The first Building Block Liability is a fixed obligation and must be paid back. Equity is residual and does not have a fixed repayment requirement. Equity can also be thought of as the foundation of a business as in the old adage. Equity provides: The cushion to absorb shrinking asset in a downturn The resilience to withstand operating losses; The leverage to avoid debt carrying costs Equity represents the ultimate business risk. In relation to the risk/reward curve, equity is at the extreme end – it tasked the greatest risk, and therefore, deserves the greatest reward.
The common observation: equity is costly. The cost of debt it measured in terms of interest to be paid: the cost of equity is related to the amount or share Of ownership given up and dividends paid. When does a business need additional equity? A significant amount of equity is needed at the start. As circumstances change throughout the life cycle of the business, additional equity will be needed. (example: a major plant and equipment expansion, market expansion by introducing new products, etc) Determining the Debt-to-equity Ratio For many business, a debt/equity ratio from to is considered satisfactory.
The debt burden must also be weighed in relation to the profitability, cash flow and product or service cycle that determine the company’s ability to service the obligation. Main sources of equity 1. Personal Assets, close friends, relatives 2. Angels 3. Government Programs 4. Industry 5. Venture Capital 6. Strategic Partnering 7. Initial Public Offering (PIP) Carefully Assess Potential Sources of Equity Many sources of referrals for potential equity investors: Government industry department, local Chambers of Commerce, Area industrial development department, Entrepreneur clubs, professional advisors (leaver, accountants), appliers, bankers.
The following are the sources of equity financing available to the entrepreneur: Private sources- informal investors (personal funds, friends, relatives, angles, clients of professional advisors, customers, recently successful entrepreneurs) Government sources (provincially sponsored business development equity corporations, grants or subsidies) Industry sources (significant competitors, suppliers or customers, strategic partnership) Foreign sources (investors immigrating to Canada, schedule 2 banks) Venture capital (corporate holding companies, private investment syndicates) Employee Stock Ownership Plan Seeps
Internal sources (retained earnings, sale/leaseback of fixed assets, turf financing by the sale of certain rights There are clearly many positives from having investors join you business, but only if you choose that investor carefully. In evaluation an investor consider: 1 . Personal chemistry (are you comfortable with the persons 2. Value-added assistance (does the investor has relevant experience to assist the company’s board and management, can he/she help to grow the company) 3. Deep pockets (Most investments require follow-on funding before full maturity. Will it have additional funds available in its capital pool in he future. . Reputation (ask references, what was the investor behavior in different situations from his past investment) Textbook 2 Chapter 7 The Valuation: Create the Framework for Fund Managers One CEO asks Knox to explain which characteristics appearing within those first fifteen minutes he feel show good leadership. Know said that if you are pushing to change the way your industry looks and works, you will be a very successful CEO. Investors define the value of a company by its strong market position, growing finances, growing revenues and long-term cash flow from year-in and year-out customers.
Early on in our initial discussions, the COPE must align company interests with the private equity investors and devise a value- creation plan together with the management team, discussing the opportunities to create wealth. It is important for the entrepreneur to have clear objectives and a mission statement that can be explained to the potential investors. When talking to the investors you have to first talk about the exit because it is important for the investor to to know his destination in five years further down the road. The entrepreneur needs to make a good plan.
A good plan is a plan of action. A fund manager will want to see a CEO ho spends some time planning strategies but more time acting on opportunities. When your funds manager asks you what keeps you up at night, the expectation is tattoo worry about the money. The fund manager wants to hear you are worried. When the fund manager walks into an office, the Coo’s communication skills will become obvious from her level of energy and ability to engage everyone around the boardroom table. The staff of the company must know the plan as well as the CEO or the fund manager do.
Entrepreneurs have to listen to their investors, make up their own mind, but do respect their outsider view, Textbook 2 chap 11 The Win/Win Deal Your are seeking a long-term relationship, not offloading property, so pick who you want as a partner and make price a secondary priority. The investors have to commit to how much money they are willing to invest, as well as how much of the company they will want to own. There will be some hardcore math and accosting formulae to determine it. However, there is also a healthy dose of subjectivity. Like strength Of the management team, market share of your product, etc) The 3 main variables for private equity in decision valuations or how much to pay for a business using a house example: 1. Growth (you rely on holding the house and getting a return because the neighborhood went up in value. This is the buy, fix and sell method) 2. Leverage (You fix up the house and the neighborhood rises in value. This is the buy, add value while paying down the debt, and sell method) 3. Multiple Arbitrage (you buy by borrowing other people’s money. You develop the house as well as wait for the value of the neighborhood to rise.
This is the buy, arbitrage, and sell method. Try not to overestimate the value of your business. That is how valuation works: futures earnings potential of the company. The valuation methods seed depend on you company’s stage of development. At the end of the day, the key factor that the investor will focus on is predictable future growth culminating in predictable future earnings. Early stage: valued of how much capital you have injected in the business. Factors such as intellectual value (sweat equity) and opportunity cost. Expansion stage: Base valuation on comparable company multiples of sales.
Late stage: Base valuation on the basis of comparable earnings multiples. Here is a quick breakdown of 2 more popular valuation measures used that are used. (Multiple of EBITDA and Discounted Cash Flow DC) (p. 23) EBITDA Multiple Valuation: 1- calculate EBITDA on a “normalized? Basis, which means removing any abnormal items not directly related to the operation of your business. These include bonuses above market average, salaries paid to family, irregular costs 2- Multiple: Standard private equity EBITDA is “six times”. 3- Net Debt= Total debt minus cash.
DC: Method compares the discounted revenue multiple of your company to similar publicly traded companies. The values of the company is the cash it generates. However, the DC methods is only as good as its input assumptions (free cash flow forecasts, discount rates and perpetuity growth dates). An investor will pay a premium if he sees: smooth growth in sales and earnings, proof of concept and recurring revenues (predictability). An investor will apply a discounted value if he sees a spotty or erratic financial results, ‘hiccup’ that requires explanation or key business plan elements pending such as customers or new products.
Investors typically aim to earn between 5 to 10 times their initial outlay within a 5 to 7 year investment term. Investors will be tough on valuation, but remember, they still want to ensure that current owners have an incentive to get out of bed every morning to make the business successful. Term Sheet Investors use a term sheet as a basis for drafting the investment documents. The term sheet is negotiated between the prospective investor and the entrepreneur. It outlines the key financial and other terms of proposal investment. A term sheet contains a whole host of provisions designed to protect the value Of an investor’s capital.
The exit strategy is sometimes clearly stipulated because there might not be an exit yet, or it is not written up in the term sheet. When bringing in investors, you are changing your rights, so the clearer these are detailed, the better. Negotiating a term sheet deed not necessarily be an adversarial exercise, but be prepared for a fair amount of negotiation, especially around the valuation of the company. The term sheet should cause momentum to finalize the deal. In other words, there should not be a situation where the due diligence drags on and after 6 months the fund announces that they have changed their mind.
In rushing to the finishing line you must be aware of the potential bear traps that could ensnare you. Here is a list of the main “bear traps: 1 . No-Shop Clause: Your investors will want the “no shop” clause, which means that you cannot show your business to other investors while this investor is humming and hawing whether to buy in as partners-40 days Of being exclusive to one fund is the longest you need. 60 days is too long to be out of the market looking for investors. 2. Investor’s Legal Expenses: “l want my legal fees paid, even if I don’t get the deal closed. It’s not the norm and you are right to push back against including this in the term sheet. Everything can be negotiated. Normally, there is a cap on legal expenses ATA fixed amount. Do not leave the amount open-ended. 3. Confidentiality Clause: The confidentiality clause protects the assets of your company. It must apply to tooth parties and must protect customer trade secrets. If your investor wants the clause inserted, and most do, understand it. Get the information in your term sheet, as it keeps your legal costs down and you are not negotiating back and forth.
You need to make sure that the results of due diligence are confidential. The investor cannot reveal the results to anyone as they could poison the market. It is also a good test to keep out investors with competing deals or competitive spaces. 4. Giving it All Back: The investor says, ” bet on you and your team and if you leave, then limit paralyzed. Your shares should be surrendered”. You could have shotgun clause that basically says either you buy or you sell and it is a two-way shotgun. Can put shares to you and you can buy me out.
Clauses for founders to sell back their shares if they leave the company are critical to define upfront. The period for exercise of shares should be short, not an open-ended time, and it should be negotiated furiously. 5. Non-Competition: Invests may try to put the non-compete clause into the term sheet, rather than in the employment contract because it adds more teeth. It means that if you leave the company and the investors buys back the shares, you must Stay out Of the market for 2 years. The non- compete does not apply to investor due to their broad focus across different parts of the value chain in one market. 6.
Security and Covenants: Asking for confidentiality at the first meeting which should be warm and fuzzy, will chill the meeting. Just be discreet in the early meetings but know that the non- disclosure agreement (AND) in the term sheet is acceptable. Look at the investor portfolio and see if any of your information could help one of these companies. An investor might meet you just to get industry information. If investor is paying fully attention= more chance of “stealing information”, sing blackberry=more chance to invest in. 7. Who Bears the Cost of Due Diligence: Some cost is borne by the company and some by the investor.
The legal costs relating to the contracts and closing is performed by lawyers. It is necessary and costly. Know the legal rights of raising capital. Due Diligence The most disturbing part of investors checking for the full details on your company, isn’t the process itself, but how the closeness to signing the deal cause huge stress for both parties. The due diligence is not an attack on you or your business. The exercise is necessary, in that it gives the investor a peer understanding of your business and ultimately a sense of comfort.
Due diligence Checklist: Intellectual property-legal patents financial review-accountant reports Marketing-all plans over the past 5 years Technology-blueprints, special knowledge Customers-signed five-year contracts Reference on management team Five Negotiation Tips for a Win/Win Outcome Treat the Investor and the Process of Due Diligence with respect (Some entrepreneurs treat due diligence as an annoyance) First Offer is Not the Last. (Be prepared not to like all the terms of the money deal but stick around; it’s not over with one yes or no) Take Your Time.
When handed the term sheet, go through it with your advisors. There is no need to give the nod straight away or agree over the phone. ) Think Win/Win. (If there is something you don’t like, have another plan of action to suggest. Your behavior will be noticed and there will always be future deals with someone who thinks broadly. ) Be a deal Closer. (Know the timing can be 3 to 7 months from first conversations to money in the bank. Just as a shotgun marriage is not a positive way to start off a life of bliss, neither is being caught in a crush for cash. Sow the see before you need the cash).
Top Ways to Get the Relationship Off to a Great Start Invite the investors to meet everyone on the team if they have not done so already. There are common questions the private equity investor will ask and your board will appreciate it if you already are targeting these matters. Your business plan is what you are contracted to do and your term sheet will be held against whatever you do achieve. Private Equity’s Big Priorities 1 . Operational Strategy (do we have an operating plan that will raise shareholder value, do we have clear, objective metrics to monitor performance, etc. 2. Board Incentive (Is the board committed to giving enough time and clarity regarding their role. Does the board have a financial incentive to maximize shareholder wealth, etc. ) 3. Financial Strategy (Is there too much cash on the balance sheet, do we have the best capital structures, etc. ) Non-Dilative Financing Options Textbook 1 Chapter 8 Government Funding-Backing Winners In today’s fast-moving business world, you cannot afford to overlook the potential for financing through government programs.
Government assistance has changed from simply handing over the hard cash to plating an advisory role. This approach is most evident in the areas of human resources ND international trade. It is important to distinguish between “assistance” and “incentive”. An incentive can be a Nan-repayable contribution because the project could no otherwise proceed. Assistance programs do not require a project to go ahead just because of the program. Those programs are predicated on need that can usually be demonstrated only by a good business plan.
Supporters, Not Leaders Governments are reluctant to take a leading role in financing, rather they prefer to supplement and complement funding from the private sector. Government funding most frequently it has the characteristics of mezzanine debt. Mezzanine: A term debt that accepts a higher level of risk, offers more flexibility, and/or offers a lower rate of interest in return for a share in the success of the business). But instead of sharing financially in the growth of the company, the government program will see its payback as the benefit to the economy provided by the success of the business.
Forms of Government funding: Relief and incentives under the Income Tax Act Reduced interest rates Loan guarantees Management assistance Cash funding (repayable and non-repayable contribution) Rules of the game Stacking. Standard government policy requires funding from all levels of overspent combined be no more than 50% of a project. Equity. Certain funding statutes specify that a project provide no less than 20% of its own equity. In fact 30 to 50% equity is the usual practice. Return on investment.
Governments weighs its investments considering the social rate Of return (ex: job created) and the the discounted cash flows anticipated from the project. Government priorities. Government are increasingly sensitive to labor and environment issues. Keep in mind that an important consideration for a government funding program will be a clean report from the relevant labor and environmental ministries. Leveraging with Government Funding Canadian businesses frequently have too high a level of debt, and therefore have little resilience at the time of a business downturn or high interest rates.
Government funding focuses on sharing the risk with entrepreneurs; however it also wants to lower the risk. Government offer different type on repayment to help businesses. Specific business activities that may be received favorably include: Financing the business industrial research and product development Exploitation of technology Training and upgrading the workforce Manufacturing a product that is or could be exported Improving present products Closing a financial gap. In addition to “cash funding” programs, governments are continually changing the tax Structure to try redirect the economy.
Preparing a Successful Application Be prepared for a lengthy process. The government funding process requires considerable time to go through the various steps. 1 . Business Consultant. (Consider if basic program parameters are met) 2. Departmental Management (Approval to proceed with investigation and report) 3. Business Consultant (Input from related departments such as Labor or Environment) 4. Approval of Department Committee. 5. Deputy Minister/Minister for Ratification (this step is often exclude for small programs) 6. Cabinet (This step is often exclude for small programs) 7. Treasury Officer. Input from related departments such as insurance, legal, engineering inspection) 8. Disbursement 9. Loan Accounting/Administration. Avoid the Common Pitfalls Common pitfalls: Read the guidelines carefully. Read the guideline carefully and keep in mind that most programs are much more flexible than you might infer from the print material Understand the criteria for the program. Ensure the application includes one or more of the factors outlined above as a key issue for the overspent. Plan the timing of your application. Approach the relevant government agency long before you make any financial commitments elsewhere.
Tailor your proposal appropriately. Show the benefits your project will bring locally and/or nationally including employment, increase in exports/ abatement goods and resources, use of domestic manufactured goods and resources. Talk to the right people. Always speak to the appropriate officials to explore your eligibility. Nothing is Perfect Even though government assistance and incentive programs can help launch a new business or put an existing one on a more solid footing, there are some repacks to using them: The Approval Process.
You usually need government approval before you can start a new project, others you may disqualify yourself for assistance. The approval process itself can also take a will and you have to be prepared for such delays. Additional Costs. Because projects expenditures often have to be audited and reported, you should be paying for accountants and layover’s. Success Can Spell Repayment. If the financing program involves funding for a prototype, subsequent sale of the prototype or commercial production from it may force repayment of the government funds. Confidentiality.
All dealings with the government are supposed to be confidential. The number of persons involved in dealings at the various government levels makes enforcement difficult. The government Maze/ You may encounter frequent staff turnover in the government departments you deal with. All this increases the chance of your paper work being interrupted and delays your approval. Restrictions. Some of the programs may have negative covenants (restrictions) that prohibit changes in voting control of the business or disposal of assets. Dealing with Government Officials Study the organization.
Understand the departmental structure so you can identify the key people reviewing and/or approving your project. Once you know who is in charge, start at the top. You may be shunted around, but at least the senior people will know you and your project. Find out how the approval process works. It will help you to overcome objections. Allow plenty of time and be patient. Allow the government officials plenty of time. Be prepared to answer all questions. Do not involve politicians. Most government departments are administered by civil servants who will still be there after the politician departs.
Do not compromise your judgment. Do not abandon solid business judgment in the Ursula of a few dollars of government assistance. Sources of Information Information on changes to government programs is usually sporadic, emanates from a multitude ministries, and can take many forms. Canada Business Locations. A one-stop shopping for information on government program through the establishment of Canada Business Service Centre. Information by telephone. Information officer are available to answer basic question and to direct callers to resources people in various government departments.
Information Via Internet. BMW. Sanguineness. Ca Information in Person. Most Canadian Business locations are open to the public and provide information National Research Council Canada (NRC) and Industrial Research Assistance Program (RAP) The NRC is focused on both basic and applied research for small and medium businesses. A lot of their programs provide “seed” money to search out and investigate ideas. The RAP technology advisor is available to: define technical requirements, identify technical opportunities, solve product and production problems, access financial or other assistance programs.
Textbook 1 Chapter 4 Term Loans Term Lending Today 3 significant trends in the long-term lending market during the past decade: 1 . Competition. The entry of several new institution groups into financing marketplace, including insurance companies, pension funds, trust companies and some schedule 2 banks. 2. Interest Rates. The increased competition of the past 20 years pushed rates to historically low levels. Now small businesses can negotiate “fixed-rate” term loans. 3. Bought Deals. The “bought deal” generally means that the lead lender commits to the entire financing and sells off major portion of the loan to an other institutions.
Should you have one lender or two? Advantages of having one lender: One institution to deal with, one set of security, elimination set of security, elimination of disputes over which lender takes which security, the total account becomes more important to one institution. Disadvantages of having one lender: The bank will not have the same level of competitive pressure, higher levels of total credit at one financial institution require higher levels of authorization, the bank could act faster in a unilateral fashion to liquidate the business in the event of financial difficulty.
Find the Best Deal Today’s market offers several interest rate alternatives. Interest rate alternatives include: 1. Floating Rate VS. Fixed-rate Debt. For short-term loans, axed rates usually provide significant reductions in interest costs. Fixed rates for longer periods are generally more expensive than floating-rate debt. Look for options, some institutions will provide floating rate interest with an option to convert to a fixed rate according to a predetermined schedule. 2.
Interest Rate Caps (Ceilings): An interest rate cap is a derivative that permits your company to place an upward limit on its interest rate without having to lock it in over the long run. 3. Interest Rate Floors. An institution will require a minimum rate (floor). The interest rate floor is Often used to offset the revision of the interest rate cap. Today’s financial service institutions offer many options. Consider that using more than one kind of interest to manage the risk, consider present and future cash flow, negotiate terms of contract, etc.
Textbook 1 Chapter 5 Lenders who offer mezzanine debt are willing to accept a higher level of risk. The target rate of return to the lender is the normal term-debt interest rate plus some factor of return that reflects the additional risk, or some benefit to be received by the borrower. The lender might offer to:advance more funds than would be available under traditional criteria, reduce or defer interest, sake payment interest only with no principal repayment, or provide long terms such as 8 to 10 years, often as a function of cash flow. Characteristics of Mezzanine Debt Less Equity Required.
A common criterion for mezzanine debt is an established, reliable and predictable cash flow instead of the traditional solid security base. Mezzanine debt should be used for: A leveraged buyout, ownership succession, a major plant expansion, acquisition, a rapid but temporary growth phase. Sharing in your business’s Future Success. While lenders play a more passive role than an investor, they may require a onus return comprised of one or more of the following: a % of net cash flow or gross revenue, a fee, nominal-cost common shares, warrants or options to purchase common shares or the right to convert debts into common shares.
Cash Flow. The advantages to borrowers funding on this basis is that cost varies with ability to pay and bonus is treated as interest. % of Financial Results. Many lenders will want to base the return solely on gross revenue. Fees. Lenders may even charge only a periodic fixed fee. Nominal-cost Common Shares. Usually, the lender will be party to a shareholders’ agreement with predetermined put/call provisions. Nominal- cost common shares preserve the borrower’s cash in the early years and assure the interests of the lender parallel those of the shareholders.
Warrants or Options. Warrants or options give the lender the right to acquire shares in the borrower’s business or convert debt to equity at a specified price and date. Where to Find Mezzanine Debt Lenders Canada has primarily a private-placement market for mezzanine debt. Trust companies and banks are beginning to take a more active Interest as the competition and sophistication of corporate increase. For large-sized companies: Banks and fund managers.