongside the controlling shareholder. Conversion feature: Gives the investor the right to convert the debt or preferred stock provided into equity.
Distressed Investing
Failure: Business ceases operations due to financial distress. Technical Insolvency: Inability to meet debts when due.
Balance Sheet Insolvency: Liabilities exceed assets. Default: Firm violates a loan agreement. Bankruptcy: Legal status for firms that enter court-supervised proceedings to liquidate assets or reorganize.
Chapter 11 – Reorganization
Focuses on the rehabilitation of the debtor, allowing them to retain control as a debtor in possession (DIP) and operate the business while restructuring the debts. Chapter 11 cases may begin either voluntarily by a debtor or involuntarily by a creditor. Most Chapter 11 filings are voluntary because creditors can be held liable for damages to a company if it can be shown that the company was working out its problems on its own.
Debtors – Retains control of assets and operations as Debtor in Possession (DIP). Office of the US Trustee – Oversees the case and forms committees. Creditors committee – Composed of the 20 largest unsecured creditors and represents the interest of all unsecured creditors. Oversees the reorganization or eventual liquidation. Other committees – In larger cases, there may be an equity committee or a bondholders committee. Secured Creditors – hold liens on the debtor’s property and actively participate in the reorganization process. Professionals – includes attorneys, accountants, financial consultants, and other specialists.
Fulcrum Security = Security or debt instrument that will be converted into equity after reorganization.
In the class of claims that is neither fully covered by the company’s assets nor completely wiped out, the security class where the value of the reorganized company is expected to break even. Holders of this security are most likely to receive equity because there is not enough value to fully satisfy senior claims, but there is some value left that extends into this class. Typically, the senior-most class that does not receive full recovery in cash and is therefore converted into equity.
However, a party with 34% of the value of the claims can exert negative control because it can prevent a vote to accept.
Each class that is impaired (doesn’t get fully repaid) must approve of the plan for it to be confirmed. However, if it is not approved by all impaired classes, the judge can still approve the plan if at least one class approves and the judge believes the plan is fair. This is known as the “cram down provision.”
Distressed investors must rely on public data. Cash flow projections for distressed companies can be very unreliable.
EBITDA is typically used as a proxy for earnings. Must be adjusted to make it more realistic. Subtract CapEx (value to maintain the level of capital assets). Subtract any non-continuing operations. Adjustments for restructuring charges that are actually incurred. Look for divisions or segments that might be sold and improve cash flow generation. Multiples are typically used to value the company. Public company comparables can act as an upper bound for valuation.
Liquidation value will act as a lower bound for valuation because the law requires that the value in a Ch. 11 plan be at least as much as it would be in liquidation.
If senior secured debt is trading in the market at 50 cents on the dollar, what is the implied enterprise value of the company, and should the investor buy? If the investor believes that the company is worth $500 million, then the debt should be worth $500 million / $750 million = $0.67 cents on the dollar. A value for the debt of 50 cents on the dollar (.50/1.00) implies that the market is valuing the company at .50/1.00 x $750 million = $375 million.
Sell-Side and Buy-Side Advisors
When a firm decides to sell a division/unit or the whole company, it hires an investment bank as its sell-side advisor.
Broad auction. Targeted auction. Negotiated sale.
The deal team values the target unit/division/company to: Assess the amount buyers might be willing to pay. Assess merger consequences (dilution and balance sheet effects). Develop a list of potential buyers. Set guidelines for acceptable bids. Evaluate offers received. Guide negotiations.
Buy-side advisors can also advise on the financing of acquisitions.
Private Equity
Well-known financial sponsors include Kohlberg Kravis Roberts & Company (KKR), Blackstone Group, Carlyle Group, Bain Capital, and Goldman Sachs Private Equity.
The financial sponsor, through the management company, charges a fixed management fee and a variable fee based on a percentage of realized profits. This variable fee is referred to as Carried Interest or just Carry.
Most PE firms focused on LBOs charge a 2% management fee and a carry of 20% after achieving a required hurdle rate.
A hurdle rate is a minimum rate of return required by limited partnerships before the sponsor can collect any carried interest.
Leveraged Buyout (LBO)
Acquisition of a company by a financial sponsor using:
Large amount of Debt + Small amount of Equity. All free cash flows that are generated by the company are used to pay off debt. Over time, debt is paid off, so the equity percentage grows, leading to higher returns for equity holders.
1) Determine Assumptions & Create “Sources & Uses Statement” A) Purchase Price B) Use of Funds
Purchase price
Net Debt – pay off debt of acquired company
Transaction Fees – Investment bank, legal fees, lender fees
Source of Funds – See previous “Potential Sources of Funds” slide
Make Financial Projections
3) Calculate Investor Return. Estimate Exit Value of Business – Often an EBITDA multiple. Unlevered Free Cash Flow Projections – Projected FCF is used to pay down debt and to determine exit value.
Calculation of Exit Value. Enterprise Value – apply estimated EBITDA exit multiple to get exit enterprise value. Calculation of Exit Debt – Start with debt raised, then add interest incurred and subtract cash flows used to pay down interest and debt.
Calculation of IRR & other return metrics
IRR = (Exit Equity Value / Equity Invested) ^ (1 / Years) – 1
Multiple on Invested Capital (MOIC) & Cash on Cash (CoC) valuation measures ignore time value
MOIC or CoC = Final equity value at exit / initial equity investment
