Raising Capital [1 ed.] 038725319X, 9780387253206, 9780387253190

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RAISING CAPITAL

RAISING CAPITAL

by

DAVID E. VANCE Rutgers University School of Business, Camden, NJ, USA

Library of Congress Cataloging-in-Publication Data A C.I.P. Catalogue record for this book is available from the Library of Congress. ISBN-10: 0-387-25319-X free paper. ISBN-13: 978-0387-25319-0

e-ISBN-10: 0-387-25320-3

Printed on acid-

e-ISBN-13: 978-0387-25320-6

 2005 Springer Science+Business Media, Inc. All rights reserved. This work may not be translated or copied in whole or in part without the written permission of the publisher (Springer Science+Business Media, Inc., 233 Spring Street, New York, NY 10013, USA), except for brief excerpts in connection with reviews or scholarly analysis. Use in connection with any form of information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now know or hereafter developed is forbidden. The use in this publication of trade names, trademarks, service marks and similar terms, even if the are not identified as such, is not to be taken as an expression of opinion as to whether or not they are subject to proprietary rights. Printed in the United States of America. 9 8 7 6 5 4 3 2 1 springeronline.com

SPIN 11378457

CONTENTS

Chapter 1

RISK, REWARD, SIZE AND TIME TO EXIT

Introduction 1 Understand Your Needs 2 What Is Capital? 4 Typical Sources of Capital 4 Risk, Reward, Transaction Size and Time 7 Risk Factors: Stages in a Company's Life Cycle 8 Factors Bearing on Reward 11 Transaction Size 12 Time to Exit 12

Chapter 2

SELF-HELP, THE ENTREPRENEUR'S SOURCES

Introduction 17 Self-Reliance 17 How Much Capital is Necessary? 18 Seven Strategies to Get Start-up Capital 19

Chapter 3

BANKS

Introductions 33 The Banker State of Mind 33 Bank Facilities 34 Underwriting 37 Quality of Financial Data 44 Bank Covenants, Terms and Conditions 45 Myth and Mythology 47 Are Banks Reliable Partners? 48 Bank Debt Is Good 49

Contents

vi

Chapter 4

SMALL BUSINESS ADMINISTRATION

Introduction 55 Overview 55 Eligibility 56 Mechanics 57 Underwriting 58 Collateral 58 Personal Guarantees 59 Documentation 59 Loan Covenants 6 1 Loan Programs 6 1

Chapter 5

ASSET BASED LENDERS AND FACTORS

Introduction 69 Traditional Asset Based Lenders 69 Specialized Asset Based Lenders 7 1 Tranche B Lenders 7 1 Sale & Leaseback 74 Note Discounters 77 Factors 79

Chapter 6

BUSINESS MODELS, BUSINESS PLANS

Introduction 89 Why Is Capital Needed? 90 How Much Capital Is Needed? 92 Risks of Underestimating or Overestimating the Capital Needed 94 Market Assessment 94 Business Model 99 Marketing Plan 105 People to Execute the Plan 106

Chapter 7

ANGEL INVESTORS

Introduction 111 What is an Angel Investor? 111 Angels Go Where Others Fear to Tread 112 What is the Profile of an Angel? 113

Contents

vii

Angel Investment Criteria 114 What Rate of Return Do Angels Want? 122 Due Diligence 122 Angel Investor Advice 123 Where Are Angels Found? 125

Chapter 8

VENTURE CAPITAL

Introduction 139 Risk versus Reward 140 Who Needs Venture Capital? 141 Scope of Venture Capital Investments 141 The Structure of Venture Capital Firms 142 Venture Firm Operations 144 General Criteria for Making an Investment 144 Oversight 145 Costs of Using Venture Capital 145 Valuation 150 Exit Strategies 152 Venture Capital Search 155

Chapter 9

STRUCTURING THE DEAL

Introduction 163 Investment Agreement 165 Valuing the Company 165 EBITDA Multiplier Method 166 Revenue Multiplier Method 168 Discounted Cash Flow 169 Similar Companies 171 Modeling 174 Intellectual Property 176 Securities 177 Payoff Analysis 179 Exit Provisions 183 Other Investment Agreement Issues 187

...

vlll

Contents

Chapter 10 THE PITCH: LANDING THE INVESTOR Introduction 197 Threshold Conditions 198 Sales 203 Time and Confidence Building 206 Financing Rounds 207 Pitch Format 208 The Deal Sheet 2 10

Chapter 11 SECURITIES REGULATON Introduction 2 15 Security Defined 2 16 Why Are There Securities Laws? 2 16 Why Bother With Securities Laws? 2 16 Overview of the Regulatory Thicket 2 17 Exemptions from Federal Securities Law 2 17 Public Offerings versus Private Placements 2 18 Private Placements, Non-Public Offerings 220 Regulation D 222 Documentation for a Private Placement 228 State Securities Laws 23 1 Overview of State Regulation 233 Selecting a Lawyer 236

Chapter 12 PUBLIC OFFERINGS Introduction 24 1 The Decision to Go Public 242 Investment Banks 245 Pricing Securities 247 Mechanics of an Initial Public Offering 25 1 Market Makers 254 IPO Road Show 254 Investment Bank Fees 255 Underwriter's Duty 257 Lock-ups: Getting Rich Slowly 258 Requirements to be Listed on Major Stock Exchanges 259 Going Private 262

Contents

Chapter 13 SMALL PUBLIC OFFERINGS Introduction 267 Regulation of Small Public Offerings 267 State Regulation 27 1 Means of Stock Distribution 274

Chapter 14 SMALL BUSINESS INVESTMENT COMPANIES Introduction 287 Characteristics of SBIC Investments 288 Eligibility for SBIC Funding 292 Restrictions on SBIC Operations 293 How SBICs Raise Capital and Are Structured 293 Finding an SBIC 296 What Will an SBIC Need to Know? 298

Chapter 15 INTERNAL SOURCES OF CASH Introduction 305 How Much Capital Is Appropriate? 306 The Cash Cycle 308 Accounts Receivable 308 Inventory 3 13 Plant, Property and Equipment 3 16 Accounts Payable 3 17

Chapter 16 BONDS Introduction 32 1 General Characteristics of Bonds 322 Risk Minimization 322 Bond Structure 325 Federal Regulation of Bond Sales 33 1 Risk Management Strategies 333 Early Bond Redemption 336 Sinking Fund 337 Junk Bonds 338 Bond Sales in Secondary Markets 340

x

Contents

Chapter 17 COMMERCIAL PAPER Introduction 345 Securities Regulation and the Definition of Commercial Paper 346 Who Can Issue Commercial Paper? 346 Cost of Commercial Paper 347 Managing Short Term Financial Risk 349 Managing a Commercial Paper Operation 349 Maturity Strategies 350

Chapter 18 OTHER FINANCING VEHICLES Introduction 353 Syndicated Loans 353 Bridge Loans 354 Mezzanine Financing 355 Securitization 355 Private Investment in Public Entities (PIPES) 357 Bankruptcy and Super Priority Loans 359 Government Grants and Loans 361

Appendix A Appendix B Appendix C Appendix D Appendix E Index 371

Future Value Interest Factor 365 Future Value Interest Factor for an Annuity 366 Present Value Interest Factor 367 Present Value Interest Factor for an Annuity 368 CD Table of Contents 369

PREFACE

All companies from the smallest to the largest need capital. Access to capital constrains growth in good times and is necessary to survive in bad times. Most business people think of banks when they need capital, but banks only lend to companies that fit within a narrow range of parameters. If a company is too small, too young, growing too fast, has an unusual product, or is in the wrong industry, banks will not provide credit. Banks change lending criteria as the economy changes and change industry preference as often as they merge. Banks also constrain a company's strategic options through conditions on loans called bank covenants. Fortunately, there is a spectrum of non-bank capital sources that fit the needs of almost every company, whether weak or strong, large or small. The entrepreneur should be cautious about considering any capital sources in isolation. For example, venture capital is often cited as the way to grow a company, but venture capitalists (VCs) rarely invest in companies that do not already have capital from other sources. So the material leading up to the chapter on venture capital is an essential part of the roadmap for anyone who wants to use venture capital. The chapters after venture capital are important because VCs typically exit an investment within five to eight years, so a company must have a strategy to fund that exit. The point is that strategies for raising capital interlock over the course of a company's life. The choices a company makes in one part of its life cycle can limit what it can do in the future or on the other hand, the choices it makes can open new possibilities. Chapter one discusses the four primary factors that determine the most appropriate source of capital for any given company: risk, reward, size and time to exit. Not all capital sources have the same risk tolerance or reward demand. Transaction size is important because some sources are limited as to the amount of capital they can provide whereas other sources are not economical below a certain size. Time to exit is an important concept because no capital provider wants its money tied up indefinitely. Some money is more patient that other money. Unless a company's needs exactly match a capital source's preferences, funds will not flow.

xii

Preface

Chapter two discusses the problems an entrepreneur has raising enough capital to develop a concept into a company or create a financial track record that can be used to leverage other capital. It also discusses seven sources of capital an entrepreneur can access before he or she qualify for his or her first business loan. Chapter three discusses banks and their world view. This provides a base line against which to measure other capital sources. Chapter four discusses Small Business Administration loans which are actually bank loans guaranteed by the federal government. Chapter five discusses asset based lenders which are often lenders of last resort when a bank cuts off a company's credit. Banks focus on a company's current and future profitability, but asset based lenders focus on whether a company has enough assets to guarantee loan repayment. Included in this broad category are commercial credit companies, tranche B or junior lenders, and factors. Chapter six discusses business models and business plans. Those providing capital want to know that a company has a well thought out business plan. In many books, the business plan boils down to inserting text under standardized headings. In this book, the business plan focuses on identifying customers, their numbers and their consumption patterns. It combines a pragmatic customer focus with economic models that test whether plans are viable before resources are committed. Chapter seven discusses angel investors. These wealthy, private individuals are often the first to invest in a company after friends and family. The chapter explores what angels look for in terms of the entrepreneur, the company and its products, a deal's structure and whether the investment meshes with the angel's personal preferences. It also discusses where and how to find an angel. Chapter eight discusses what it takes to get venture capital. Less than one percent of companies qualify for venture capital and venture capitalists invest for limited periods of time typically five to eight years before they exit. Venture capital is one of the most expensive sources of capital and venture capital deals are usually structured so that if the owner entrepreneur fails to perform, he or she can be removed. On the other hand, venture capitalists drive companies very hard and can create great wealth in the process. Chapter nine discusses structuring the private equity investment. Entrepreneurs want to give little and get a lot and investors want to give little and demand a lot. This chapter helps the entrepreneur understand the types of demands an investor is likely to make, those which are reasonable, those which are unreasonable, and it provides an analytical framework for deciding how much equity the owner must give up to close a deal. Chapter ten discusses pitching, the art of making the case that an investor should invest in a company. The entrepreneur should understand that he or she is competing with a large number of alternative investments and

Preface

...

Xlll

proper preparation is necessary to attract investor interest. The topics covered in this chapter include formal and informal pitching and ways the entrepreneur can build confidence in himself or herself and his or her company. Raising capital is one of the most highly regulated aspects of business. At the federal level, the Securities and Exchange Commission (SEC) has the dominant role, but every state has its own securities law as well. Chapter eleven provides a broad overview of securities regulation and a more detailed analysis of private placements. It also discusses instances where federal securities law pre-empts a state's right to regulate securities. Securities offered to the public must be registered with the SEC. A company's initial public offering (IPO) is often the most difficult because of lack experience issuing securities and because the investing public lacks information about the company. Chapter twelve discusses the steps needed to go public, methods for valuing a company's shares, the purpose of the IPO road show, underwriter's fees and services, and lock-ups. This chapter also discusses the criteria for listing a company's stock on a major exchange. Traditional IPOs are only cost effective for very large companies because of the complexity and expense of registration. However, securities law provides simplified registration for small public offerings. Chapter thirteen discusses simplified registration, the characteristics of companies that are good candidates for a small public offering, and how a company can distribute its stock. Small Business Investment Companies (SBICs) are one of the best kept secrets in capital markets. They can provide more capital than angel investors, but do not need the high growth rates required by venture capital firms. Chapter fourteen compares SBICs to venture capital firms in terms of investment size and industry preference. It also describes the information SBICs need to make a funding decision and how to find an SBIC. By the time most entrepreneurs are ready to exit their business thorough a sale or public offering, they have given away most of their equity to investors. One reason is that business owners tie up cash in under producing assets such as accounts receivable, inventory and plant and equipment. Chapter fifteen discusses how a company can tell whether it is over investing in assets and how to squeeze cash from exiting assets. Every dollar an owner can squeeze out of assets is a dollar he or she does not have to raise from an investor. Large companies can bypass banks and borrow money by issuing bonds to the public. Bonds are superior to bank loans because they can be structured to have longer maturities than bank debt, lower interest rates and fewer covenants that limit management action. Chapter sixteen discusses the mechanics of issuing bonds as well as strategies for lowering a bond's risk and consequently the amount of interest a company must pay to attract buyers.

xiv

Preface

Commercial paper is a mechanism for top rated companies to raise large amounts of capital in public markets without having to register with the SEC. Commercial paper is the least expensive form of capital and costs far less than bank credit. Chapter seventeen discusses what qualifies as commercial paper and the mechanics of using it. Financiers are very creative and have designed a number of vehicles to raise capital for specialized purposes. Chapter eighteen discusses several of these vehicles including syndicated loans, super priority loans, bridge loans, mezzanine financing, asset securitization, and private investment in public entities (PIPES). In summary, this book embraces a broad spectrum of financing sources. Capital is available for almost every kind of company, large or small, weak or strong, if a business person knows where to look, what to expect, and how to ask for it.

ACKNOWLEDGEMENTS I would like thank Carolyn Nelson who reviewed and commented on the first eight chapters of this book. I would like to give special thanks Jeremiah Williams who did an outstanding job of proofing, checking equations, and making suggestions as to how to polish the book's format. I would also like to thank the hundred and fifty graduate and undergraduate students who have used, commented on, and vetted various editions of this text. Their comments, questions and criticisms have helped sharpen explanations and integrate what has been a fragmented body of knowledge about a variety of capital sources into continuum of strategic options. Their relentless probing as to why things work as they do has helped unite theory and practice. Anything good about this book I owe to them. The faults are my own.

Chapter 1

RISK, REWARD, SIZE AND TIME TO EXIT

INTRODUCTION Businesses from street vendors to billion dollar multinationals need capital to grow, even to exist. Many businesses look to banks for capital, but banks only lend to companies that fit a narrow profile and banks are not always the most cost effective or reliable source of funds. The objective of this book is to equip entrepreneurs, as well as corporate executives, with an understanding of the options they have in raising capital, how they can find funding, and reasonable expectations about what it takes to close a deal. The important thing to know is that there are many alternatives to banks. Some are more expensive than others in terms of cash payments, equity and loss of control. This book discusses more than a dozen alternatives to traditional bank loans. Some only work for the biggest, most creditworthy companies, others are designed for companies on the brink of failure. Some capital sources provide permanent financing, while others provide financing for as short as a day. Raising capital is difficult because the company seeking it and the source providing it must fit together like a lock and key. If they do not, funds will not flow. The best capital source for any company will depend on four factors: (i) risk, or creditworthiness of the company, (ii) reward which is how much the company must pay, (iii) transaction size, some sources cannot provide large amounts of capital, others are too expensive to raise small amounts, and (iv) the time to exit, that is the time until the source wants its money back. A good way to understand the interaction of these factors is to consider the plight of the entrepreneur from the time he or she starts a

2

Raising Capital

company until that company grows to the point where it requires hundreds of millions in capital. Let us start at the beginning. Entrepreneurs have special problems raising capital because they generally do not fit into the tried and true, steady state mold that banks prefer. Rather than rely on banks, entrepreneurs must live off the land and find capital when and where they can. As a company grows from start-up to early stage, to rapid growth, to maturity, its capital needs will change, and so will the best source of capital. In this chapter we will list some of those alternatives, but more important we will set the foundation for deciding which capital source is best for any particular company. Business people are very competitive and they can succeed in any game where they know the rules.

UNDERSTAND YOUR NEEDS Capital is an indispensable fuel for growth because of timing differences between expenditures and customer payments. For capital goods such as plant and equipment, this timing difference may be years. For inventory, that delay might be weeks or months. Capital is also important for product development because expenditures must be made .long before products are shipped and customers pay. Capital is also important to fund marketing and advertising and to develop a sales force. One of the most important rules in raising capital is that a company must understand itself and its needs at a deep level. Those providing capital will probe that understanding and if they find it lacking they will walk away. Two key questions capital suppliers will ask are: (i) why is the money needed? and (ii) how much is needed?

Why Does the Company Need Capital? If a business doesn't have a well thought-out idea of what it is going to use the capital for, no one will provide it. Those providing capital want to know if the company's object is to: Reach cash flow "break-even?' Cash flow break-even is the i) point at which a company generates more cash than it needs to sustain operations. Fund Research & Development? Research and development ii) is essential to keep technology companies from falling behind. However, a company is more likely to get funding for a specific project than for research

Risk, Reward, Size and Time to Exit

3

generally because pure research may be perceived as an unfocused drain on resources. iii) Facilitate superior growth? Superior growth comes from reinvesting in the company through advanced manufacturing technology, new plant capacity, etc. Dominate the market? Market domination can take the form iv) of a ubiquitous distribution system, heavy advertising, or superior products and services. Buy a competitor? Buying a competitor can be a strategic v) step in expanding into a new territory, acquiring patents and technology, or increasing market share. Stay alive? If the objective is simply to stay alive, the vi) investor will ask how much will be necessary to reach cash flow break-even. Will the investor be faced with a demand for continued cash infusions to save his or her initial investment? vii) To pay old bills? Payment of old bills doesn't generate new revenue and as a result will probably not attract more capital. One entrepreneur asked for advice on raising $50,000 to pay himself a back-salary for the year he spent developing his idea. His chance of raising capital is zero. Unless a company has a well articulated reason for raising capital and can demonstrate that capital is going to create new wealth, it is unlikely to attract funding.

How Much Is Needed? An investor or lender needs to know that a company has a well thought out idea of the amount of capital it needs to reach its goals. This is important because investors and lenders want to understand the maximum amount they will have to risk. They want to know that the entrepreneur won't come back, asking for another infusion of cash to rescue the investor's initial investment. More importantly, they want to know that achieving stated goals will put the company in a position to either pay back loans or add significant value to an equity investment. In chapter 6, we will explore how to estimate the amount of cash that a company should ask for. We will also discuss the concept of contingencies. Business never unfolds exactly according to plan, so it is necessary to build reasonable contingencies into any estimate of the amount to be raised. Knowing the exact amount of capital needed is important because there are risks to raising too much or too little capital. The risk in raising too

4

Raising Capital

much capital is that company owners will give up more equity than necessary or agree to pay excess fees and interest. The risk of raising too little capital is that a company may not be able to achieve its stated goals. That means it may have to return to the marketplace at a time when conditions are unfavorable, and capital suppliers may use that disadvantage to squeeze additional concessions from the owners. Lack of adequate funding can also result in the inability to pay bills as they come due which could push a company in bankruptcy.

WHAT IS CAPITAL? Assets are the resources a company has to use. It includes: cash, accounts receivable, inventory, cars, trucks, furniture, equipment, patents, copyrights, land and other things of value in which the company has an ownership interest. Capital is how assets are financed. There are two forms of capital debt and equity. Debt is money borrowed from someone else. Equity is the money the owners have invested in a company. Examples of debt include accounts payable, unpaid wages and taxes, bank loans, and mortgages. Equity is what would be left over if all assets were sold at book value and the money raised was use to pay off debt. Accountants embody this principal in the accounting equation Eq 1.1. Liabilities is the accounting term for debt. Assets = Liabilities + Equity

Eq.l.1

When people talk about raising capital for a venture, they could be talking about borrowing money, which will become a liability, or they could be talking about accepting money in return for a share of ownership, which is equity. Profit earned by the company, and not paid out as dividends is a kind of equity called retained earnings. As a general rule, raising capital by selling an ownership interest in a company is more costly than borrowing money. Interest paid on debt is tax deductible lowering the cost of debt. Equity is expensive because it reduces the return of the original investors.

TYPICAL SOURCES OF CAPTIAL The sources of capital that are available to a company will depend on its maturity, profitability and other factors. However, it is instructive to look at capital sources for small businesses.

Risk, Reward, Size and Time to Exit

5

Figure 1-1 is an Analysis of Start Up Funding for 328 fast growing manufacturing and service companies.' Note that 92 percent of start up companies used non-bank sources. Figure 1-1 Analysis of Start Up Funding for Manufacturing Companies Owner, Friends & Family Investors Bank Loans Suppliers & Customers Note: percentages do not equal 100% because most companies use multiple sources

Figure 1-2, is an Analysis of Sources of Seed Money for Inc. 500 Inc. is a magazine that tracks the fastest growing small companies, and by implication, Inc. 500 companies are relatively successful. This analysis shows a somewhat different mix of capital sources. Almost of 86 percent of funding came from non-bank sources.

Figure 1-2 Sources of Seed Capital for Inc. 500 Companies Personal Savings Bank Loans Family Employees / Partners Friends Venture Capital Mortgaged Property Government Guaranteed Loans Other Note: Percentages do not equal 100% because most companies use multiple sources.

Figure 1-3 is an analysis of the funding sources of companies with up to 500 employees.3 This survey shows that as companies grow, they have access to a much broader array of funding sources.

Raising Capital Figure 1-3 Analysis of Funding Sources for Businesses with up to 500 Employees Credit Cards Commercial Banks Leasing Vendor / Supplier Credit Asset Based Lenders Personal or Home Equity Bank Loans Angel Investors Private Loan Small Business Administration Loan Selling / Pledging Accounts Receivable Private Placement of Stock Venture Capital IPO Other

50% 43% 24% 23% 20% 19% 19% 18% 6% 3% 2% 2% 1% 1%

Note: Percentages do not add to 100% because companies use multiple sources.

These surveys tell similar, though not identical stories. However, they share a number of common elements. See Figure 1-4, Composite Analysis of Start-up Funding. One element is that self-help, rather than banks or funds from professional investors dominate. Self-help includes: personal savings, loans from friends and family, credit cards and home equity loans. Another common element is that few companies have gotten funds from government sources. Figure 1-4 Composite Analysis of Start-up Funding; Sources Figure 1-1 Figure 1-2 Figure 1-3 Range Self-Help: Personal savings, loans from friends and family, credit cards and home home equity loans

71.0%

100.0%

69.0%

69.0%-100.0%

Banks:

13.0%

14.3%

43 .O%

13.O%-43.O%

Professional Investors: Venture Capitalists, Angel Investors or Other professionals

8.0%

6.3%

61.O%

8.0%-61.O%

Government:

0.0%

0.1%

6.0%

0.0%-6.0%

All Other:

8.0%

19.8%

92.0%

8.0%-92.0%

Risk, Reward, Size and Time to Exit

RISK, REWARD, TRANSACTION SIZE AND TIME Every financial transaction whether it is buying an insurance policy, investing in a certificate of deposit, or buying stock involves risk, reward, transaction size and time.4 Individual investors know the risks that he or she is willing to take and the rewards he or she demands in return. Those with a low risk tolerance put their money in banks, but expect low rewards in terms of interest. Others invest in stocks with the expectation that he or she will reap significantly higher returns than those that put their money in banks. Transaction size also limits the options of individual investors. For example, banks usually pay higher interest on certificates of deposit over $100,000, but not every depositor has a $100,000. Finally, there is the issue of time to exit. Banks usually pay higher interest to those willing to invest for the long term, but not everyone is willing to commit funds for five or more years. Just as individuals have risk-tolerance, reward-demands, transaction size limitations and time preferences, so to do those supplying capital. Businesses must realistically evaluate their risk-reward-size-time characteristics and select a funding source that it. Otherwise the search for funds will waste time and result in frustration. Restating the issues as questions we must ask: How risky does the enterprise look to the investor? For purposes of this discussion, we will call both lenders and equity investors, investors. We must also ask: What is the likely reward? Few financial professionals purchase lottery tickets. Why? Even though the potential reward for a $1 investment might be millions, the risk of losing the investment is very high. Suppose, on the other hand, an investor was asked to put up $100, with a one in three chance of winning $1,000? A financial professional, certain of the odds, would probably make such an investment. The risk of losing is still high, but the reward, relative to the risk, is higher. At every stage of a businesses' life cycle, investors balance risk and reward. The riskheward assessment of a company is compared to that of other companies and is also compared to publicly traded stocks and bonds, bank savings accounts and U.S. Treasury Notes. Factors bearing on risk include:

9 9

Financial Performance

9

Quality and experience of management

9

Other Risk Factors

Stage of development

Raising Capital

Stages In A Company's Life Cycle Companies, like people are born, live and die. The bluest of the Blue Chip companies of yesterday, are only distant memories today. The Pennsylvania Railroad in the 1930's and1940's was the king of the hill, a sure bet, a company people could count on. Never the less by the 1970's it went bankrupt. At the other end of the scale are small, start-up companies, most of which fail in the first five years. The reasons for failure include: (i)

Less experienced management,

(ii)

Novel, unproven, or not-fully-developed products,

(iii)

Fewer outside advisors like boards of directors, accounting or law firms,

(iv)

Reliance on a few customers for the bulk of their sales and profits, and

(v)

Few resources to fall back on should it make a mistake.

Large companies, on the other hand, tend to survive because they have greater resources to fall back on if they make a mistake or must weather an economic downturn. Their revenue is spread across many clients so the loss of one or two is not fatal. They have broad constituencies of customers, suppliers and investors that have a stake in assuring the company succeeds, and are frequently public companies which means they are required to disclose and react to problems as they develop. Large companies also have Boards of Directors, public accountants and lawyers, all of who help guide the decision making process. The point is that size and stage of development are important factors in determination of risk. Different people define the stages of a company's development somewhat differently. However, the MoneytreeTMdefinitions analyzed in Figure 1-5, Stages of Development, are representative.

9

Risk, Reward, Size and Time t o Exit

Stage

Figure 1-5 Stage o f ~ e v e l o ~ m e n t ~ Definition Implication

Start-up

A start-up business is one that is purely conceptual. No sales have been made, and there might not even be a prototype product.

The product or technology may not be feasible. Costs and prices are only broadly known. Market acceptance is untested.

Early Stage

An early stage company may have some venture capital, but it is still in product development. The investment in the company is illiquid, but there are prospects of becoming liquid through an IPO or acquisition. In a Biotech or medical device company, it has progressed to clinical trials.

The product may be technically feasible, but management may not be able to commercialize it. Production and distribution costs are not well defined. Market acceptance at needed price points is untested.

Expansion

An expansion stage company may be shipping products or servicing customers, but is not generating enough revenue to fund growth or make steady profits.

The product has been successfully commercialized. There is substantial customer acceptance. Costs have been refined and price points tested. Management has been tested

Later Stage

A later stage company is Risks are limited to external shipping products and making factors such as competition, a profit. changing markets and technology.

Financial Performance Financial analysis provides another way to measure risk. It is important to note that different investors look for different things. Some focus on a company's ability to generate cash on an ongoing basis. Others focus on whether a company can pay its bills as they become due, others are only interested in the value of assets pledged as security. A t this point, let us consider just one measure o f financial performance, the debt ratio. A debt ratio the percentage o f assets financed by debt and is simply total liabilities divided by total assets. The debt ratio plus

10

Raising Capital

the percentage of assets financed by owners' equity must equal 100%. If the debt ratio is 75%, then for every dollar of assets financed by the owners, three dollars is financed by creditors. Consider what would happen if a bank had to take over a company and sell its assets. Assume a bank seized the assets of a company with a debt ratio of 75%. Even if the assets sold for 10% below book value, and the cost of sales, for brokers, etc. was another lo%, then net proceeds would be 80% of assets. If total debt were only 75% of assets there would be enough to payoff the bank and all other creditors. But what if the debt ratio were 85% or 90% of book value? In such cases, a bank would have a hard time paying itself and might have to compete with other creditors for funds. Banks usually collateralize loans by taking a lien on assets such as accounts receivable, inventory and real estate, so that they will get first priority in liquidation. Often they used appraisers to make sure the market value of assets is more than enough to cover all liabilities. Use of ratios such as the debt ratio, and asset appraisal are risk management techniques. Investors whether debt or equity, are looking for a superior return on their investment. Trouble signs include low gross margins, insufficient earnings before interest taxes depreciation and amortization (EBITDA,) low sales growth, negative cash flow and losses.

Quality and Experience of Management Although this is a tough risk factor to analyze, there are some broad guidelines that give some indications. Owners and managers that have started and run businesses before are perceived as less risky than those who have not. Those with prior work experience in their industry are perceived as less risky than those changing industries. Finally, those with an impeccable personal credit history appear less risky than those that appear incapable of managing their own finances. These general guidelines aside, angel investors, venture capitalists and others base their assessment in part on whether they think the person requesting funds is honest, straightforward, and driven to succeed. But while personal characteristics are important, they are rarely able to overcome factors like lack of industry experience or a bad personal credit history.

Other Risk Factors The risk factors discussed above are not exhaustive, but they provide some insight as to as to the factors investors will evaluate. Other risk factors include: competition, market maturity, the availability of patents, copyrights

Risk, Reward, Size and Time to Exit

11

or licenses to protect markets, and the ongoing capital needs of the firm. The risk factors peculiar to specific capital sources will be discussed in subsequent chapters. So what can an entrepreneur do? Investors want to feel confident that the person who they are entrusting their money to knows what he or she needs to do. Ways to build confidence and reduce the perception of risk include having: (i) (ii) (iii) (iv) (v) (vi)

an understandable product or service, solid business and marketing plans, appropriate positioning in the marketplace, appropriate technology, officers and directors with relevant experience, and an entrepreneur with a good, solid, company story.

FACTORS BEARING ON REWARD Investors balanced potential reward against risk. The greater the risk, the greater the reward investors will demand. Banks consider interest, origination fees, fees for services such as checking accounts and account balances when calculating the reward a company might generate. Banks generate about half their income from fees, whereas, commercial credit companies focus on interest income. Angel investors, venture capitalists, and some equity investors look for a variety of rewards including bond interest and dividends on preferred stock. But most of the reward for this class of investors comes when they exit the investment. They are likely to demand bonds and preferred shares convertible into common stock which will allow them to participate in a company's success. Factors bearing on the payout at exit include (i) the total size of the market for the company's products or services (venture capitalists rarely invest in companies with markets of less than $500 million), (ii) the company's growth rate, (iii) the income and cash flow the company will be able to generate, (iv) the multiplier or other factors that will be used to value the company, and (v) companies that might want to acquire the company being invested in, or in the alternative, a public market for shares in the company.

Raising Capital

TRANSACTION SIZE Transaction size is the third major dimension in finding the right fit between a company and a funding source. Some sources are limited by capacity or regulations, for example: friends and family, angel investors and small business administration guaranteed loans. On the other hand, some forms of financing such as public offerings and corporate bonds have such high transaction costs that it is impractical to use them for to raise small amounts of capital. Money center banks might not want to make loans under $10 million, whereas local banks might not be able to make loans above $1 million. Liquidity requirements for some capital sources also drive minimum size. For some securities, there must be enough of them in the hands of the public to create a continuous market for their purchase and sale.

TIIME TO EXIT The time to exit is the amount of time an investor's money is likely to be tied up in an investment which is another way of saying how long the investor's money is at risk. If a company needs to borrow $100,000 for thirty days the risk is less, all things being equal, than if a company wants to borrow money for thirty years. For example, a venture capitalist will want to know how long it will take for his or her investment to payoff. Venture capitalists create funds to invest pools of money for financial institutions. Those funds have a life of ten years at which time the funds are liquidated and invested capital and profits are returned to the investing institutions. So when venture capitalists invest in a company, they are critically interested in whether they can exit before their funds wind up. Therefore, venture capitalists will examine factors including the stage of development, current size of the company and time needed to reach a size attractive to other investors. Venture capitalists will also want to know how they will exit an investment in a company whether it is through an initial public offering (IPO,) sale to a public company, sale to a private company, or sale to company's management. Banks, angel investors and others all want to know when to expect their money back and each is comfortable with a different timeframe.

Risk, Reward, Size and Time to Exit

SUMMARY Capital is an indispensable fuel for growth because of timing differences between expenditures to produce products and services and the receipt of customer payments. For capital goods such as plant and equipment, this timing difference may be years. For inventory, that delay might be weeks or months. There are two kinds of capital, debt and equity. The accounting equation: assets equal liabilities plus owners equity, expresses the concept that assets must be financed through debt capital or equity capital. Debt capital is other peoples' money; equity capital is the business owners' capital. The most common sources of capital for start-up companies are: the owner, his friends and family, and sources of credit he or she personally guarantees such as credit cards and home equity loans. Once a business has been operating for a while, suppliers become an important source of capital. Bank loans can only be obtained after a company has a track record, and then only if stringent credit criteria are met. Other sources of capital such as angel investors, venture capitalists, government grants and loans are only available when certain risk/reward/transaction size profiles are met. The concepts of risk versus reward and transaction size provide the overarching framework for raising capital. Each of those providing capital has a certain risk tolerance and reward expectation. They also have transaction size preferences. The surest way to raise capital is to know the risk/reward/transaction size profile of each capital source and choose the one that most closely matches the profile of your company.

14

Raising Capital

DISCUSSION QUESTIONS What is capital? Why is it important for a company to have it? Name the four major factors in determining whether a particular funding source is right for a particular company. Businesses must tell capital sources why they need capital and what they are going to do with it. What are some of the things investors are likely to respond favorably to, and what are some of things they are going to respond unfavorably to? Why? Is there a "best" source to get capital under all circumstances? Why or why not? Is there any over-arching principal that can be used to describe which capital source is likely to close a deal with a company at any point in its life cycle? If so, what is that principal? What does it mean? What is the relationship between the stage of a company's development and the risk of providing funds at that stage? Can you cite any facts to support your answer? What kinds of issues might an investor try to address by looking at financial statements and using ratios? Why are angel investors and venture capitalists so focused on exit strategy, whereas bankers and commercial credit companies are not? What are the most common sources of capital for start-ups and small businesses?

Risk, Reward, Size and Time to Exit

ENDNOTES

'

"Trendsetter Barometer," Coopers & Lybrand, Philadelphia, PA, 1994, reprinted in New Jersey Financing Resources Manual, p.2 Martha E. Mangelosforf. "Behind The Scenes," by Martha E. Mangelosdorf, &., October 1992, pp. 72-80, reprinted in New Jersey Financing Resources Manual, p.3. 3 "Plastic Was Favorite Financing Medium For Small Businesses," Small Business Banker, Thompson Financial Media, August 6,2000. Some say all financial transactions revolve around two poles, fear and greed. , c'Pricewaterho~~eC~~pers: Global: Inights & MoneyTreeTMSurvey Report" www.pwcmoneytree.com/moneytree/nav.jsp?page=definations

Chapter 2

SELF-HELP, THE ENTREPRENEUR'S SOURCES

INTRODUCTION In this chapter we discuss the difficulties entrepreneurs have raising start-up capital. The problem is that banks and most professional investors only want to supply capital to businesses with a track record and start-up businesses have short records, if they have any at all. In this chapter we discuss seven strategies entrepreneurs can use to get start-up capital and build a financial track record that will give them access to other sources of capital.

SELF-RELIANCE One of the key characteristics of a successful entrepreneur is self reliance. Many people are frustrated from the outset of their venture because they rely upon banks and others for resources. Mark Twain is reported to have said, "A banker is a person who will lend you an umbrella on a sunny day, and take it back when it rains." Most institutional investors are like bankers. Some take back the umbrella at the first cloud, others in the midst of a thunderstorm. When they take back the umbrella that means the investor's perception of risk outweighs the likely reward. When a bank lending officer, angel investor or venture capitalist looks at an entrepreneur's business plan, most see only rain. And in the face of that rain, the entrepreneur's hopes and dreams carry no weight.

18

Raising Capital

Why? Institutional investors look for (i) a revenue stream, from a demonstrable product or service, (ii) satisfied customers - which give them some assurance the revenue stream will continue, (iii) profits which give investors confidence that the enterprise's costs are under control, and (iv) assets which are a secondary source of repayment if the enterprise fails. In short, institutional investors' perception of risk, at the beginning of an enterprise, far outweighs any reward they are likely to receive because a startup enterprise usually lacks some or all to the aforementioned indicia of success. The problems for the entrepreneur are getting started, developing a product, finding the first customers, and establishing a financial track record. So where should the entrepreneur begin? Before we answer that question, let us examine how much is needed to start a company.

HOW MUCH CAPITAL IS NECESSARY? Inc. magazine focuses on small, emerging companies and the Inc. 500 is a list of the fastest growing small companies in the country. Figure 2-1, Inc S Analysis of Start-up Funding indicates that many of the fastest growing companies started with relatively little capital.' Figure 2.1 Analysis of Start-up Funding

Amount Under $1,000 $1,000 to $10,000 $10,000 to $20,000 $20,000 to $50,000 $50,000 to $100,000 Over $100,000

Percent 14% 27% 10% 15% 12% 22%

Cumulative Percentage 14% 41% 51% 66% 78% 100%

Two thirds of companies in this survey started with less than $50,000, which is well within the reach of most individuals who have been working a few years and can employ the seven self-help strategies discussed in this chapter.

Self-help, the Entrepreneur's Sources

SEVEN STRATEGIES TO GET START-UP CAPITAL Most entrepreneurs know they want to start and run their own businesses long before they launch it. The interval between when a person knows they want their own business and the time they start should be a time of preparation, of carefully laying the foundation for success. One part of that foundation involves setting the stage for raising start-up capital. A number of the strategies discussed below can only be effective if the proper seeds are planted months, or years before capital must be raised. The seven strategies discussed in this chapter include: The entrepreneur's own funds from salary, savings and bonuses Investments and loans from friends and family, Credit cards Home equity loans Customers Suppliers and Vendors Leases

Savings, Salary & Bonuses Saving money is the first step on the road to becoming an entrepreneur. A little money saved every payday is important for several reasons. If an entrepreneur can accumulate seed money, he or she has already taken a major step toward financial independence. Saving a regular amount out of each pay requires discipline, and an entrepreneur needs discipline. When the entrepreneur has his or her own money invested in a venture, it builds the confidence of potential investors. A widely used strategy is to save all salary increases and half the amount of after tax bonuses. In addition to that, an entrepreneur needs to live below his or her means. For example, keeping the car an extra two or three years and foregoing the Caribbean vacation are all part of the trade off for future financial independence.

Raising Capital

Friends and Family Capital from friends and family is often the first outside financing for a start-up business. The reason is that if those who know the entrepreneur best, his or her intellect, personality, strengths and weaknesses, do not believe he or she has the drive to build a business, how can strangers be expected to believe? On the other hand, raising money from such close sources has risks.

"Neither a borrower nor a levder be, For loan ofr loses both self andfriend. And borrowing dullx the edge of hztsbandry. HamIet, Act I, Scene iii "

I

-

I

According to Hamlet, when asking friends and family to invest, the entrepreneur risks losing both their investment and their friendship. But this is only one issue, another one is the form of investment friends and family make. If the enterprise is successful, investors may believe they are entitled to a share of the profits when you only intended their investment to be a loan. On the other hand, if the business fails, they may demand repayment with interest when you meant for them to share the risk of the enterprise for good or ill. In addition to that, courts may agree with friends and family if litigation ensues. The solution is to these potential problems are document loans with promissory notes and equity investments with stock certificates.

Promissory Notes

A loan can be documented with a promissory note. The elements of a promissory note are:

P

Principal - this is usually the amount received. However, sometimes promissory notes are made for a round amount, perhaps $10,000 or $100,000 and sold at a discount or premium.

P

Interest Rate - this should be the going rate of interest. If the note bears no interest, and does not sell at a discount, the note begins to "look like" an equity investment. Courts often ignore the title of a

Self-help, the Entrepreneur's Sources

21

document, e.g. "Promissory Note," to find its substance. At a minimum, interest should be equal to the rate on U.S. Treasury Bills. A fairer rate of return to your investors would be the rate banks charge on auto or personal loans, typically 8% to 12%.

9

Terms of Repayment - Things to consider in terms of repayment are: Is the loan principal due at a date certain with interest to be accumulated to maturity? Is the loan principal and interest to be paid back in even payments over a term of years? Is the loan to be amortized over a term of 20 years with a balloon payment after five years? Some term of repayment should be specified. If the repayment term is too open ended, it begins to look like an equity investment.

P

Maker's Signature - The maker is the person who is responsible for repayment of the loan. Is the loan a personal loan with liability flowing to the borrower personally? Or, is this a corporate loan with liability for payment flowing to a corporation. This is an important distinction and must be explicitly stated in the promissory note. If the loan is an obligation of the corporation, and the corporation fails, the entrepreneur has no obligation to repay the loan. On the other hand, if the entrepreneur signs individually the entrepreneur becomes personally liability for the debt.

Promissory Notes can be purchased in any good stationary store.2 Figure 2.2 is a Sample Promissory Note. Figure 2.2 Sample Promissory Note Promissory Note

Amount: $10,000 For v a h e received, Blanko Corporation, the borrower, promises to pay the lender, Murray L. Schwartz, $10,000 with interest at 12% per annum as follows: I ) Monthly interest only for five years. 2) At the end of five years the entire loan balance with accumulated interest, shall be due and payable. Date: 6/30/2005

%.d st%&W President, Blanko Corporation

Raising Capital

Stock Only corporations can legally issue stock. Corporations are formed by filing Articles of Incorporation with the Secretary of State of the state in which the company intends to incorporate. Articles of Incorporation state the company's name, the number of shares authorized, the names and addresses of officers and organizers, the intended purpose of the corporation, and a number of other requirements that vary from state to state basis. Corporations can be formed relatively inexpensively, often for under $500. After the state grants permission to form a corporation, stock can be issued. Stock certificates can be ordered from printers that specialize in printing stock certificates. A stock ledger is usually included with stock certificates. It is used to record issuance, repurchase and cancellation of stock. This ledger will be a critical document in any audit, or due diligence review by a future investor. Before an equity investor invests, he or she will want to know how much stock was authorized in the Articles of Incorporation and how much is outstanding. A sophisticated investor will also want to know whether any options or warrants have been issued, so the company should keep a detailed ledger of options or warrants granted, vesting terms, exercise prices and expiration dates. Stock issued to investors is subject to securities laws that will be discussed in subsequent chapters. If stock is sold to the public it must be registered with the SEC and it must comply with the state security laws in every state where the stock is sold. If it is not sold to the public, it must still comply with state and federal securities laws. However, regulations covering these "so called" private placements are simpler and less costly to comply with. Securities laws will be discussed in further detail in chapters 11 through 13.

Credit Cards Entrepreneur can't get bank credit until they demonstrate creditworthiness, and they can't demonstrate creditworthiness until they have credit. This circular logic can be frustrating, but many entrepreneurs have found a way through it using credit cards. About 50% of small and medium sized businesses used credit cards as part of their financing strategy in 2000, up from 34% in 1997.3 Charlene Connell, CEO of Vital Resources, Inc., a Cleveland computer company used ten credit cards to finance her company for seven

Self-help, the Entrepreneur's Sources

23

years. Among other things, she used cash advances to meet payroll until client accounts could be co~lected.~ Shoshana Berger, founder of the magazine ReadyMade, is boot-strapping her start-up with money from family, friends and 10 credit cards. Sally Williams and her partners in Hellas International, a Massachusetts importer, borrowed $150,000 on 18 credit cards to finance their business. She even found credit cards, judiciously used, were more cost effective than a Small Business Administration (SBA) loan. Her SBA fees were $7,500 on a $150,000 loan plus 11.5% interest. The average interest on her credit cards was 13.5%. She also noted that time is money and the SBA loan application process was very time consuming.5 Credit cards aren't just for travel, office supplies and computers either. People are starting to purchase inventory and raw materials with credit cards. American Express reported that 55,000 wholesalers nationwide now accept credit cards. Broudy Printing, Inc. a Pittsburgh company now buys $50,000 per month of supplies on credit cards. Champion Lumber purchases materials from Weyerhaeuser Company on credit cards and in April, 1999, monthly purchases reached $400,000 per r n ~ n t h . ~

Credit Card Advantages, Disadvantages and Strategy Credit cards have both advantages and disadvantages. Therefore, a well defined strategy should be worked out before the first credit card is used.

Advantages of Credit Cards

The advantages of credit cards include:

9

They are easy to get. Most people are solicited for pre-approved credit cards many times each year.

9

They provide instant credit with tens of thousands of vendors.

9

Most allow cash advances.

9

Credit limits can be as high as $100,000, and

9

Introductory rates can be as low as 3 .9%.7

24

9

Raising Capital It can be one of the first financing sources in the company's name.

Disadvantages of Credit Cards Balanced against the advantages of credits cards are some significant disadvantages, none of which should be minimized.

9

Credit card companies often charge fees for late payment, balance transfers, and annual membership.

9

Interest rates can be punishing.

9

It would take years to liquidate card balances paying only monthly minimums.

9

When card balances reach their limit, credit is cut off.

9

Late fees of $25 or more are often charged when a payment is a day late. Two late fees can cause you to be reclassified as a "risky" client and rates can jump to a punitive 25% - 30%.

9

Balances on personal credit cards used for business are not discharged through a corporate bankruptcy.

Credit Card Management Strategies Credit cards should be used as part of a planned strategy, not on an impromptu basis. The following strategies have been successfully used by a number of companies:

9

Search for low cost cards and transfer balances to them on a monthly basis. Beware of cards that charge a transfer fee. A comparison of credit card rates is published monthly at: www.cardweb.com.

9

Use some credit cards for business only, and use others for personal purposes only.

9

Pay off and discontinue high rate / high fee cards.

Self-help, the Entrepreneur's Sources

25

P

Watch for rate jumps. If a card's rate jumps up, call and ask whether it can be reduced. Card companies often raise rates when they think consumers aren't looking and reduce rates when they get "caught."

9

Pay balances monthly, during grace periods, to avoid interest. One survey reports about 60% of small businesses pay off their balances each month.

9

One manufacturer works with his vendors to post credit card charges the day after his statement closes. That gives him an extra 15 to 30 days of float.

9

One entrepreneur suggests getting as many credit cards as possible before quitting your job to work full time in your business.

9

Use the credit history documented through use of credit cards to get a Small Business Administration or conventional bank loan.

Use credit cards cautiously. One out of every three entrepreneurs that uses credit cards choke on the debt, fees and crushing interest.'

Home Equity Loans Home equity loans can provide a significant and cost effective source of capital for a start-up business. The rate on home equity loans rises and falls with a bank's cost of capital and economic conditions. To get a sense of whether the interest rate on a particular home equity loan is reasonable, we can compare it to benchmark rates. Figure 2.3, Analysis of Home Equity and Personal Unsecured Loan Rates compares home equity loan rates to the Federal Funds Rate, the Prime Rate and bank card rates. Home equity loans are about 6.7% less than unsecured personal loans and 7.0% less than bank credit cards. When the Federal Funds Rate and Prime Rate rise Home Equity and Unsecured Personal Loan rates will rise as well. There will always be a differential between these rates and Figure 2.3 provides an estimate of that differential.

26

Raising Capital

Figure 2.3 Analysis of Home Equity and Personal Unsecured Loan Rates

Number of Banks

Points Over Federal Funds Rate

Points Over Prime

Benchmark ~ a t e s ~ Federal Funds Rate 1.24 Prime Rate 4.25 Loan ~ a t e s " Unsecured Personal Loan 12.81 Bank Credit Card 13.19 Home Equity Loan 6.16

Advantages of home equity loans include:

9

A home equity loan is relatively quick and easy to get if the entrepreneur has equity in his or her home and a steady job.

9

They have relatively low interest rates, much lower than conventional or SBA loans.

9

Relatively large amounts can be raised through a home equity loan; $30,000 to $100,000 is possible.

9

The entrepreneur doesn't have to give up equity in his or her business or round up a number of small investors to raise a significant amount of capital.

Disadvantages of home equity loans include:

9

If the business fails, the entrepreneur could lose his or home.

9

Corporate bankruptcy will not discharge the amount the entrepreneur personally borrowed through a home equity loan.

Self-help, the Entrepreneur's Sources

27

P

If the entrepreneur is married, he or she will have to get the consent of his or her spouse to get the loan. On the other hand, if the entrepreneur obtains a conventional or SBA loan, lenders will require the entrepreneur and spouse to sign personally for the loan.

9

Banks are more comfortable lending money for credit card consolidation or a vacation than they are for a start-up business.

If you plan to get a home equity loan, it is much easier while still employed. Once an entrepreneur quits his or her job to start a business, a bank will view him or her as having no verifiable income. However, after two successful years of operations, most banks will accept tax returns in lieu of a W-2 to verify income.

Vendors and Suppliers When a vendor or supplier sells to a business on credit, it is supplying capital as surely as if it made a loan. Prompt payment of vendor invoices is a way to build a credit history that can be leveraged into a bank loan. Chronic late payments can destroy any hope of getting a bank loan or further vendor credit.

Customers The transition from having an idea for a company to starting a company frequently comes with the first customer. Customers can be a source of capital if they can be induced to pay some or all of their bill in advance. An example of customer financing occurs in home remodeling. Contractors ask for one-third in advance, one-third half way through the project and one-third on completion. The one-third in advance allows the contractor to purchase supplies and material and meet the first few payrolls. The second third provides another infusion of capital, and the amount of financing that the builder has to provide from other sources to complete the project is only about a third. Consultants sometimes ask for part payment in advance and negotiate progress payments on large projects. Custom manufacturers require prepayment from new customers and those prepayments help provide start-up funding.

28

Raising Capital

A related customer financing strategy is to get customers to pay before vendors must be paid. One T-shirt manufacturer sells their goods to retailers on ten day terms, but has thirty day terms with its suppliers. So customers and vendors finance the business.

Leases A lease is another way to get someone else to fund a business. Need a copier and don't have the cash to buy one? Lease one. That way someone else is putting up the purchase money. There are two basic types of leases: operating leases and capital leases.

Operating Leases

Operating leases are like renting. The lessor retains ownership at the end of the lease. Equipment must be returned. Operating leases are accounted for on a pay-as-you-go basis. That is each payment is expensed when due.

Capital Leases

Capital Leases are an alternative to bank financing. At the end of the lease, ownership is transferred to the lessee for a nominal buyout. Because it is like a bank loan, the value of equipment leased is booked as an asset, and the amount financed through the lease is recorded as a liability. The liability recorded is not the sum of all the lease payments. Rather, it is the value of the asset leased less deposits and prepayments. Since operating leases are not capitalized, that is, they are not recorded as a liability, the decision as to whether to use an operating or capital lease has some importance. Avoidance of liabilities may be a strategic issue if the company is applying for a bank or SBA loan. The more liabilities a company has, the higher it's debt ratio, and the less attractive it is.

Leasing versus Bank Loans

There are both advantages and disadvantages to financing through leasing. Advantages Include:

Self-help, the Entrepreneur's Sources

29

9

Quick turnaround - leasing companies can make a decision in a day or two. It sometimes takes banks weeks or months to make a loan.

9

Few strings - banks try to tie clients down with a hundred strings called bank covenants. These include targets on tangible net worth, profitability, and many other restrictions. Leasing companies primarily focus on whether timely payments are made every month.

Disadvantages to leasing include:

P

Higher interest rates - the effective interest rate on leases is always higher than on bank loans.

9

Effective interest rates are never given. This makes if very difficult to compare leasing to other sources of capital.

>

Lease terms can raise the effective interest rate - deposits, prepayment of the first and last lease payment, and origination fees can increase the effective interest rate by 40%.

If leasing is considered, it is strongly recommended that the interest rate be computed. Several books are available to help with this computation. Once implicit interest rates are determined, it is easier to negotiate with lessors and or decide whether other financing sources are more appropriate. 11

SUMMARY Entrepreneurs face significant obstacles in raising start-up capital because a start-up, by definition, has no financial track record that a lender or professional investor can use to evaluate risk. This information asymmetry causes those with capital to err on the side of caution and not provide funds. Entrepreneurs must therefore be self-reliant, and find alternative sources of capital. Many successful, fast growing companies were started with less than $100,000, an amount well within reach of most working individuals. An entrepreneur's own savings often provides the seed money for a new enterprise. For this reason, those thinking about starting a company should have a regular savings program. Friends and family are another source of capital. If those who know the entrepreneur best are not convinced that he or she has the drive and ability

30

Raising Capital

to build a business, it will be difficult to convince others to invest in the entrepreneur's company. Document whether friends and family are lending money to the company, in which case they are only entitled to repayment with interest, or whether they are equity investors in which case they share risks and rewards with the entrepreneur. Many entrepreneurs use credit cards to start businesses, but high cost can put a company at risk unless credit cards are carefully managed. The strategy most often used to manage credit card debt is to pay off balances each month during the grace period. Home equity loans can raise relatively large amounts of capital at low cost. However, if the business fails, the entrepreneur could lose his or her home. The entrepreneur should understand that many banks are more comfortable making a home equity loan to fund remodeling or debt consolidation than to fund a start-up business. Customers and Suppliers represent two additional sources of capital. If the entrepreneur can get a customer to prepay some or all of their bill, the customer is supplying valuable capital. Such prepayments are customary in home remodeling and some consulting work. When a supplier sells to a company on credit, they are lending the company capital as surely as if they gave it a loan in cash. Leases represent another way to raise capital because a lease shifts the burden of equipment purchase to another party, thus freeing up the entrepreneur's capital for other uses. Operating leases are like renting and at the end of the lease the equipment is returned to the lessor. A capital lease is an alternative to bank financing and at the end of the lease, the entrepreneur can buy the equipment from the lessor at nominal cost. One disadvantage to a capital lease is the value of the equipment is booked as an asset and the principal amount due on the lease booked as a liability. While it is difficult for first time entrepreneurs to raise start-up capital, there are a number of methods that can be used to raise enough capital to launch a start-up. The keys to success in raising start-up capital are self-reliance and building a financial track record that banks and professional investors can evaluate in providing additional funds.

Self-help, the Entrepreneur's Sources

DISCUSSION QUESTIONS How much capital does it take to start a successful business? What is typical? What are seven sources of capital an entrepreneur can use besides a bank loan? What are the main issues in soliciting funds from friends and family? What are the advantages and disadvantages of using credit cards? What strategies can be used to exploit advantages and avoid the disadvantages? What are the advantages and risks of using a home equity loan? Is there any way to estimate the rate an entrepreneur will pay for a home equity loan? How can vendors and suppliers supply capital? How can customers supply capital? What are the advantages and disadvantages to using a lease to acquire capital assets? What should a company's overarching financial objective be when raising capital through friends and family, credit cards, a home equity loan, or when getting credit from vendors?

Raising Capital

ENDNOTES 1

Ilan Mochari, "The Numbers Game," Inc., October, 2002. A question often asked is whether a lawyer is needed to draft a promissory note. On the back of the Bar Association card is a rule that says, whenever anyone asks "Do I need a lawyer for this?" Members of the Bar are obligated to say: "Yes you need a lawyer." Example: Do I need a lawyer to paint my house? "Yes, you need a lawyer." 3 -, "Plastic Was Favorite Financing Medium For Small Businesses," Small Business Banker, Thomsom Financial Media, August 6,2000; Phaedra Hise, "Don't Start Your Business Without One," Inc.,February 1, 1998. Hise. 5 Greg Lindsay and Sarah Gonser, "The Art Of The Start-up,", Folio: The Magazine For Magazine Management, Vo1.30, Issue 8, Primedia Intertec, June 15,2001. 6 "Credit Cars Charge Into Small Business," Wall Street Journal, Friday, June 4, 1999, p.A2 & A6 7 Phaedra Hise, "Don't Start A Business Without One," Inc., February 1, 1998. 8 Hise. Federal Reserve Statistical Release, Selected Interest Rates (Daily) H. 15, ~.federalreserve.gov~eleaseslH 15/update as of 4/4/2003, downloaded 4/6/2003. 10 Philadelphia Inquirer, Money Watch, p.E5,4/6/24 l' =id Vance, Financial Problems & Decision Making, McGraw Hill, 2002, pp.119-128.

Chapter 3

BANKS

INTRODUCTION Although banks are essential to the economic health of the nation, they only deal with companies that lie within a narrow range of parameters. Fortunately, there are a number of alternatives to banks. Our discussion of banks in this chapter will provide a basis for contrasting the strengths and weaknesses of banks to the strengths and weaknesses of other financing sources. This chapter views the world as banks do. By understanding the forces that drive banks, the entrepreneur should be able to make them more responsive to his or her needs. This chapter discusses the main types of credit services (facilities) banks provide; underwriting, the process banks use to determine who will get credit; and it explores some of the misconceptions about banks.

THE BANKER STAKE OF MIND Banks aggregate money by accepting deposits from the public and make money available to businesses and individuals at interest. They also provide other services such as checking accounts and cash management. Most U.S. banks are federal banks chartered by the Comptroller of the Currency of the United States. A few banks are chartered by states. Banks

34

Raising Capital

with Federal Charters must join the Federal Reserve and are subject to examination by the Comptroller of the Currency. Banks with state charters are regulated by the state that issued their charter, and under the Monetary Control Act of 1980, are subject to regulation by the Federal Reserve. The Federal Deposit Insurance Corporation (FDIC) also regulates banks and has the power to examine bank records.' The founders of our country recognized the importance of banks to the economy and history has confirmed their judgment. Countries with strong banking systems have tended to prosper (i.e. Germany and the U.S. after World War 11) and those with weak banking systems have less robust economies (i.e. Russia and Japan from 1990 to 2004.) A high degree of regulation has been placed on banks because of their importance to the economy and because they hold the deposits of millions of ordinary citizens. One of the consequences of this regulation is that bankers have limited credit granting discretion. Fifty years ago, credit was largely granted based on a banker's personal knowledge of an individual borrower, but regulators cannot test or evaluate personal relationships. They can only evaluate facts on the record. This has made banks very conservative in the range of risks they are willing to tolerate. The implication is that banks will only provide capital to firms that fit within a narrow range of documented financial performance. Companies that fall outside that range, for any reason, are wasting their time trying to get a bank loan and are better off considering other sources of capital discussed in this book.

BANK FACILITIES Banks call the credit services they offer facilities. The three main facilities offered by banks are term loans, lines of credit and letters of credit. Similar criteria are used to decide on extending each of these facilities.

Term Loans Term loans are loans that must be paid off with regular monthly payments. Term loans are used for things like plant expansion, equipment and working capital for installation, training, raw materials, finished goods inventory, and accounts receivable related to expansion. These loans are typically for three to seven years. Repayment terms can vary, for example, there can be even payments of principal and interest, similar to a car loan. With even payments, the portion of the payment that is allocated to interest

Banks

35

decreases every month and the portion allocated to principal increases. More often a fixed amount of principal is paid off every month, and interest on the unpaid balance charged at the prime rate plus some percentage reflecting a company's credit risk. The prime rate is the rate that money center banks charge their best customers. It is available in the Wall Street Journal.

Line of Credit A line of credit is somewhat like a corporate credit card. A company can draw on the line as they need cash and pay it back when they have surplus cash. A line of credit is the perfect facility for a seasonal business which must purchase inventory and hire employees before a season, but do not collect their accounts receivable until months later. A line of credit differs from a term loan in several respects. One of the most important ways it differs is that banks require a line of credit to be "cleaned up," or paid down to zero for at least a month each year. This makes a line of credit a current liability. Contrast this to the balance of a term loan which must be apportioned between the current portion due within twelve months of the balance sheet date, and the non-current portion payable later. In addition to interest on the amount of the line borrowed, companies usually have to pay a fee, perhaps 1% on the unused balance, just for the privilege of having the line available.

Letters of Credit and other Guarantees A letter of credit is a guarantee given to a third party that the bank's customer will perform as they have promised. For example, a company signs a three year lease on a building for $20,000 per month. The landlord is skeptical as to whether the company has the financial capacity to make the lease payments asks the company to get a letter of credit from its bank guaranteeing performance on the lease. If the company fails to make its rent payments, the landlord must first try to collect from the company and if he or she cannot, then the landlord can take its letter of credit to the bank and the bank will make the lease payments. The bank can then try to recoup the payments it made from its client. Banks charge a fee for a Letter of Credit. Often, when a company requests a Letter of Credit or some other additional facility, banks use the application as an opportunity to re-examine the company's creditworthiness

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Raising Capital

and sometimes negotiate higher fees and interest on existing facilities as a condition of granting a new facility.

Loan Application Process It's hard to generalize about the loan application process because it varies depending on the size of the borrower and the size of the bank. Generally, banks want a company to complete an application and provide three years of financial statements. For companies in business less than three years, banks may accept alternative documentation. However, these companies tend to fall outside the range of bank lending parameters. For convenience, we will discuss small borrowers and large borrowers and the criteria applied to each. The line between the two is somewhat fuzzy, but companies with revenue of $20 million have sometimes been treated as small borrowers.

Small Borrowers The owners of small businesses will generally be asked to provide three years of personal tax returns and a personal balance sheet that lists their assets and liabilities in addition to information about their company. Banks will also perform a personal credit check on the owner and possibly a criminal background check. Banks will ask for a personal guarantee on facilities and will ask for a lien on personal assets, usually real estate. For example, if an entrepreneur is a home owner, the bank will probably ask for a security lien on the entrepreneur's home to reduce the risk that the entrepreneur's company will default and the bank will lose the value of the loan. Because most states protect the spouse's interest in real estate, the bank will want the spouse to sign a security lien on the property as well. That way a bank can overcome any spousal defense if it has to seize the entrepreneur's home.

Large Borrowers Owners and officers of large companies usually don't have to provide personal guarantees. For companies in the gray area between large and small, personal guarantees are subject to negotiation. Large companies must complete the bank's application and provide three years of financial

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37

statements. If the credit facility is for more than $2 million, audited financial statements will probably be required. For facilities over $500,000 reviewed financial statements may be required.' Often three years of corporate tax returns are required as well. A bank may conduct a personal credit check or criminal background investigation of senior officers. The bank's application may request supplemental schedules such as aged accounts receivable and accounts payable, schedules of real estate and insurance, disclosure of related party transactions, lists of the top ten customers and the percentage of business the company does with each, a list of the top ten suppliers and other data. One thing the borrower should understand is that applying for and getting a loan is a relatively slow process. If funds are needed in weeks or days rather than months, the borrower should probably consider other sources mentioned in this book.

UNDERWRITING Underwriting is the term banks use for analyzing a company's creditworthiness. There are two main approaches to underwriting, one is financial analysis, the other is credit scoring. But before we discuss underwriting, we need to discuss the threshold tests a company must pass to get to underwriting. These tests involve bank policies concerning location, industry and time in business.

9

Location - Banks usually don't lend outside of a given geographic area. Reasons include the difficulty in monitoring businesses outside their physical reach, and reluctance to deal with the laws of other states.

9

Industry - Banks favor certain industries, and disfavor others. One bank may think telemarketing companies are beneath contempt, whereas a bank with experience in the telemarketing industry may find it a fertile ground for lending. Bank mergers are problematic because the acquiring bank may have preferences different from the one that originated a company's loan. A company must be sensitive to signs that a bank has changed its attitude.

9

Time In Business - Most businesses fail in their first five years. Banks are therefore more reluctant to lend to new businesses, than to those that have an established track records.

Raising Capital Once threshold tests are met, small borrowers will be analyzed using a credit scoring process and large borrowers will be analyzed using financial analysis.

Credit Scoring Credit scoring is a statistically based system for assessing credit risk. It is based on an analysis of thousands of loans to determine the factors that can predict who will pay their loans timely and who will not. Credit scoring is a highly automated process originally used for personal loans, credit cards and mortgages. It is now being used for small business loans. Having evaluated dozens of variables, researchers have found that factors like: age, net worth, and profitability have little predictive value. On the other hand, the personal credit history of business owners has been found to be highly predictive of whether a business will repay loans in a timely manner.3 Originally, credit scoring was limited to very large banks that had extensive data on loan applications and performance. These models were proprietary and there was no guarantee that models developed by any two banks would be the same. However, in 1995, Robert Morris Associates (an organization that provides statistical services to commercial banks) and Fair Isaac, Inc. (a modeling company), developed a Credit Scoring System that is available to medium and small sized banks. It is popularly known as the FairIsaac Small Business Scoring System. While the details of business credit scoring systems are proprietary, the Credit Union National Association has disclosed the five most important factors in personal credit scoring. These are4: (i) (ii) (iii) (iv) (v)

35% 30% 15% 10% 10%

Payment history Amount owed versus additional capacity Length of credit history New credit acquired in the last month Mix of credit: credit card, car loans, home equity loans, mortgages, etc.

Credit scoring has proven highly effective in reducing loan delinquency. Originally credit scoring was only used for relatively small loans under $35,000. The Hibernia bank in Louisiana implemented credit scoring and reduced its delinquency rate 83%. As a result of similar

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39

experience, at many banks, loan amounts underwritten through credit scoring are rising. It is know that the Fair-Isaac, Small Business Scoring System is being used for loans up to $250,000 and there are rumors that it is being used for loans as large as $750,000.~ Knowing that banks use credit scoring extensively and knowing the factors that credit scoring is based on, entrepreneurs should be able to shape his or her behavior to maximize the likelihood of getting the loan they need.

Financial Underwriting There are a number of considerations in financial underwriting. The paramount consideration is whether a company can repay principal and interest on time. There is usually no one indicator that a company has the ability and willingness to pay timely. Among the factors considered are degree of profitability, the amount of cash flow and the general management of the company. The impression a banker gets when he or she makes a site visit should not be discounted either. A company that is neat, orderly and organized leaves the impression that it is under control. Whereas, a company that looks chaotic and unorganized, probably is, and may not be able to follow through on its obligations. Comparative Data: Financial Statement Studies, and Benchmarks As a first order analysis, banks will compute a company's current ratio, quick ratio, debt to equity ratio, debt coverage ratio and others. After a bank computes a company's ratios, the question is: What constitutes a good or bad ratio? Is, for example, a current ratio of 1.25 good or bad? For ratios to have any meaning, they have to be compared to industry norms. These norms are published in the Risk Management Association ( M A ) and Dun and Bradstreet (D&B) financial statement studies. These are available in most public libraries. Ratios are organized by industry and size of business. The M A studies classifjr companies data into quartiles, indicating for example, the current ratios of the best 25% of companies, the next best 25%, the next best 25% and the lowest 25%. To maximize the probability of getting a loan, a company should rate in the top 25% on all ratios. If a company rates in the lowest 50% on some or all of the ratios discussed above, the probability of getting a loan drops precipitously. Financial statement studies only provide information on small to medium size companies. In the case of SIC code 251 1, Wood Household

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Furniture, Except Upholstered, the largest revenue category is $25 million or more. Comparing a company with $2.5 billion in sales to one with $25 million in sales is not very informative. So when underwriting a loan for very large companies bench marking is used. Benchmarking is the process of using ratios from a target company's main competitors as a measure of creditworthiness. Data from at least seven to ten companies are used to develop benchmark ratios. Larger companies are more likely to be publicly traded. Publicly traded companies file annual financial reports with the SEC. These reports are available on the SEC's website at www.sec.gov. by clicking on the Forms Lookup link; searching on company name and then searching for a company's Form 10-K. The 10-K includes a company's annual financial report in addition to a description of the business and management's discussion of operations.

How To Read RMA Annual Statement Studies RMA collects loan application data from several hundred banks nationwide and organize and analyze data by Standard Industrial Code (SIC). SIC codes are a system for classification that facilitates comparison of similar companies. For example, SIC 25 1 1 is Wood Household Furniture, Except Upholstered. Each SIC code gets two facing pages in the RMA Study. On the left page, businesses are grouped by assets. For example, the median DebEquity ratio for companies with assets between $500,000 and $2,000,000 is 2.5, whereas, the DebtEquity ratio for a company with assets of $10 to $50 million was 1.&, clearly much better. On the corresponding right hand page, businesses are grouped by sales. For example, the DebtIEquity ratio of companies with sales of $1 to $3 million was 3.1, whereas, the Debt/Equity ratio of companies with sales more than $25 million was 1.5. See Risk hlanngetnent Associafion Anntlal Sintentent Sludies, 2001-2002pp. 308-

309.

Banks Other Financial Underwriting Analyses In addition to ratios, banks analyze other aspects of a company's performance. For example, they will use equation Eq.3.1 to estimate a company's cash flow. Cash Flow = Net Income + Depreciation and Amortization

Eq. 3.1

This is an estimate of cash generated on a steady state basis by a company that is not rapidly expanding. Rapid expansion will tie up cash in accounts receivable and inventory reducing the cash available to service debt. A rapidly expanding manufacturing company might commit cash to plant and equipment, which also reduces the amount of cash available to pay bills and meet debt service. Banks use equation Eq.3-2 to compute working capital. Working capital is the difference between current assets and current liabilities. Working Capital = Current Assets - Current Liabilities

Eq. 3.2

Current assets are assets expected to be converted to cash in a year. Current liabilities are obligations that will come due within a year. Working Capital is a measure of the cushion available to pay bills as they become due. Companies with zero or negative working capital are unlikely to get a bank loan. Other information banks look at include aged accounts receivable and aged accounts payable. Accounts receivable is usually one of a company's largest assets and one of the easiest to convert to cash. Accounts receivable are classified by the amount of time between when a service is rendered, or product is shipped and the invoice is paid. Typical brackets for classification of receivables are: 0 - 30 days, 3 1 to 60 days, 61 to 90 days, 91 to 180 days, over 180 days. The longer it takes for a customer to pay, the less likely they are to pay. Therefore, banks carefully look at the accounts receivable in each bracket. Aged accounts payable are to determine how a company has treated other vendors. If it pays everyone else late, it is likely to pay the bank late as well. On the other hand, if it promptly pays its bills, it is likely to make bank payments promptly. Banks also want to know how loan proceeds will be used. Proceeds used to pay a large overhang of old bills aren't going to generate new revenue or cash flow and are less likely to get approved. Proceeds used to expand a business and generate more revenue are more likely to be approved.

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Take Away Lessons: I ) Manage your business from day one in such a way that your ratios are in the top quurtile. 2) Cut expenses, limit growth in marginally pro$table areas and take other steps to "burnishyozirflnancial statements. " 3) Pay billspromptly or at least within vendor terms, and 4) Collect outstanding receivables promptly.

Borrowing Capacity Banks want to know that a company has sufficient assets to collateralize a loan. But, they won't accept the value of assets on the balance sheet at face value. Generally, banks request a Tangible Net Worth Certificate monthly, and some banks request them each time a company draws on its line of credit. The Tangible Net Worth Certificate is an affidavit signed by the controller, CFO or CEO attesting to a company's assets and liabilities at the instant the Certificate is filed. Certificate data is used to compute borrowing capacity. Tangible Net Worth is defined as tangible assets such as cash, securities, accounts receivable, inventory, and plant property and equipment (net of depreciation) minus liabilities other than bank loans, plus other adjustments. Tangible Net Worth excludes: (i) loans to officers and employees, (ii) patents & copyrights, (iii) goodwill, (iv) ineligible accounts receivable, usually those over 90 days old, (v) pre-paid expenses and (vi) investments in non-public, bankrupt or thinly traded companies because they are difficult to convert to cash. In addition, a factor is usually applied to the resulting Tangible Net Worth, perhaps 70% or 80% to get borrowing capacity. Outstanding bank loans are subtracted from borrowing capacity to get available borrowing capacity. Figure 3.1 is an example of a Borrowing Capacity calculation.

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43 Figure 3.1 Borrowing Capacity Example (Thousands of dollars)

Assets: Cash Accounts Receivable Due from Officer Prepaid Expenses Inventory Plant, Property & Equipment net (net of depreciation) Total Assets:

$50 450 50 20 500

Liabilities: Accounts Payable Wages Payable Line of Credit Leases Term Loan

950 Total Liabilities Equity $2,020 Total Liabilities & Equity

$300 10 560 20 360 $1,250

$770 $2,020

Aged Accounts Receivable: 0-30 days $200; 3 1-60 days $60; 61-90 days $90; Over 90 days $100

..........................

Borrowing Capacity Calculation........................... Assets: $2,020 Less: Ineligible Assets Prepaid Expenses $20 Due From Officer 50 Accounts Receivable Over 90 days: 100 $170 Less: Non-bank Liabilities: Accounts Payable Wages Payable Leases Tangible Net Worth Factor Borrowing Capacity Less Outstanding Bank Debt: Term Loan Line of Credit Remaining Capacity:

Raising Capital If the remaining capacity ever becomes negative, loan terms stipulate the amount needed to bring the Remaining Capacity to at least zero must be remitted at once. Remaining capacity limits the amount that can be drawn on a line of credit. For example, if the company in Figure 3.1 had negotiated a $1 million line of credit and has drawn $560 thousand, one might expect $440 thousand to be available. However, the maximum amount of the negotiated line that can be drawn will be limited to the remaining capacity of $296 thousand. Every bank will have its own version of the Tangible Net Worth/Borrowing Capacity formula. Some banks exclude Accounts Receivable over 60 days; others use a factor of 70%. If terms for the company show in figure 3-1 were changed to exclude accounts receivable over 60 days and the factor were changed to 70%, the company's remaining capacity would drop from $296 thousand to $81 thou~and.~

away lessons: I ) Know your bank and the terms on which it extends credit 2) I f the line of credit is filly extended, and the compavy has additional Remaining Capacity under the bank's formula, use that as nn argumentfor getting additional credit. 3) Be aware ofthe terms other bank i17 your area are granting; they may be better than your bank S terms

0Take

QUALITY OF FINANCIAL DATA Banks ask for financial statements, but how do they know such statements are accurate? Often they look to public accountants for assurance. Certified Public Accounts (CPAs), also called outside accountants, provide three levels of service with regard to financial statements. As the amount a company wants to borrow rises, the level of assurance a bank demands rises.

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Compilation - At this level of service, all a CPA does is to organize a client's records in the form of financial statements. They provide no assurance as to accuracy.

9

Review - At this level of service, a CPA analyzes statements for reasonableness, compares them to prior statements, does some ratio analysis and may even compare ratios to industry norms. They

Banks provide negative assurance in the form of a statement that nothing has come to their attention to indicate there are any material misstatements within financial statements.

9

Audit - With an audit, a CPA performs detailed testing of transactions on a sample basis, including confirmation of accounts receivable, accounts payable, and loan balances. Positive assurance is made in the form of representations that the CPA performed tests in accordance with generally accepted audit standards and financial statements appear to be correct in all material respects.

The larger the loan, the more importance a bank will place on having reviewed or audited financial statements. For loans over $1 million reviewed financial statements will certainly be required and some banks will require audited financial statements.

BANK COVENANTS, TERMS AND CONDITIONS Banks wrap lending agreements in a snugly fitting jacket of conditions known as loan covenants. Loan covenants are often couched in terms of ratios, calculations and so forth, but are reallty designed to detect any deviation from the flight path the bank had in mind when it made the loan and restrict a company's ability to act. Some are quite reasonable, for example, a borrower must warrant that it will not sell anything pledged as collateral or move it out of state, and the company must allow inspection of collateral from time to time. Other covenants are more burdensome. Depending on the relative bargaining strengths of the bank and its customer and the amount of bank competition, a bank may insist on some or all of the following types of covenants: (i)

The DebtJEquity Ratio will not exceed x.x

(ii)

The CEOs salary and bonuses will be capped at $yyy,000.

(iii)

The company may not borrow funds from other sources or lease more than $zzz,000 of equipment.

(iv)

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) may not drop below: $www,000

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(v)

Revenue must be at least $x,xxx,xxx and or must grow at y% per year.

(vi)

Ratios a, by c, and d must be maintained at the level of w, x, y and z or better.

A company should not wait until closing on a loan to find out about the covenants a bank is going to impose. The better course of action is to ask a bank for a list of typical covenants early in the process of selecting a bank. In any event, a company should ask for such covenants no later when the loan application is submitted. If bank covenants are violated, the company is in technical default. It doesn't matter that the company is making timely principal and interest payments. The consequences of default can be onerous. One way to visualize the effect of loan covenants is to imagine yourself flying an airplane between Philadelphia and Los Angeles. The covenants represent an invisible tube that you must fly through. If you fly outside the tube you are in default. It doesn't matter that you arrived in Los Angeles safely, and on time. It doesn't matter that you changed course to avoid a storm or were blown off course by the jet stream. The fact of the matter is that you flew outside the tube, and that put you in default. Default generally gives a bank the right to demand immediate repayment of principal and interest. The legal term for this right is acceleration. Acceleration is a death sentence for most companies. So instead of execution, most banks offer a one time Waiver of Default, but at a price. In exchange for a waiver of default, a bank may charge a fee, add additional restrictive covenants, raise interest rates and demand additional collateral. Banks also charge their customers for the "costs" of the waiver which include legal fees and charges to have outside accountants "review" the client company's books and records. For a company already on the edge, such additional burdens can be crushing and may be enough to tip them into bankruptcy. A bank may also transfer their customer to its Workout Department. Once that happens, the bank has made the decision to get rid of the customer as soon as possible and charge them as much as possible in additional fees before they leave. Companies in Workout shouldn't expect to have their line of credit renewed or to get new credit facilities. Once a company is transferred to the Workout Department, it should immediately start looking for replacement financing. It shouldn't wait for the bank to cut off credit, call its loan or charge additional fees.

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Take away Iessons: I ) Ifyou want a bank loan, know what the bank wants. Position your j7rm ahead of the curve so that w h e ~you apply for the loan, the bank sees what you want it to see. 2) Loan covenants give banks confort that a conlpany will perform as they have promised, but the consequences of breaking covenants can be onerous, so a conpany should do everything in their power to stay within loan covenants. 3) Get a copy of a bank's loan covenants early in the applicationprocess.

MYTH AND MYTHOLOGY Small businesses cite inadequate access to credit as one of the most important challenges they face. Lenders cite lack of reliable information on the creditworthiness of small businesses as a problem. Creditworthiness is another term for lending risk. As risk rises, lenders and investors demand greater rewards. For a bank, rewards are reflected in increased interest rates. Therefore, interest rates ought to be a good indicator of a bank's perception of creditworthiness and risk. A study of bank attitudes found:

9

A personal relationship between a firm's owners or managers and bank staff was statistically related to %% reduction in interest rates.

9

Businesses located within a half mile of its bank were statistically related to a %% reduction in interest rates.

9

Factors that were not correlated with reduced interest included the amount of deposits or loans a company has with a bank, and the number of years the business has had a relationship with a bank.

'

It is striking that other than ability to repay a loan or adequacy of collateral, the only two factors that have a significant impact on a bank's perception of risk are a personal relationship with a company's owners or managers and the proximity of a company to its bank. None of the other "good deeds" a company does to build a banking relationship seem to matter.

Raising Capital

ARE BANKS RELIABLE PARTNERS? We expect our employees to come to work every day. We expect vendors to supply materials as needed. Should we expect less of our banks? No, but that doesn't mean banks always come through. In many ways, banks are fickle creatures. They may lend to a business one year and not the next. As the economy goes through periodic down turns, banks change the rules of the game, rationing credit so that only investment grade companies have access to credit. This leaves many companies without a reliable funding source. Downturns may be the result of the general economic conditions or the excesses of banks themselves. In the early 1990's real-estate speculation funded by overly generous lending policies, wiped out billions of bank capital. As a result, banks radically scaled back lending to everyone until their capital base had been rebuilt through high fees and interest rates, and conservative lending practices.8 In the years leading up to 2000, banks loaned enormous sums of money to technology companies, many of which foundered because of poor business plans. Most of these loans were unrecoverable because they were backed by projected profits, not assets? Those losses depleted bank capital and made banks much more risk averse. Businesses that are doing well, but rely on a revolving line of credit to smooth out seasonal cash flow, or to finance plant, equipment and working capital for expansion can get caught flat-footed if bank funding evaporates. Worse, if a shift in bank policy is not conveyed to borrowers in a timely fashion, which it almost never is, there will be little time to find alternative financing. Another factor that calls into question the reliability of banks as business partners is that each bank has its own personality and its own riskreward profile. One bank may feel comfortable lending to strip-stores, another might not. In an era of bank mergers, a bank's assessment of an industry's credit worthiness might change over night. As bank personnel change, the assessment of a particular business might change as well. The bank for one turnaround client went through three sets of bank officers in eighteen months. Each had his own credit standards. Banks may red-line an entire industry. Over a six month period in 2001, the number of banks that refused to lend to technology companies rose from 40% to 80'36, according to a survey of 85 lenders by the Chadds Ford firm of Phoenix Management Services. Even worse, whole industries, like health care, have been put on many bank's "Do Not Finance" lists."

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Banking is also highly regulated. The Treasury Department's Office of the Comptroller of the Currency are charged with regulating federally chartered banks. Their examiners can down grade loans, or use other levers to force a bank to rebuild capital, and the easiest way to do that is to reduce the ratio of lending to loan repayments." Banks are poised to snatch credit from companies through a variety of devices. First, most lines of credit must be paid off annually, and most are renewed annually. The simple act of non-renewal can have a devastating impact on a company if it doesn't get enough notice. Second, draws on lines of credit are often conditioned on meeting a target Tangible Net Worth. Two factors a bank can change in computing this figure are: the age of acceptable accounts receivable, 90 days is typical, but a bank may shorten this to 60 days, dramatically reducing Tangible Net Worth. The other thing banks can change is the percentage of Tangible Net Worth they will lend. This percentage is often SO%, but reducing it to 70% can also have a dramatic impact on credit availability. Bank term loans usually have maturities of three to five years. They can simply not renew the loan, or they can decline to provide additional credit. Both of these actions can have a devastating effect on growing companies. Should a company need a new credit facility, such as a Letter of Credit, a bank may use that as an excuse to raise interest, fees or impose additional restrictions on a company. Q

Take Away Lessons: I ) Don 't bet your company on your bank 2) Plan on yuur bank changing the rules 3) The$rsf time your bank twitches, start looking for alternativefinding.

BANK DEBT IS GOOD The problem with equity financing is that the entrepreneur 1 owner who spend years building a company may find that by the time he or she reach and IPO or some other exit, they've given away both control and most of their ownership. Debt is a way for a company to raise capital without giving away equity. Banks are a cheap source of funds. Except for an entrepreneur's own capital, loans from friends and family and home equity loans, almost all other

50

Raising Capital

funding sources are more expensive than banks. Since interest paid on bank loans is tax deductible, the real cost of bank funding is reduced compared to an equity investor who may expect non-deductible dividend. So while banks should be used prudently and with caution, they do have some advantages over other funding sources if you qualify.

SUMMARY Banks are highly regulated and such regulation makes them risk averse. Regulation comes from the Comptroller of the Currency, the Federal Reserve and the Federal Deposit Insurance Corporation. Banks call credit related services facilities. The three most common facilities are: (i) term loans, which are usually for periods of three to seven years and require repayment of principal and interest over regular monthly payments, (ii) letters of credit guarantee to a third party that a bank's customer will perform a contract, and (iii) line of credit which allows a company to draw cash when needed and repay it at its convenience. A line of credit is often used to finance seasonal business. However, a line of credit must be repaid within a year. The loan application process requires a lot of detailed documentation including personal financial statements and tax returns for small borrowers. Personal loan guarantees are common on businesses with up to $20 million in sales. Large borrowers must provide a loan application and audited financial statements. Underwriting is the term used to decide whether a bank will extend credit to a given company. Banks use credit scoring, a statistical model, to evaluate most loans under $250,000. The prime determinant of credit worthiness is the owner's personal credit history, not a company's profits or cash flow. Loan underwriting for large borrowers is based on an analysis of financial statements for profits, cash flow, the ability of the company to repay borrowings, and on net tangible assets, which provide the bank a secondary source of payment if the borrower fails. Bank loan documents contain conditions that must be met on an ongoing basis called covenants. Covenants require businesses to maintain certain ratios and preserve collateral. Even if a borrower makes all payments timely, it can still be in default if it breaches any of the covenants it made. Default gives a bank the right to accelerate a loan by demanding immediate repayment of the loan balance. Banks sometimes waive defaults in return for additional fees, increased interest, the pledge of additional capital, and additional covenants.

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51

Some have raised a question as to whether banks make reliable business partners. Banks favor some industries and disfavor others. The problem is that the industries a particular bank favors or disfavors changes over time, with mergers, and with the change of bank personnel. Another factor that creates tension between banks and their customers is that bank terms are easy when the economy is good, but can tighten dramatically when the economy weakens. Finally, many companies are suspicious of the tripwire nature of bank covenants which can be used to extract extra fees interest and concessions from a borrower even though they continue to make their payments in a timely manner.

Raising Capital

DISCUSSION QUESTIONS What are some of the external factors that limit a bank's lending flexibility? What are a banks three major credit facilities and when might a company use each of them? What are the two main approaches banks use to underwrite loans? What are the main factors that go into each? For small business borrowers, exactly how personal do banks get? What are they likely to demand from small business owners in addition to an application, company financial statements, and a lien on company assets? What is credit scoring? When and where is it used? What are the five main factors used in credit scoring? Financial underwriting usually involves an analysis of ratios. How does a bank know whether a company's ratios are good or bad? If a company has a good understanding of what a bank is looking for in terms of financial performance and collateral, what can a business do to help close a loan? Banks complain that one of the biggest problems in lending to small businesses is lack of reliable information. What can a bank do to improve the quality of information it has? What is tangible net worth? What is borrowing capacity? How are they calculated? What is their relevance? What are bank covenants? If a customer makes all payments timely, but violates a covenant, what are the consequences? Do covenants give a bank an unfair bargaining position? What are the benefits of using bank financing? Is bank financing superior to other forms of financing in any specific ways?

Banks

12.

53

Are banks reliable business partners? If not, what steps should a business take to lessen dependence on banks and lessen the impact of abrupt changes in policy?

Raising Capital

ENDNOTES 1

Herbert B. Mayo. Financial Institutions, Investments and Management, 6IhEd., Dryden Press, Fort Worth, Texas, (1998) p. 159. * Definitions of audited and reviewed financial statements are discussed later in this chapter under the heading: Quality of Financial Data. Justin G. Longenecker, Carlos W. Moore and J. William Petty. Baylor University "Credit Scoring and the Small Business: A Review and the Need for Research," www.usasbe.org/conference/l997/Proceedings/papers/P 148Longnecker.PDF, downloaded 1/5/2003; Loretta J. Mester. "What's the Point of Credit Scoring,", Federal Reserve Bank of Philadelphia, September October, 1997, p.7. "Blending Ingredients of Credit Bureau Score," An Electronic Report from the CKA Lending Council Spectrum, Credit Union National Association, Madison Wisconsin, May 2002, downloaded 1/5/2003. 5 Longenecker If the business shown in figure 3-1 were subject to 60 excluded accounts receivable and a 70% factor their remaining capacity in thousands would be only $8 1 computed as follows: (assets of $2,020 - (accounts receivable over 60 days $190 + due from officer $50 + prepaid expense $20) - non-bank liabilities $330) x 70% - bank debt of $920. Margaret Jane Miller. "The Role of Social Relationships in Financial Intermediation: Empirical Evidence form the United States Small Business Credit Market," University of California, 1996, under Contract No. SBA-8027-OA-93, United States Small Business Administration Research Summary RS Number 173. 8 John Rutledge. Wall Street Journal, "A Credit Crunch Imperils The Economy," November 6,200 1, p.A26 Rutledge, p.A26 lo The Philadelphia Inquirer, "Loose Change," by Joseph DiStefano, May 29,200 1, p.C1 & C4. ' l Rutledge. p.A26

Chapter 4

SMALL BUSINESS ADMINISTRATION

INTRODUCTION In this chapter we will discuss how Small Business Administration (SBA) loan programs provide capital by reducing the risk of commercial lenders. Eligibility for SBA loan programs and prohibited loan uses will be discussed as will the mechanics of applying for an SBA loan. We will discuss SBA's criteria for granting loan guarantees and how they apply to a variety of loan programs.

OVERVIEW The Small Business Administration (SBA) does not lend money.' It provides a guarantee on money lent by commercial institutions. Since lenders constantly weigh risk and reward, anything that reduces risk improves the likelihood that a loan will be granted. On the other hand, a business must clearly demonstrate their ability to repay a loan. Even where the SBA guarantees 80% of a loan, the lender will not want to lose the remaining 20%, nor will it want to service loans with collection problems. So how does an SBA loan guarantee help? Some loans are clearly worth granting with or without an SBA guarantee and some would be declined under any circumstances. SBA guarantees are useful for those companies that are almost, but not quite good enough to qualie for a

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conventional loan. For those, an SBA guarantee can tip the balance in favor of granting the loan. SBA guarantees also make it possible for banks to extend repayment terms. Where a bank may only grant a conventional loan for four or five years, it might extend terms for an SBA guaranteed loan to six or seven years. The length of the loan will be a function of the loan purpose and the assets it finances.

ELIGIBILITY Before a company can use an SBA loan program it must meet two types of eligibility criteria. First, a business must qualify as a small business within the meaning of the Small Business Administration Act and the regulations promulgated there under. The second criterion is that SBA loan programs can't be used in certain industries or for prohibited purposes.

What Constitutes a Small Business? There are limits on the size of companies that qualify for small business loans. Limits vary by industry, and limits are stated in terms of both number of employees and revenue. Figure 4-1, Small Business Size Limits, provides some examples of maximum size limits by industry. Figure 4-1 Small Business Size Limits Manufacturing and Mining:

500 employees

Wholesaling:

100 employees

Services:

$6 million in revenue

Retailing:

$6 million in revenue.

General Construction:

$28.5 million in revenue.

Special Trade Construction:

$12 million in revenue.

Agriculture:

$0.75 million revenue

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Obviously this is not a one dimensional size test. More detailed criteria are available at the SBA website, www.sba.gov. About one quarter of businesses that exceed the above guidelines are ultimately classified as small businesses for SBA purposes because they qualify for special exceptions.2 SBA size guidelines change from time to time and are usually revised upward.

Prohibited Loan Purposes Loan proceeds cannot be used for investment or to finance a company engaged in ~ ~ e c u l a t i o nBorrowing .~ money to purchase stock or to trade commodities would be considered an investment or speculation. For example, buying real estate for rental income or buying real estate for repair and resale would be considered investment and speculation respectively. On the other hand, if a company purchased a building it occupied at least 5 1%; the loan would probably not be considered an investment. Other prohibited purposes would be to engage in certain types of businesses such as pornography or an illegal business.

MECHANICS Two classes of commercial lenders work with the SBA loan program, Preferred Lenders and Certified Lenders. Preferred Lenders have complete authority to underwrite and service SBA loans. They are usually banks, but may be other lenders such as commercial credit companies. Certified Lenders are banks that use their own underwriting criteria to decide whether to grant a loan with an additional step; borrowers must also get independent approval from the Small Business Administration in their state. About 80% of all SBA loans are granted by Preferred Lenders and 20% are granted by Certified Lenders. While companies may want to visit SBA offices for information there is no need for this step. Both Preferred and Certified Lenders have the forms and other paperwork needed to process SBA 10ans.~A list of SBA approved lenders is available on the SBA website at: www.sba.aov/gopher/Local-Information/Certified-Preferred-Lenders/.The general website www.sba.gov provides additional information and answers to frequently asked questions.

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Once a loan is granted, the commercial lender deposits loan proceeds directly into the borrower's account. The borrower then repays the lender according to the terms of the loan agreement.

UNDERWRITING What are the critical items the SBA looks for when trying to decide whether to approve loan guarantees? Since Preferred Lenders have authority to grant SBA guaranteed loans, the following discussion only applies to loans from Certified Lenders which must get SBA approval. First, SBA looks for the ability to repay loans. Second, it looks for a secondary source of repayment, usually collateral. But what are the indicators of the ability to repay? Among the things SBA evaluates are: Historical trends - are revenue and profits increasing or decreasing? Consistency of Cost of Goods Sold and Operating Expenses Customer trends: a) has the company lost any customers? b) are there significant bad debt reserves? c) is the company dependent on a small number of customers? Inventory integrity - do records accurately reflect physical inventory Are owner(s) withdrawing capital from the company in the form of repayments of loans from officers and shareholders, share repurchase or dividends? Are owners and officers withdrawing capital by borrowing money from the business?

COLLATERAL Generally, SBA loans must be collateralized. That means there must be sufficient assets to pay off the loan. Assets purchased with loan proceeds can serve as collateral. Assets are only useful as collateral to the extent they are unencumbered. For example, a $100,000 building cannot be counted as $100,000 of collateral if it is subject to an $80,000 mortgage. At most its value as collateral is $20,000 ($100,000 fair market value - $80,000 mortgage). However, lending institutions know the cost of seizing and selling an asset reduces the amount that can be recovered. Therefore, if a lender estimated the cost of seizing and selling the aforementioned building at

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$10,000, its real value as collateral would only be $10,000 ($100,000 fair market value - $80,000 mortgage - $10,000 liquidation costs.) Generally loans are not declined when insufficient collateral is the only unfavorable factor on the loan application.5 However, the prudent entrepreneur will not rely on an exception to a lender's underwriting guidelines to secure a loan. The prudent investor conforms his or her loan application to a lender's underwriting guidelines to maximize the probability that the loan will be promptly granted.

PERSONAL GUARANTEES Virtually all SBA loans require personal guarantees from all the principal owners of the bu~iness.~ This means that if the loan is not repaid by the business, the lender can bring a claim against each of the owners who provided a personal guarantee. Moreover, liens on the personal assets of the principal business owners may also be required. This includes a lien on the business owner's personal residence. Such a lien means the business person cannot sell, or further mortgage his or her house without the consent of the lender. The business owner's spouse will also be asked to personally guarantee loans, at least to the extent of their interest in the family home.

DOCUMENTATION The Small Business Association requires a number of documents to complete the application process. The following is a brief list of required documents.

Financial Statements Banks, the ultimate lenders, always require financial statements. For a start-up business, with no financial history, proforma financial statements are required. Every bank has policies about the "quality" of financial statements, for loans under $500,000 a bank may only require a Compilation or financial statement prepared by the company itself. For loans between $500,000 and $2,000,000 banks frequently require statements Reviewed by a Certified Public Accountant. For loans over $2,000,000 Audited financial statements are usually required.

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Some banks will accept copies of Tax Returns obtained directly from the IRS as an alternative to reviewed financial statements. Tax returns can be requested from the IRS using Form 4506. The IRS charges about $23 for each tax return. Typically banks require 3 years of returns which totals about $69.

Business Plans Banks always require business plans. One of the main things a bank looks for in a business plan is how the proceeds are going to be used. The issue is whether the proceeds are going to benefit the business or the business owner. If loan proceeds benefit the business, the likelihood of repayment is increased. If proceeds only benefit the business owner, the likelihood of payment is reduced because the debt only adds another burden the company must carry. Favored uses of proceeds include purchase of real estate, equipment or inventory, financing accounts receivable, and hiring new employees. Disfavored uses of proceeds include increasing the owner's salary, repayment of loans made to the company by the owner, buyout of owner's invested capital, or payment of back taxes.

Personal Credit Checks Banks do personal credit checks on SBA borrowers.

Personal Financial Statements Banks require personal financial statements which are essentially personal balance sheets listing the borrower's personal assets and personal liabilities. The data on this statement must not be more than six months old.

SBA Form 912, Statement of Personal History The personal history form inquires about whether the borrower a) owes any outstanding taxes, b) has any contingent liabilities, for instance has the borrower co-signed for another, c) has filed for bankruptcy, and d) other

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items which might provide information about a borrower's ability and willingness to pay.

Personal Tax Returns Personal tax returns for three years are usually required. The lender can get official copies of tax returns direct from the IRS if the borrower completes IRS Form 4506.

Buy-sell Agreement If the loan is to buy a business, the buy-sell agreement must be provided. However, the entrepreneur should understand that banks are reluctant to finance business purchases because change of ownership involves risks that are difficult to evaluate. A library of SBA Forms is available at: www.sba.gov/library/forms.html.

LOAN COVENANTS SBA loans are subject to loan covenants the same as conventional bank loans. Periodic reporting is also required as a way to monitor compliance with covenants. For example, a company may be required to certifjl the amount of their accounts receivable and other assets every month. If the loan covenants are breached, the lender usually has the right to accelerate the loan. Acceleration means a company must repay their entire loan balance immediately.

LOAN PROGRAMS The Small Business Administration has an astonishing array of lending programs, each with slightly different underwriting criteria, terms and conditions. The more narrowly an entrepreneur can tailor his or her application to fit into a category, the more likely it is that he or she will get a loan on the most favorable possible terms.

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The 7(A) Loan Guarantee Program The Small Business Administration's primary loan program is the 7(A) loan guarantee. The SBA will guarantee 80% of the first $100,000 of a loan and 75% on loans greater than $100,000. The maximum loan under this program is $1 million, and the maximum guarantee is $750,000. Loan proceeds can be used to (i) purchase or renovate facilities or leaseholds, (ii) purchase machinery and equipment, (iii) finance accounts receivable, inventory and other working capital needs, and (iv) construct or purchase commercial buildings. Repayment terms are generally 5 to 10 years for working capital loans depending on a company's ability to pay, and up to 25 years for fixed assets depending on the useful life of the asset. Both fixed and variable rates are available. Interest rates are limited to the prime rate plus 2.25% for loans of less than seven years, and the prime rate plus 2.75% for loans over seven years. The prime rate is the rate that money center banks charge their very best customers. It is published in the Wall Street Journal daily. For fixed rate loans, it is the prime rate on the day the SBA application was received. Lenders are not allowed to demand balloon payments, pre-payment penalties, application fees or points. The SBA charges lenders a guarantee fee, which the lender may pass on to the borrower. On loans of a year or less, the fee is 0.25% of the guaranteed portion of the loan. For example, the guarantee fee on a $100,000, 80% guaranteed loan would be: $200 ($100,000 x 80% x 0.25%). On loans of more than one year, where the amount guaranteed is less than $80,000, the guarantee fee is 2%. On loans of more than a year, and for more than $80,000 the guarantee fee rises on a sliding scale beginning at 3%. Presumably, these fees are assessed once, at loan inception, and may be amortized (expensed) over the life of the loan.

Specialized 7(A) Programs Several variations of the basic 7(A) loan program have been developed to service particular sectors of the capital market. These include:

Small Business Administration

Low Documentation (LowDoc) Loans Generally LowDoc loans are for $150,000 or less and require only a one page SBA loan application and tax returns for 3 years.8

SBA Express Loans SBA preferred lenders can lend up to $1 50,000 using their own forms and credit analysis. The SBA guarantees 50% of these loans. Loans under $25,000 do not require collateral;

CAPLines Programs There are five CAPlines programs, each providing temporary financing for a particular project or asset, which is expected to be liquidated in a specified period of time.

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Contract Loan Proaam Contract loans are used to finance completion of one or more discrete projects. Loans are for the life of the project, but not more than five years.

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Seasonal Line of Credit Line of credit loans are used to finance seasonal increases in inventory and accounts receivable. Usually, a business must demonstrate the seasonal nature of its business to qualify. The line can be approved for several years, but it must be "cleaned-up," that is paid down to zero, for 30 days each year.

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Builders Line Program The builder's loan program provides capital for builders to construct or rehabilitate residential or commercial structures. Up to 20% of the loan value can be for land. Loan terms vary from 3 to 5 years.

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Asset Based Lines Asset based lines can be used to finance inventory, accounts receivable, and direct labor. For amounts under $200,000 the lender's servicing and monitoring fees are limited to 2% in addition

Raising Capital to interest. Above $200,000 the monitoring is stricter and the cost of intensified asset monitoring is passed along to the borrower.

504 Loan Program The purpose of this program is to promote business expansion by providing subordinate mortgage financing for long term fixed assets such as real estate and capital equipment. Subordinate mortgage financing is provided through an SBA intermediary called a Certified Development Company. The effect of this dual financing is to reduce down payments to as low as lo%." For example, suppose a company wants to acquire a $1 million facility. A conventional lender might take back a $500,000 mortgage on the facility. With a loan to value ratio of 50%, the lender's risk is minimal, making it easier for the borrower to negotiate favorable rates. The Certified Development Company (CDA) backed by SBA guarantees, would take a second mortgage against the property for $400,000. The business would then only have to provide a down payment of $100,000 to acquire the property. What happens if the business cannot repay a loan? The first mortgage holder has the right to seize and sell the property. If net proceeds of the sale are $700,000, the first mortgage holder recovers its entire loan of $500,000 and pays the balance of $200,000 to the second mortgage holder, the CDA. The CDA can then collect the difference between their outstanding loan balance of $400,000 and the proceeds they received from sale of the property from the borrower's personal assets. If the net proceeds are $900,000, then both lenders are made whole, but the business would lose its $100,000 down payment. Loans under the 504 program are usually at fixed, below market, interest rates. Terms on real estate loans are 20 years and terms on capital equipment loans can range from 10 to 20 years depending on the life of the equipment. Since the mortgaged assets provide the collateral, other company assets can be used as collateral for other loans. However, to qualifL for a 504 loan, the business must have a net worth of less than $6 million, and after tax profit of less than $2 million."

Other SBA Programs The Small Business Administration has a number of specialized programs designed to help small business people with specific problems.

Small Business Administration

Export Working Capital Loan This loan provides pre and post export working capital. This is a transaction based loan. The transaction is the sale. It can also be used for performance bonds or guarantees related to an export sale. The SBA will guarantee 90% of export loans up to a maximum of $750,000. The SBA charges a guarantee fee of 0.25%. Maturity on these loans is usually less than a year.

International Trade Loan This program is an extension of the Export Working Capital Loan program for businesses that are adversely affected by import competition, or which are going to increase exports. This program provides an additional guarantee of up to $500,000 for long term fixed assets.

Defense Loan and Technical Assistance This program, also known as the DELTA program, is .designed to provide financial and technical assistance to firms that are highly dependent on Department of Defense contracts. The SBA will guarantee 75% of loans up to $1.25 million under the 7(A) loan program or $1 million under the 504 Loan program. 12

The 7(m) Microloan Program This program makes loans from $500 to $25,000 through non-profit financial intermediaries. Loan proceeds may be used for most non-speculative business purposes. Interest rates vary. SBA District Offices for each state have a list of these financial intermediaries.13 Each of these loan problems is described in detail on the SBA website www.sba.gov. Additional information may be found in the Frequently Asked Questions (FAQ) section of their website.

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SUMMARY Small Business Administration usually doesn't make loans. It provides loan guarantees. These guarantees reduce a lender's risk which makes them more willing to extend credit to companies with a less than perfect application. Eligibility for SBA guarantees is based on company size by industry. For some industries, there are limits on number of employees, in others there are limits on revenue. A company otherwise qualifying for an SBA loan can become ineligible if it intends to use loan proceeds for prohibited purposes. Prohibited purposes include investment, speculation or a legally questionable business. Banks and Commercial Credit Companies that are Preferred Lenders can underwrite loans and grant SBA loan guarantees themselves. Certified Lenders can underwrite loans, but must get SBA consent to receive a guarantee. The two principal factors that the SBA looks for are the ability to repay a loan and a secondary source of repayment, which usually means collateral. The SBA has a number of loan programs that vary in terms of: repayment terms, amount guaranteed, and the level of required documentation. A company that tailors their application narrowly to fit a given loan program is more likely to get approval than a company that prepares a generic application.

Small Business Administration

DISCUSSION QUESTIONS If the Small Business Administration Loan Program doesn't make loans, how do they help? How does the SBA define small businesses for purposes of the SBA loan program? What is the difference between a Preferred Lender and a Certified Lender? How are such lenders found? What are the most important factors in underwriting an SBA guaranteed loan? Why does the SBA require collateral? What types of collateral should an entrepreneur owner expect to post? What considerations go into calculating the building's value as collateral? Name seven types of documents an SBA lender would expect if loan proceeds were to be used to purchase a company? How much of a guarantee does a lender get under the SBA's 7(A) Loan Program? How much of a $100,000 loan would be guaranteed? How much of a $200,000 loan would be guaranteed? How much of a $2,000,000 loan would be guaranteed? How does the subordinate mortgage financing available under the 504 Loan Program work? Suppose a company wants to purchase a property for $1.5 million, but the first mortgage company will only lend $1.0 million. What is the minimum a business can put down and how can the difference be financed? Suppose a company purchases a $2,000,000 factory using $1,200,000 from a first mortgage finance company, $600,000 from a CDA loan. Suppose further that the business fails and the facility is sold for $1,600,000. Who gets paid? How much? And from what source? Name five specialized loan programs other than the 7(A) or 504 Programs.

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ENDNOTES I

This is a general rule. However, special provisions have been made for direct loans to businesses affected by the 911 1 disaster. Small Business Administration web site: www.sba.gov and navigate to FAQ or http://appl .sba.gov/faqs/faqindex.cfm?areaID=15 downloaded 3/28/2003 Ibid. p. 16 "New Jersey Small Business Resource Guide," 1999 Issue, p. 16 RENI Publishing, 441 East Central Avenue, Winter Haven, Florida 33880 973-645-2434, p.17 "New Jersey Small Business Resource Guide," 1999 Issue, p. 16 RENI Publishing, 441 East Central Avenue, Winter Haven, Florida 33880 973-645-2434, p.17 Ibid. p. 16 "New Jersey Small Business Resource Guide," 1999 Issue, p. 14 RENI Publishing, 44 1 East Central Avenue, Winter Haven, Florida pp. 14-17. "New Jersey Small Business Resource Guide," p. 17 "New Jersey Small Business Resource Guide, "pp. 18-20. lo "New Jersey Small Business Resource Guide, "p.20. " "New Jersey Small Business Resource Guide," p.19-20 "New Jersey Small Business Resource Guide," p. 19 l 3 "New Jersey Small Business Resource Guide, "pp. 19-20.

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Chapter 5

ASSET BASED LENDERS AND FACTORS

INTRODUCTION Not every company has the characteristics to qualify for a bank loan. In this chapter we will discuss alternatives including (i) asset based lenders, (ii) factors, and (iii) note purchasers. These firms are highly diverse, each having their own specific preferences. This chapter discusses the circumstances in which each might be considered, the strengths and weaknesses of each alternative, and reasonable expectations as to cost.

TRADITIONAL ASSET BASED LENDERS Like banks, asset based lenders balance risk and reward. However, they analyze risk in a completely different manner. Banks want to know that a business is profitable, is willing and able to pay its bills on time, and generates cash on an on-going basis. Asset based lenders are less concerned about whether you will be in business next year than whether the value of assets pledged as security will be impaired. For this reason, a company in trouble is much more likely to get funding from an asset based lender than a bank. That's not to say that commercial credit companies are unconcerned about revenue, profits and cash flow. They are. A healthy company is more likely to preserve and protect the assets and is less likely to go into default, sparing the lender the

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burden of liquidating assets. The difference is in the balance. Assets based lenders are more willing to overlook some of the imperfections in credit history that banks are not. Commercial credit companies cover a wide variety of companies that invest in leases, working capital loans, sale and lease back, and other special financial situations. Many do not fit neatly into the categories discussed above and every commercial credit company has a slightly different risk / reward profile. Unlike a purely asset based lender, commercial credit companies sometimes extend credit on the basis of both assets and a company's ability to generate income in the future. They charge interest rates higher than banks, but cost much less than venture capitalist. In addition, commercial credit companies rarely demand equity in return for capital. To understand the scope and breadth of asset based lending consider Figure 5-1 Examples of Asset Based Lending Characteristics which analyzes two highly diverse firms. Figure 5-1 Examples of Asset Based Lending Characteristics KRB capital' I ~ransamerica~ Operating Parameters: San Francisco Fort ~ b r t h Transaction Size $10,000,000 $50,000 to $5,000,000 to $150,000,000 Percent of eligible accounts receivable 90% 85% Percent of eligible inventory 75% 65% Percent of appraised liquidation &lue of machinery 90% 80% Percent of Fair Market Value of owner occupied real estate 85% 65% Working Capital loan terms Until assets are 2 years liquidated Term Loans and Leases 2 to 5 years Up to 7 years Commercial rates are likely to be substantially higher than bank rates due to the increased risk. Most are based on the prime rate or the LIBOR (London Interbank Offer Bank) plus some number of points. Asset based lenders are likely to want to change the rate up or down every month to avoid interest rate risk. Like banks, they favor some industries and disfavor others. Unlike banks, their loan agreements contain minimal covenants and limited or no personal guarantees.

Asset Based Lenders and Factors

SPECIALIZED ASSET BASED LENDERS Some asset based lenders and commercial finance companies specialize in specific niches. Depending on a company's circumstances, it might want to seek out one of the following specialists (i) Tranche B lenders, (lenders to take junior liens on assets), (ii) companies that specialize in sale and lease-back arrangements, and (iii) those that routinely purchase notes at a discount.

Tranche B Lenders Bankers are highly risk averse and place very conservative values on collateral. For example, suppose a company owns an asset with a fair market value of $100,000. In valuing the asset as collateral, the bank will first subtract any disposition costs, say 10% in this example, and see it as a $90,000 asset net of liquidation costs. They will discount it further, perhaps another 10% to 20% just in case the fair market value has been overestimated, or disposition costs are higher than expected, or they can't dispose of the asset in a timely basis. So from the point of view of a bank, a $100,000 asset could quickly become a $72,000 asset (($100,000 - 10% x $100,000) x SO%.) If the asset is one they don't understand or don't want to deal with, like inventory, machinery or real estate, they may discount the asset even further to get the base against which they are willing to lend. Tranche B lenders, also called Junior Secured Lenders, can often see value where banks cannot. This additional value provides an asset base against which Tranche B lenders are willing to lend. Tranche B lenders consider two types of value (i) the liquidation value of assets and, (ii) the enterprise value as a going conce~-n.3 Tranche B lenders most often value assets on a worst case scenario basis, which is what they could get in liquidation. This implies that all costs needed to prepare assets for sale, as well as the cost of disposition are subtracted from the value of an asset to arrive at a net value against which they will lend. If the Tranche B lender's value is greater than the borrowing base value the bank will lend against, a window of opportunity exists for an additional layer of credit. Consider the situation summarized in Figure 5-2 Tranche B Asset Value Analysis. Note that the book value of assets has limited relevance to the amount a lender will advance against assets. Fair market value, the price a willing buyer and willing seller would put on an asset is more relevant.

Raising Capital Figure 5-2 Analysis of Tranche B Asset Value Analysis (Millions of dollars) Bank Tranche Book Fair B Additional Value Market Borrowing Net Value Value Credit - Base Accounts Receivable Inventory Office Equipment Machinery Real Estate

$10.0 $9.0 8.0 8.0 1.0 0.8 7.0 7.0 2.0 8.0 28.0 32.8

Both banks and Tranche B lenders recognize that if they have to foreclose on assets to recover their funds, they will probably get far less than the fair market value. There are two reasons for this. One is that lenders don't want to hold assets. They want to convert them to cash as expeditiously as possible, which means they may not take time to find that willing buyer, and may settle for the buyer they can find. The other reason is that when buyers sense a seller wants to liquidate an asset quickly, it becomes a buyers' market. In a buyers' market, prices are low. Banks, being cautious, will assign relatively low exit values. In this example, they have valued the asset borrowing base at $17.9 million. The Tranche B lender, however, may value those same assets at $24.6 million. The difference of $6.7 million represents the additional credit that a Tranche B lender would advance on assets beyond that already liened by the bank. Of course, the prime or first lender could be either a bank or another asset based lender. Some Tranche B lenders look at the entire company as the asset, and not just the assets the company owns. This approach, called Enterprise Value examines issues like (i) the quality and sustainability of cash flow, (i) size of the market and share of market, (iii) product position, (iv) the quality of management, and (v) the value of intangible assets such as brand names, proprietary technology, patents, customer base, distribution footprint and customer contacts. The industry as a whole is also evaluated for (i) profitability, (ii) growth potential, and (iii) competition in both technology and in terms of substitute products.4

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Enterprise valuation goes beyond a simple valuation based on a multiple of EBITDA, revenue or profit. This analysis looks for buyers and assesses the enterprise in terms of what a buyer would be willing to pay, not only at the time the loan is granted, but two or three years into the future when the loan must be repaid. The valuation is simpler if similar companies have recently been sold. It is more difficult if there are no similar sales. There are three factors that might make acquisition by a competitor difficult. First, if the target is larger than its competitors, a relevant question is whether any of them would be in a position to buy the target out. Second, if an industry is extremely competitive or in decline, there may be no other company with the resources to acquire the target company. In such a case, a company's competitors might simply be happier if the company failed. The third factor that can impede a buyout is industry concentration. If an industry is already concentrated, the Federal Trade Commission may block purchase of one competitor by another. A sophisticated Tranche B lender will want to identify at lest two potential purchasers. If there is only one potential purchaser, the value of the company will be low. If there are two or more potential purchasers, there is the possibility of them bidding up the price. Another Tranche B strategy is to look at the break-up value of a company. If a company has several divisions, their value as individual businesses might be greater than the value of the business as a whole. Tranche B lenders value brand names whereas banks do not. What is the value of the brand name Coke? Of Pepsi? Of Excedrin? Of Schwinn? From time to time companies with valuable brand names, patents or customer bases come on the market. The trick for Tranche B lenders is to find the buyers who will place the greatest value on these intangible assets5 Tranche B lenders have less "cushion" in the assets they use as collateral which translates into more risk. Greater risk means they will demand a greater reward. Therefore, a borrower can expect to pay more for funds borrowed from a Tranche B lender than from a bank or a senior commercial lender. Where does a company find a Tranche B lender? Unfortunately, no directory of Tranche B lenders exists. On the other hand, they can be found with a little digging. Find asset based lenders and inquire as to whether they engage in Tranche B, or junior secured lending. Not every company will quali@ for Tranche B credit. A company must have value that is not already encumbered by a first lender. However, knowing how conservative banks are suggests they have probably left some unencumbered assets on the table that could be used to obtain another lay of credit.

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Sale & Lease Back Some commercial credit companies specialize in sale and leaseback arrangements. Sale and lease back is a financing strategy in which a company sells its facility to a company that agrees to lease it back to the seller. Because the commercial lender owns the facility, it will not have to go through expensive and time consuming foreclosure proceedings should the borrower default. The owner can simply evict a non-paying customer and liquidate the property at much lower cost. The benefits to the seller are (i) an infusion of cash from the sale and (ii) the continued right to use the facility which means avoidance of relocation costs. The disadvantages are (i) the company will no longer own the facility and (ii) the company will usually be locked into the lease for a relatively long period of time. Those offering to purchase a facility and lease it back to its former owners structure deals that minimize their risk and maximize their return. Their considerations include the following questions: (i) (ii) (iii) (iv) (v) (vi) (vii)

Will the selling company be able to make lease payments over the course of the lease? Is the facility in marketable conditions at the present time, or would it have to be refurbished or upgraded to make it marketable? What would be the costs of preparing the facility for sale, should the selling company default on its payments? Are there other mortgages or liens on the property? What sales or brokerage commission would be incurred should it be necessary to sell the property? How long might it take to sell the property? What target rate of return does the lessor need?

Suppose a company has a building with a fair market value of $500,000. It is willing to enter a 10 year lease, with even monthly payments. The property is subject to a $140,000 mortgage. A sales brokerage commission of 10% is typical for the type of property in question. It would cost $10,000 to clean up the property for sale, and the investor needs a 12% return to do the deal. The two questions presented by this hypothetical are (i) How much can a company raise through sale and leaseback, and (ii) What will the monthly lease payments be?

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First, we compute the net proceeds the buyer/lessor could receive if it had to sell the property immediately after the transaction. Sale price at Fair Market Value Less: Sales brokerage fee Reserve for Price Uncertainty Cost to clean and refurbish

$500,000 10% 2%

Total Costs

$50,000 10,000 10,000 70,000

Net Proceeds Suppose the average amount of time it takes to sell similar properties at their fair market value is six months. That means if they had to immediately put the property back on the market, the buyer/lessor would have to carry its investment for six months. Another way to say that is, the buyer/lessor would not receive its $430,000 for six months and because of the time value of money, the net proceeds of sale must be discounted back to the present. This can be done using equation Eq.5.1. Discounted Proceeds = Net Proceeds / (1 + k)"

Eq.5.1

Where: is the period discount rate, and kis the number of periods for discounting. nIn this example, the buyer/lessor needs a 12% per year return to justify the investment. The monthly discount is simply the annual required yield divided by 12 months in a year; k = 1% (12% / 12). The number of periods for discounting, n, is just the number of months the property is expected to be on the market. In this case n=6. Using the facts in the example in equation Eq.5.1 gives:

In this example, about $405,000 is the most a seller could hope to raise through a sale and leaseback. However, if the price reserve were 3%

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and the buyer/lessor though it might have to hold the property on the market for a year, the most a seller would be able to raise would only be $377,107 (($500,000 - $50,000 - $15,000 - $10,000) / (1 + 1%)12). If a company is contemplating a sale and lease back, it will need to know the amount of its monthly payment. Often, a firm providing sale and lease back financing will want to recover the entire amount provided to the client through the lease payment stream. That means the client considering sale and lease back financing must be willing to enter a long term lease on their facility. Suppose, for example, the client is willing to enter a ten year lease. Equation Eq.5.2 provides a means of computing lease payments. PV

= Pmt x PVIFA(k n)

Eq.5.2

Where: PV - is the present value of the lease payments. In this analysis it is also equal to the amount of funds provided by the buyer/lessor to the seller Pmt - is the monthly lease payment PVIFA - is the Present Value Interest Factor of an Annuity. See Appendix D. kis the period discount rate. The required yield is 12% per year and payments are monthly, so the period interest rate k is 12% / 12 months per year or 1%, and is the number of periods for discounting which in this case is the nsame as the number of lease payments, 12 per year times 10 years or 120.

Applying the facts of the example to equation Eq.5.2 gives: $405,000

= Pmt x PVIFA (1%,

$405,000

= Pmt x

Pmt

= $405,000 /

120)

69.7005 69.7005

Of course at the end of the lease, the financing company will own the client's facility. The client could continue to lease the facility, or they could structure a buy-back price at the end of the lease. The buyback price will be a

Asset Based Lenders and Factors

77

function of the strength of the real estate market, the anticipated condition of the facility, and the strength of the client's bargaining position. Sale and lease back deals can also be negotiated for machinery and capital equipment. The same fundamental analysis applies. However, since the life of machinery and equipment is usually much shorter than for facilities, the repayment rate will be considerably higher. A significant problem with sale and lease-back transactions is that the imputed interest rate on the lease is rarely given. This puts the company trying to raise capital at a significant bargaining disadvantage. Techniques to compute imputed lease interest rate are beyond the scope of this book. However, there are books that provide this inf~rmation.~

Note Discounters Many companies offer financing to their customers through installment sale plans. Installment sale terms are memorialized through loan notes that usually bear interest. Retail examples include appliance and furniture stores and auto dealerships. As a general rule, companies offer installment sale terms do not want to hold notes and collect payments over time. They want to sell these notes at a discount to a finance or commercial credit company.

What Does It Cost to Raise Capital by Discounting Notes?

Retailers may offer "reasonable" interest rates to consumers to encourage the purchase, but a rate that seems reasonable to a consumer might not be enough to induce a financing company to purchase a note. The cost is best illustrated through an example. Suppose a furniture store offers terms of 12% interest for two years on a sale of $4,000. The furniture store plans to sell the note to a commercial credit company that demands a yield of 18%. What is the note discount? The first step is to compute the monthly payments using equation Eq.5.2. Since this problem involves monthly installment payments, the number of periods per years is 12 (12 months per year) which means the monthly, or period interest rate is 0.75% (9% / 12 months per year.) The number of periods is 24 (2 years x 12 months per year.) The Present Value Interest Factor of an Annuity (PVIFA) can be found in Appendix D. $4,000

= Pmt x PVIFA(0.75%, 24)

Raising Capital $4,000

= Pmt x

21.8891

Pmt

= $4,000 /

2 1.9981

= $18 1.83 per month

The next step is to discount this payment stream at the 18% per year that the note buyer requires. We can still use equation Eq.5.2, but this time the payment is known. The unknown is the present value of that payment stream. That present value is what the note buyer will pay. In this case the period interest rate is 1.5% (18% per annum 1 12 months per year.)

The present value of the note at an 18% discount per annum is the amount the retailer would get if it sold the note to a finance company. The discount is the difference between the retail price of the sale and the amount the retailer can sell the note for is the discount. The advantages to the retailer are (i) the note buyer is providing financing to the retailer's customers which may lead to more sales, and (ii) the seller can raise immediate cash by discounting the note. The disadvantage is that the seller, in this example, is accepting about 8.5% less than the retail price from the note buyer. That leads to the question of whether the seller must always sell at an 8.5% discount. The answer is no. If the seller in this example could get his customer to pay, 15% interest, the discount would be reduced. On the other hand, if the seller offered the low, low rates of 6%, the discount would increase. If the note buyer could be induced to purchase the note at a 15% yield rather than an 18% yield, the discount would be reduced, on the other hand, if the note buyer insisted on a 24% yield, the discount would increase.

Who Buys Notes At A Discount? Some consumer finance companies and commercial credit companies purchase notes at a discount. They generally want an on-going relationship

Asset Based Lenders and Factors

79

with a retailer that can provide a large number of notes. This lowers their administrative cost. On the other hand, individual investors may be willing to purchase individual notes depending on their ability to assess credit risk and the yield on the note.

FACTORS A factor is an individual or company that purchases and collects accounts receivables. There are several considerations in deciding whether to use a factor. One is how desperately a company needs cash. When a company is really needy, a bank is unlikely to extend credit, so a factor may be one of the few alternatives that a company has. Another consideration is that credit checking, processing and collection costs are shifted to the factor. Overhead reduction and avoidance of poor credit risks are both important for a company in trouble. Finally, if a company is going to use a factor on an ongoing basis, it should include factoring costs as an explicit component of its business model. There are number of variations on the services factors provide, but generally, they purchase and collect a company's accounts receivable. Some factors will collect a block of accounts receivable on a one time basis. Other factors want a long term relationship with a client company. Of course the nature of the relationship will impact the fees charged, with higher fees for one-time work, and lower fees for ongoing work. There are at least two models for factors (i) purchase with recourse and (ii) purchase without recourse.

Traditional Factors The primary reason many companies use factors is for credit protection. Factors perform credit checks on client's customers before agreeing to accept individual accounts. They can do this two ways. Either they evaluate the buyer's credit on an invoice by invoice basis or if a client has an on-going relationship with customers the factor can pre-approve a line of credit for each customer's use.7 The second most important reason to use factoring is that factors provide collection services. They send follow-up notices, if needed, receive deposits and provide payment information to the client company. Outsourcing credit checks and collections can save costs. The third most important reason companies turn to a factor is that companies can get advances against outstanding accounts receivable from

80

Raising Capital

factors. Advances can be as much as 90%. For many companies, the ability to generate ready cash on invoicing is the prime reason to factor accounts receivable.

Mechanics of Factoring Factors require an application from their clients. The reasons for this application are to determine: (i) (ii) (iii)

whether the company and its invoices are legitimate, to determine whether there is any superceding liens on the outstanding receivables, for example an IRS lien, and to assess the size, nature and volume of accounts receivable.

Factors may ask for sample invoices. Factors usually require an aged, detailed, accounts receivable listing with the application. The aged receivables listing and the application are used to determine whether the company's accounts are current, delinquent, or a combination of the two. The quality of the accounts receivable, as measured by delinquency, will affect how hard the factor will have to work to collect accounts. Based on this analysis, it may decline the client's business, accept part of the business, or accept all the business. If the factor decides to accept the accounts, it will quote its fees. It usually takes 2 to 10 days for a factor to evaluate an application.8 The client is asked to open a lock box where collection proceeds are directed. A lock-box is a bank service wherein a bank processes incoming payments, provides the factor, and or client with a list of who paid, and how much, and deposits the funds directly to the lock box bank account. Since each factor client has its own lock box, there is no chance of co-mingling funds with another client's funds. Traditional factoring is "with notification," meaning the client's customers are notified that the accounts have been factored. This notice instructs customers to remit to the lock box address. If the client company expects to work with a factor over a long period of time, it might redesign its invoice so the "Remit To:" address is the lock-box address. If the relationship is an on-going one, the client company will fax a copy of the invoice to the factor. The factor will evaluate the customer for creditworthiness and advise the company via email whether the credit risk is acceptable the day the fax is received. Factors generally have enormous

Asset Based Lenders and Factors

81

databases of credit information on hundreds of thousands of companies so they are highly efficient at evaluating credit risk. When a factor gets paid, they remit the invoice amount less any fees. In some cases, a client company may need cash prior to the date the invoice is due. In that case the factor will "lend" up to 90% of the amount of the invoice to the client. Interest is charged on these loans. In this case, when the customer pays, the loan is paid off, and the remaining 10% of the invoice, less fees and interest is remitted to the client.

Factoring Costs There are three potential costs: (i) the factor's fee, (ii) credit checks, and (iii) interest, if the client company borrows against uncollected balances. The factor's fee is a one time discount on the face amount of the invoice. These fees vary widely depending on the quality and size of accounts receivable. In Mayo's book, he uses a 2.5% fee on a $10,000 invoice as an example.9 The Liberty Hartford Financial Group, LLC uses a 3% fee on a $5,000 invoice in their website example.'0 Factors may request a separate fee for credit checking customers. For a client's regular, on-going customers, there may be only one credit check at the beginning of the client-factor relationship to establish a credit limit for each of the client company's customers. These fees should be comparable fees charged by other credit organizations. In the event a customer needs cash immediately, the factor will lend some portion of the outstanding balance to the client company. Factoring companies differ in their approach, for example CIT Commercial Finance indicates that it will advance up to 90% of the invoice amount, whereas, the Liberty Hartford Financial Group only advances SO%." Equation Eq.5.4 is used to compute the amount of the invoice that can be advanced to the client company. The remaining balance is a reserve against bad debts. Factors claim their interest rates are comparable to other short term interest rates. However, such rates can be prime plus four or five points. Example: Suppose a client company factors a $10,000 invoice, payable in 60 days. The client company immediately borrows the maximum the factor will advance of 85% of the invoice face value. Further suppose the factor's fee rate is 3% and its interest rate is 12%. What does the client company receive and what is the cost to the client company? Advance Received

= Invoice Amount x

Advance Rate

Eq.5.4

Raising Capital

Equation Eq.5.5 is used to compute the interest on the advance to the client company. In 60 days the customer remits $10,000 to the lock box. The factor computes the interest on the advance: Interest = Amount Advanced x Interest Rate x Days Advanced / 365 Eq. 5.5

Equation Eq.5.6 is used to compute the factoring fee. Note the factor computes it fee based on the entire amount of the invoice Factor Fee

= Invoice Amount x Factor Fee Rate

Eq.5.6

The factor then remits the balance due to the client: Invoice Amount: Less: Advance Interest Factor Fee Balance remitted to client

$10,000.00 $8,500.00 167.67 300.00 $8.967.67 $1,032.33

Some have criticized the relatively high cost of factoring. In the above example it cost $467.67 to borrow $8,500 for 60 days. Annualized that would be about $2,844.99 ($467.67 x 365 / 60) on a loan of $8,500 making the effective annual interest rate about 33.5%. On the other hand, allowing customers to purchase using credit cards has similar costs. Assuming a credit card company pays in 10 days and a customer would pay in 40 days, a company is using credit cards to finance a customer's accounts receivable for 30 days. Credit card companies discount credit card

Asset Based Lenders and Factors

83

slips 2% to 4%. So, on a $1,000 invoice, the discounts, which is a form of interest, is $20 to $40. Annualized, the interest cost would be $243.33 to $486.67 ($20 x 365 1 30 to $40 x 365 1 30). That is equivalent to an annualized interest rate of between 24.3% and 48.7%. So the effective cost of factoring isn't much different than the cost of a merchant using credit cards.

Sale With Recourse versus Sale Without Recourse Some factors purchase accounts receivable and reserve the right to return uncollectible accounts to the client company. Since credit protection is one of the reasons for using a factor, sale with recourse means the client retains some level of risk, but still gets the benefit of the factors credit analysis which reduces that risk. Some factors agree to buy a company's accounts receivable without recourse. That means if the factor cannot collect it must take the loss. The burden of uncollectability shifts from the company to the factor. This is important for companies that are concerned about the creditworthiness of their customers. To compensate for assuming additional risk, factors purchasing accounts receivable without recourse charge substantially higher fees.

Other Factoring Considerations Whether factoring with recourse or without, factors cannot collect what is not documented. Simple account balances are not enough. Factors may ask for information such as:

9

The seller's invoice number

9

The customer's purchase order number

9

The date(s) service was rendered or product was shipped

9

Description of the service(s) rendered or product shipped

9

Unit and extended prices

>

Copies of invoices

9

Copies of contracts, purchase orders or other documentation that the customer, in fact, ordered the company's goods.

Raising Capital Factors tend to specialize in, or avoid particular industries. Some limit their practice to a certain region of the country others are nation wide. Still others operate in niche markets overlooked by mainstream factors. For example, one factor created a whole business out of purchasing, without recourse, written off accounts receivable for 5% to 15% of face value.

Take Away Lessons: I . Terms change from factor lo factor and time to time. Shop around! 2. Prepare in advance in case a factor is needed. Keep detailed information on credit sales and age accounts receivables.

SUMMARY There are many alternatives to bank financing. Two of the more common are asset based lenders, sometimes called commercial credit companies, and factors. Commercial credit provide a wide variety of services including (i) working capital and term loans, (ii) leases, (iii) junior loans, also called Tranche B loans, and (iv) purchase of notes at a discount. Factors purchase and manage accounts receivable. Asset based lenders assess risk differently than banks and have a greater risk tolerance. They generally focus on the ability to get paid from a company's assets and secondarily look at a company's ability to generate revenue, profit and cash flow. This is the opposite of banks. Banks and commercial credit companies like to have first priority in any asset in which they have a security interest. Tranche B lenders use the difference between conservative bank valuations and their own, less conservative valuation as the basis for extending additional credit. The liens that Tranche B lenders place on assets is junior to the liens placed on assets by banks or other asset based lenders. Some Tranche B lenders view the entire enterprise as the asset. Loans from asset based lenders are more expensive than bank loans and Tranche B loans are more expensive than senior asset backed loans. Some commercial credit companies specialize in sale and lease-back transactions. A company can raise cash by selling an asset, usually equipment or real estate, to a commercial credit company and immediately

Asset Based Lenders and Factors

85

lease it back. Lease payments and the length of the lease are sufficient for the buyer 1 lessor to recover its entire investment plus interest. The imputed interest rate on a lease transaction is higher than interest rates on bank loans. Because lease-back companies rarely disclose their imputed interest rate, the selling company loses bargaining power. Many retailers offer customers an installment sales plan that allows customers to pay over time. Installment sales are memorialized by loan notes at interest. Few retailers want to collect and process monthly payments, so they sell these notes to consumer finance or commercial credit companies at a discount. The discount is equal to the difference between the selling price and the present value of the customer's payment stream discounted by the amount the finance company needs to justify its investment. Factors can provide credit analysis, collections, and advances on collections which make cash available to companies within days of invoicing their customers. For business to business sales, factors can evaluate the creditworthiness of a buyer and provide that information to the seller within a day. Accounts receivable can be sold to factors with recourse or without recourse. Most sales are sales with recourse which means that if the factor cannot collect from the customer, it can return the receivable and get back the price it paid. Sale without recourse is absolute and shifts the entire risk of collection on the factor. Factors charge a fee for their service and interest on funds advanced until accounts receivable are collected. The cost of using factors is dramatically higher than the cost of borrowing from banks. The cost of selling accounts receivable without recourse is higher than the cost of selling accounts receivable with recourse.

86

Raising Capital

DISCUSSION QUESTIONS Why do asset based lenders assess risk differently than banks? What are the consequences for business borrowers? What kinds of assets do asset base lenders consider and about how much do they lend against those kinds of assets? What are Tranche B lenders? How do they differ from banks or other asset based lenders? How can a company estimate the amount it can raise if it sells a facility or equipment and leases it back? How would it estimate the lease payments? Is there any way to compute the imputed interest rate on a lease so that its cost can be compared to bank or other financing? What kinds of companies raise capital by discounting notes? Why do they do it? Who buys notes at a discount? How can a company estimate the amount it will have to discount an installment sale note to make it attractive to an investor? What are factors and what are the services that they provide? What is factoring with recourse as compared to factoring without recourse? What are the mechanics of factoring? What does a company have to do? How long does it take? What issues do a factor consider before quoting a fee or deciding to take on a new client? What kinds of information does a company have to provide about individual sales to help the factor do the best job possible?

Asset Based Lenders and Factors

ENDNOTES 1

KRB Capital Corporation, Fort Worth Texas, ~.kbkcapital.com/commercialbusinesscredit.htm 8/5/2001 2 Transamerica Business Capital, f i . ~ r a n s a m e r i c a ~ i n a n c e . c o m / t f c / ~ o m m ~ ~ e n d i n ~ ? ~ ~downloaded ~iz~redit 6/3/2002. 3 Collin Cross. "Tranche B Lenders Analyze Asset, Enterprise Values," The Journal of Corporate Renewal, Turnaround Management Association, Dec. 2002, pp. 12-13. Collin Cross. "Tranche B Lenders Analyze Asset, Enterprise Values," The Journal of Corporate Renewal, Turnaround Management Association, Dec. 2002, pp. 13-14. 5 Collin Cross. "Tranche B Lenders Analyze Asset, Enterprise Values," The Journal of Corporate Renewal, Turnaround Management Association, Dec. 2002, p. 14. 6 David E. Vance. Financial Analysis & Decision Making, McGraw-Hill, 2002, pp.119-128. 7 "Facts On Factoring," CIT Commercial Finance website: ~.citcommercialfinance.com/services/dsp~factoring.asp downloaded April 4,2003 8 Liberty Hartford Financial Group website: ~.libertyhartford.com/~W~index.htm downloaded 4/4/2003 9 Herbert B. Mayo. Financial Institutions, Investments, and Management, 6IhEd., Dryden Press, New York, 1998, p. 552-553. 10 Liberty Hartford Financial Group website: ~ l i b e r t y h a r t f o r d . c o r n / ~ W ~ i n d e x . hdownloaded tm 4/4/2003 11 CIT Commercial Finance, "Facts on Factoring" www~citcommercialfiance/services/dsp~factoring.asp, downloaded 4/4/2003.

Chapter 6

BUSINESS MODELS, BUSINESS PLANS

INTRODUCTION People and institutions will not invest or lend based on the vague promise of some future payoff. They have to believe a company has a well thought out plan. This chapter discusses some of the key elements of a persuasive and useful plan. For example, an investor will want to know why a company wants to raise capital. Some reasons are good, and some are fatal. This chapter will also discuss how to estimate the capital needed so that investors will have confidence a company can achieve its goals without ongoing cash infusions. Investors will want to know whether the company understands the dynamics of its market and whether it has a strategy for dealing with that market. They will want to know whether the company has a well thought out business model, with reasonable revenue and expense projections as well as a basis for those projections. This chapter discusses some of the key elements of the marketing plan, detailed cash budgets, contingencies, and other requirements to raise capital, such as the entrepreneur's background and the experience of the company's management team. All of these issues should be addressed before contacting investors or lenders.

Raising Capital

WHY IS CAPITAL NEEDED? The reason a company needs to raise capital is intimately linked to the payoff potential for an investor. Neither banks nor investors want to throw their money into a pit with no clearly identified goal. The pivotal question for the investor is: 'Is my investment going to add enough value to the enterprise so that I can recoup my investment and earn a good return, or is my investment going to be burned up and vanish?' One of the keys to answering that question is to find out why capital is being raised. Figure 6-1, Reasons for Raising Capital, lists a number of goals a company might want to achieve by raising capital and gives some indication of how those goals might be perceived by investors. Recall the story of the entrepreneur who wanted to raise $50,000 to pay himself a salary for the year it took him to think up his business concept. Paying the entrepreneur for past efforts will not help the company find its next customer, will not generate a single dollar of new sales, will not advertise the product or lower its manufacturing cost. In short, it would do nothing to grow the company. The chances of raising funds for back pay are zero. A worthy use of proceeds is an integral component of a business plan that an investor will view favorably. Figure 6-1, Reasons for Raising Capital Reason CashFlow Break Even

Likely Perception Cash flow break even is the point at which company is generating more cash than it is using. This is a worthy goal because future cash infusions will not be required.

Research & Development

Even if research demonstrates a product is feasible, it is a long way from feasibility to commercialization. Market acceptance must still be demonstrated. This would probably be considered a high risk investment, right for only for investors that specialize in products related to the research.

New Product Introduction

This goal assumes a product has been developed and its market acceptance demonstrated. Bringing a product to market requires cash for pre-sale manufacturing, inventory, sales 1 promotion, and to finance accounts receivable. If the company I has successfully introduced other products, this will probably be ( perceived as a moderate to low risk opportunity.

Equipment

I

If a company has an established product line and it seeks funding for more efficient plant and equipment, this would be perceived as a fairly low risk opportunity.

Business Models, Business Plans

91

Achieve Superior Growth

Depending on the company's track record this could be perceived as either a low risk investment or a fairly speculative opportunity. If the product has wide acceptance in one region, and the funds will be used to expand into other territories in a well thought out way, risk will be low. If the product hasn't established itself as a revenue generator, and the funds will be used for advertising, the risk would be perceived as high.

Dominate the Market

Dominating the market is a worthy goal, but whether it is perceived as high risk or low will depend on the plan. For example, domination though consolidating an industry might be considered low risk if the result was to firm up pricing and if economies of scale resulted in superior cash flow.

Reach Initial Public Offering (IPO)

If a company is realistically within reach of going public, but needs funds to finance that final spurt of sales and do other things to make the company attractive to the public, most investors will view this as a very worthy goal. In part because an IPO provides a clear exit strategy, and in part because investors will expect a high payoff from the transaction.

Reach the next round of financing

Most companies raise several rounds of funds, each of which is contingent on achieving certain milestones. Examples include: $1 million in sales, $10 million in sales or $1 million in cash flow. If the plan is good and supported by a record of achieving past goals, an investor may be willing to invest, on the expectation that future investors will push the company toward the point where they can all exit the investment profitably.

Buy a Competitor

Purchasing a competitor would turn on questions such as the cost of the target, post acquisition cost savings, whether industry consolidation would firm up pricing and the amount of cash the acquired company could realistically generate.

Pay Old Debts

Payment of old debts does little to grow a company. If anything, it might be interpreted as management's inability to manage the resources they have.

Fund Officers

Capital that will be used to fund officer's back salary, allow them to withdraw capital from the enterprise, lend themselves money or repay loans from officers are not considered worthy goals. These proposed uses for funds raise the implication that officers are putting their own needs above those of the business.

Stay Alive

Companies are often desperate to raise cash when they need to meet tax, payroll or other critical obligations. Investors are likely to perceive this as a situation in which the company is unable to manage its resources, and perceive that any other resources it receives will be similarly mismanaged.

Raising Capital

HOW MUCH CAPITAL IS NEEDED? Unfortunately, there is no simple formula to determine how much capital should be raised. The process involves setting goals that lead to further funding rounds or to an exit for the investor, developing a business model that explains how a business will make money, developing a business plan which is a step by step map of how to reach the goal, establishing a cash budget and estimating contingencies.

Goal Determine the goal you want to reach with the current round of funding. Select a goal for this round with either an exit or the next round in mind. Why? Subsequent investors are going to want to know whether prior round goals were met. Companies that fell short in prior rounds are likely to fall short in subsequent rounds. A goal that will bring the company a point where investors can exit is also good. Common exits include an initial public offering or sale to a larger company, but reaching such exits usually means driving a company to a critical size or establishing market acceptance for a proprietary technology.

Business Model A business model is a description of how a business plans to make money. Some of the important elements of a business model include (i) the price customers are willing and able to pay, (ii) cost of goods or services sold, (iii) sales and marketing costs, (iv) operating expenses and other overhead, (v) financing costs and (vi) target profit. The business model should identify all the revenue streams that a company can generate including (i) sale of the basic product, (ii) service and installation revenue, (iii) revenue from maintenance contracts, (iv) enhancements and upgrades, (v) consulting, and (vi) spare parts. The business model should also consider future revenue from repeat sales. Repeat sales are one of the keys to building a successful business. Business models are discussed in more detail below.

Business Models, Business Plans

Business Plan A business plan is a road map. It articulates a step by step method of reaching articulated goals. Investors want to know the entrepreneur has a well thought out and reasonable method of getting from A to B. The business plan, which will be discussed in more detail later in this chapter, lays out things like target markets and the marketing plan, products and services, means of production and distribution, timetables, and staffing plans.

Detailed Cash Budget Construct a detailed cash budget. If the company is pre-revenue, the cash budget should be weekly. If the company has a revenue stream and a cost track record, consider a monthly budget. For most start-up companies, quarterly budgets are too crude to navigate by because unexpected expenses and opportunities to generate revenue occur on a daily basis. The concept of a start-up company also evolves quickly during this period as assumptions are tested in the marketplace and accepted, rejected or modified.

Contingencies After you have constructed the best, most reasonable cash budget you can, step back and think about all the things that can go wrong with the plan. For example, the plan may have your builder start April 1 and complete a project June 30, but what if the builder does not complete until July 31 or August 15'~?What will that cost in terms of unproductive salaries? Financing costs? Lost sales? At each major milestone in your plan, there should be some amount budgeted for contingencies. The total contingencies for a funding round might add up to 30%. As you complete each milestone on time, you can "bank" the contingency dollars for something else like paying down costly debt, or reducing the amount needed in the next round of funding. Do not under any circumstances consider this "found" money and spend it. If you do, those funding the next round of your business will not provide any contingency dollars.

94

Raising Capital

RISKS OF UNDERESTIMATING OR OVERESTIMATING THE CAPITAL NEEDED There are risks in both overestimating and underestimating the amount of capital needed. If the firm overestimates the amount of capital needed, they risk: (0

Loss of investor confidence in the company's ability to understand what it needs to do.

(ii)

Cash requirements may exceed the amount investors are willing to provide

(iii)

Investors may feel that if funds are required from too many investors, their stake will be diluted. The risks of underestimating required capital are:

(0

The firm may run out of money before it reaches its next round funding goal,

(ii)

Investors will lose confidence in the firm's ability to achieve goals, and or forecast revenue and expenses.

Any of these could be fatal if investors decide not to provide additional funds.

MARKET ASSESSMENT The reasonableness of goals and business plans is closely linked to the type of market the company is entering. Is it a new market in which the company has a virtual monopoly? Is it an oligopolistic market in which a handful of large companies react to each other's pricing decisions? Is the market dominated by pure competition in which no one has pricing power? Or does the market have some characteristics of each of these markets? The type of market has implications for price flexibility, the degree of competition, and prospects for profitability.

Business Models, Business Plans

Pure Competition Pure competition is characterized by ease of entry and exit, and a large number of buyers and sellers with standardized products. Price competition is generally fierce in these markets, so raising price to increase profitability is not an option. To achieve superior profits in a market in pure competition a company must become a low priced producer.

'

Pure Monopoly A pure monopoly exists when one firm is the sole supplier of a good or service. While there are few pure monopolies, some companies hold such a dominant market position that they have the characteristics of a monopoly. Monopolies can control price by controlling supply. If they supply less, prices will rise, and if they supply more prices will drop. Monopolies are in a position to adjust price and supply to optimize their profits. However, monopolies can only exist over the long term if (i) there are barriers to entry, and (ii) no close substitutes develop. The phone company was a pure monopoly for almost a hundred years. However, the advent of cable modems and cell phones has created substitutes that are significantly eroding their market share and pricing power.

Oligopoly An oligopoly is an industry that is dominated by a small number of relatively large firms that react to one another's b e h a ~ i o r . ~The airline industry is an example of an oligolopolistic industry. When one airline raises prices other airlines tend to raise prices. When one airline lowers prices, other airlines tend to lower prices. Because of the reactive nature of competitors, firms have only limited control over price and often must compete on a non-price basis. Non-price competition involves developing superior features, services, warranties, or channels of distribution.

Raising Capital

Monopolistic Competition Monopolistic competition is characterized by a large number of sellers, differentiated products, and easy entry and exit of the industry. They have price control only to the extent they differentiate their products in the mind of buyers. Many would argue that Coke has differentiated itself from Pepsi more through heavy advertising than by differences in ingredients and formulation. Investors need to know that a firm understands the type of market it is in and what it has to do to succeed. With a monopoly, they need to maintain barriers to competition and maximize profits before substitutes materialize. With pure competition, they have to be the low cost, high quality producer. With an oligopoly they have to be aware of how competitors are going to react to every move they make and try to win share through better products and service rather than through price cuts. In monopolistic competition, it is important to differentiate products in the marketplace. But game theory teaches one additional lesson. Game theory teaches it is often more profitable to change the game, rather than play the game you find.3 If you can change the game, change the dynamics of a market, you are more likely to attract the attention of an investor.

Price Elasticity The concept of price elasticity helps a firm and its investors understand some of the pricing issues that underlie a company's business model. Generally speaking, if a product's price is reduced, the number of units sold increases. If prices rise, we expect fewer units to be sold. A product's price is elastic if reducing price increases the number of units sold so much that total revenue rises. One implication of elastic prices is that raising price will reduce the number of units sold so much that total revenue will decline. A product's price is inelastic if lowering prices results in so few additional units being sold that total revenue declines. On the other hand, raising prices on a good which is inelastic will increase total revenue, despite the fact that fewer units are sold. Generally, if there are a lot of close substitutes for a product or service, price is elastic. If, however, there are few close substitutes for a product, price tends to be inelastic. The price of Porsche is inelastic because,

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arguably, there are few close substitutes. Many prescription drugs are price inelastic. On the other hand, prices are elastic for compact cars and aspirin. Know whether your products have elastic or inelastic demand. If demand is elastic, consider cutting price and acquiring more market share while raising total revenue. However, if price is inelastic, raise prices and increase total revenue while increasing gross margin. Position your product or service so that it is perceived to have no close substitutes which will change its price characteristics from elastic to inelastic.

Product Life Cycle Another way to think about your firm's product is to think about its product life cycle. Products have a life cycle which affects the strategic decision making that underlies the business plan. Generally, there are four phases to the product life cycle: Introduction

The product is new, its price is usually high, there is a scarcity of suppliers, and not all the uses for the product have been identified. It is purchased by early adopters. Price is relatively inelastic because of lack of competition and the indifference of early adopters to price. Growth

Customers become aware of the product or service and its features and there is a general acceptance of the product category. There is often a fight to determine who will set industry standards. Demand may exceed productive capacity. Price is somewhat inelastic and the product can command a premium price. Maturity

Many companies bring productive capacity on-line, products become standardized, and consumers identify key value features. Competitive pricing begins in earnest, price is elastic, and pricing flexibility is limited.

Raising Capital

Decline The product becomes standardized; the industry consolidates and is dominated by a few large companies. High quality and many features are demanded, low price producers fight for market share and non-low-cost producers are driven from the market. Customers become very price sensitive and price is very elastic. Different products have different life cycles. Fashion items and some toys have very short life cycles. Others, for example, Barbie Dolls or GI Joe, have very long product life cycles. Personal computers have gone from the hobby-experimentalist phase in the 1970's when computers were often sold as electronic kits, to a mature product in thirty years. Analog cell phones gave way to digital cell phones in a quarter of that time, and voice-only cell phones are being supplanted by cell phonelorganizers, video cell phones, and these products are on the cusp of merging with ultra-light laptops. The life cycle of a product can be manipulated to a certain extent. If the product is "re-invented," that is, if the product or its features are changed enough so the marketplace perceives it as a "new," it can be shifted toward the beginning of the product life cycle. Examples of this include the constant "re-invention" of computers and cell phones to add new "must have" features. Why is it important to know about price elasticity and product life cycle to raise capital? The investors want to know that an entrepreneur understands the competitive environment he or she and. their products are going to face and that they understand the appropriate strategy for each environment.

* Take Away Lessons: I ) Recognize when prices are inelmtic and maximize gross

margin during those times. 2) Realize that eventually price competition is going to

squeeze prices and profit margins, so plan to engineer costs downward as the product matures. 3) Re-invent products to ntove then? back toward the growth phase of the product lye cycle where pricing is more inelastic.

Business Models, Business Plans

BUSINESS MODEL A business model, sometimes called a financial or economic model, is framework for describing how a company makes money. So what is a business model? Broadly, it answers a variety of questions: Who are the company's customers? This informs issues like the size of the sales force, channels of distribution, advertising or other means for getting the company's product or service in front of potential customers. What do customers need? A major why companies fail is that they do not think deeply about the needs of the customer. Is the product critical to the customer's production? Or is it an overhead item? Will the product replace an existing product? What is the utilitylcost or valuelprice relationship between the company's product and competitor's products. Will the company's product be an additional cost for the customer? If it is an additional cost, what is the compelling reason that a customer should incur that additional cost? How much are customers willing to pay for the product? If the product is a substitute for an existing product, what is the cost of the product it replaces? If the product is new, what price is required to induce a customer to try it? How big is the market? How many potential customers are there and how many units of the product are they likely to purchase? For example, if the product is a software system used to manage state budgets, the total market is the 50 states, and each of them is only likely to purchase one unit. What is the likely market penetration? If a company is entering a crowded market, even a large one, its percentage of penetration might be extremely low for a long time. Is a company selling to an ultimate consumer, or to an intermediary, either a retailer, or manufacturer? This question informs sales and marketing strategy. For example, if a business is selling computer power supplies, most sales and advertising dollars should be directed to computer manufacturers. However, if a business is selling canned soup through supermarkets, sales and advertising should be directed to the ultimate consumer, creating a demand pull through their immediate customer, the supermarket.

Raising Capital What is the likelihood of repeat sales? If a company is selling refrigerators with a ten year life span, the repeat sale is probably ten years away. If it is selling software to state governments, there may be no repeat sales. On the other hand, if it is selling fruit, it might have a repeat sale every week. How much field support and maintenance does the product require? Some products require very little support, for example a television. However, products like radar systems, commercial aircraft, nuclear power plants, and complex software systems require considerable support. The parts after-market is also a factor to be considered. Some say that Ford and GM make as much profit selling spare parts as they do selling new cars. Answering these questions will go a long way toward construction of a business model. Models are important because investors need revenue, expense, and cash flow projections as input to their decision making process. While revenue and expense projections must work together to create profits, consider these projections independently, and then modify each in a realistic way to set budget goals.

Revenue Forecast Investors are usually skeptical of revenue projections because they are frequently based on profound optimism, and a few facts. Revenue is often forecast as a gross number with no regard for the components of the revenue stream. This somewhat simplistic approach can result in overestimating or underestimating actual revenue. Total revenue is the result of several streams of revenue coming together: first time sales, repeat sales, installation, maintenance, spare parts and product upgrades or enhancements. If a company is selling services, there are analogues to these revenue streams. Since first time sales are usually harder and more expensive to make than repeat sales, we will start by analyzing first time sales. First Time Sales First time sales will be a function of the number of customers in a market that can be reached through advertising or outside sales people. Customers may need to see or hear an advertisement ten to twenty times before they feel comfortable enough to make a purchase, even if they are looking for the kind of good advertised. Sales people may have to call on five or more times to get the first sale. Resources devoted to selling will

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constrain revenue, but devoting an unlimited amount of money to sales people and advertising will not guarantee sales. The number of units each customer will purchase will also influence the revenue forecast. For example, a computer seller who targets companies with 200 or more employees is going to sell more units per sale than a sales person who targets companies with 10 or fewer employees. When an entrepreneur says he or she is going to target firms with 200 or more employees, it is not enough to simply tell an investor that. The entrepreneur should provide a list of potential customers, or at least a count of target customers. Price information can be developed from an analysis of competitors' pricing. Focus groups are another means of gauging market acceptance for a company's product or service and the price needed to induce a customer to try the product. Focus Groups A focus group is a way to measure people's attitude and perceptions under controlled circumstances. Focus groups can be used to:

;?: ;?:

Test the acceptance of new products or services, Assess quality,

;?: :?:

Compare a product to competing products, Determine sensitivity to price.

Focus groups usually bring together 8 to 20 people at a time from the target market under consideration. Often people are paid to participate in a focus group. Focus groups are usually run by outside professionals, not the company whose product is under review so that questions can be put in the most neutral possible way. Otherwise, the results can become contaminated with the moderator's bias. Focus groups usually last from one to two hours. The focus group usually discusses three to five questions or issues. Questions should be open ended to capture new information, with responses written on a flip chart for everyone to see. Participants should also be asked to provide written responses to questions requiring well defined answers such as: On a scale of 1 to 5... and "At what price would you consider trying this product?"

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Once information on the number of customers, market reach, units per customer and price at which the product will be accepted have been developed, a revenue forecast can be made. Repeat Sales Repeat sales are both a way to build a successful business and an early warning indicator if the company's products, services or prices become unacceptable or uncompetitive. A company should keep detailed records of repeat sales to determine whether the percentage of repeat sales is increasing or decreasing and why. The percentage of repeat sales can be used to support forecasts of future sales. In addition, repeat sales indicate customer satisfaction, which will reduce an investor's perception of risk. By combining information about sales contacts, the number of contacts that will convert to a sale, estimates of the price and quantity of each sale, credible revenue forecast can be generated. Statistics on repeat sales will provide information on how a company's business is building and will help project revenue into the future.

Profit Modeling Profit can be modeled using a modified version of break even analysis. The components of this model are gross margin, sales costs as a percentage of revenue, overhead, financing costs, and the pre-tax profit target. The output of this model is the sales that are required to meet target profit.4 Gross margin is gross profit divided by revenue. Gross profit is sales minus the cost of goods sold. See equation Eq.6.1. Gross margin is the percent of every dollar of sales left over after the product or service is made to cover sales costs, overhead, financing costs, and pre-tax profit. Firms with a thin or non-existent gross margin are probably not viable. Gross Margin

= (Revenue - Cost of Goods

So1d)lRevenue

Eq.6.1

Sales cost percent is total sales costs divided by sales. See equation Eq.6.2. Total sales costs include advertising and other marketing expenses such as call centers, direct mail and sales peoples' commissions. Sales and marketing costs tend to rise and fall with sales. This ratio is important

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because it is subtracted from gross margin and reduces the amount of every dollar of sales available to cover overhead, financing costs and pre-tax profit. Sales Cost%

= Total

Sales CostIRevenue

Eq.6.2

Overhead includes all operating expenses except sales and marketing costs. Financing costs include interest, imputed interest on leases and credit card and note discounts. Profit is the pre-tax target profit that the entrepreneur wants and the investor needs to justify his or her investment. Equation Eq.6.3 combines these elements to find a company's required sales. Required Sales

= Overhead + Financing Costs + Target Profit

Eq.6.1

Gross Margin - Sales Cost% Example: Suppose a company has forecast sales of $12,000,000 overhead of $4,000,000, financing costs of $160,000, gross margin of 47%, Sales Cost% of 11% and a Target Profit of $500,000. What are Required Sales? Required Sales = $4,000,000 + $160,000 + $500,000 47% - 11%

Since Required Sales of $12,944,444 exceed Forecast Sales of $12,000,000, the firm will not be able to reach the investor's profit target. So what must the company and or entrepreneur do? They have to rethink their business model; increase gross margin, reduce sales costs as a percentage of sales and cut overhead or financing costs. Cutting target profit is not the way to win the hearts and minds of investors. The real world is complex and solutions to complex problems usually require several iterations. With this model, a company can try several approaches on paper before committing management time and company resources to see whether a plan will work and they can test their model before submitting it to investors. Entrepreneurs and investors can also use this model to ask question such as: what if gross margins deteriorate or financing costs rise?

Raising Capital Probability and Sensitivity Analysis Is it highly probably, that actual sales will equal forecast? In the real world the odds of hitting every mark in a plan are slight to non-existent. So what can be done? One approach is to estimate the probability of meeting various revenue targets by varying the components of the revenue forecast. For example, what if sales people can only call on 90% of the companies targeted, or what if 6 sales calls are need to close a deal versus 5? The result can be compiled into a table with the cumulative likelihood of reaching a certain sales goal. Figure 6-2, Sales Forecast Probability is an example of such a table. There are a number of ways to calculate these probabilities. The one suggested above is generally referred to as a form of Monte Carlo simulation and can be constructed using an Excel spreadsheet and varying the inputs over a reasonable range of values. Statistical means can also be used to construct a probability table similar to Figure 6-2.5 Figure 6-2 Sales Forecast Probability

Cumulative Probabilitv

Sales Forecast

Given the data above, there is about a 25% probability of reaching the required sales of $12,944,444. This is a signal the company must dramatically rethink their business model. On the other hand, if the company cuts its overhead to about $3,480,000, its required sales will drop to about $1 1,500,000. Based on the revenue forecast, the company has about a 95% chance of reaching such a sales goal.

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One thing an entrepreneur can be sure of is that investors are going to tear apart any numbers, models or forecasts given them. But by using the model discussed above the entrepreneur can be more prepared to address inevitable questions.

MARKETING PLAN The core of the Business Plan is the Marketing Plan. Questions such as: Who the customers are and how many there are should have been worked out while constructing the Business Model. Now the question is: How will they be reached? How will they be convinced to buy? What will it take to close each sale? These are not trivial questions and for the entrepreneur to say that he or she is going to hire the best salespeople and send them into the field is no answer. The marketing plan should be as specific as possible as to: How customers will be found? What techniques will be used to reach the market (mass media, personal sales call, direct mail, or telemarketing)? What channels of distribution will be used (direct mail, Internet, wholesale, retail, original equipment manufacturer) How will sales territories or customers be assigned to sales people Price points and pricing strategies The pitch - sometimes a company needs to help customers understand how a product meets a customer's needs. Overcoming objections - often a customer will see a problem with the product; find it not cost effective, etc. If so, marketing must be prepared to overcome those objections and close the deal. How orders will be fulfilled? Who is responsible for warehousing, shipping, etc?

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The marketing plan should also have goals, and for each goal, there should be one or more corrective actions if goals are not met.

PEOPLE TO EXECUTE THE PLAN Integral to any business plan are the people who will have to put it in motion, to convert words on paper to action. While business plans are extremely important, they are merely pieces of paper until implemented. A bad business plan can prevent you from getting capital, but a good plan is insufficient. Investors look for other indications you can deliver.

Entrepreneur's Personal Finances Investors will want to know how the entrepreneur manages his or her own money before letting the entrepreneur manage theirs. So, the entrepreneur's personal finances become an important factor in closing a deal. What should an entrepreneur expect an investor to ask for:

9

A personal financial statement. Banks almost always want personal guarantees and some commercial lenders ask for them.

9

Tax returns

9

A personal credit check

Investors will look for bankruptcies, late mortgage, auto or credit card payments, and only a reasonable amount of personal debt.

* Tllkc mvuy Ie.~sorr: If you are thinking about going into, or starting a business, make sure your personal finances are squeaky clean

Business Models, Business Plans

Entrepreneur's Experience Investors place a tremendous amount of weight on the entrepreneur's experience. If you've worked for telecommunications companies for twenty years and you are raising money for a telecommunications start up, you'll get a close hearing. If you've worked for telecommunications companies for twenty years and you are raising money for an airline start-up, you are not likely to get very far. Every industry is unique. Every industry has its own nomenclature, conventions, trap doors, and dead ends. Investors don't want you to learn about them with their money. So, is going into a new industry fatal? No. If an entrepreneur is entering a new field they must demonstrate three things:

9

How their prior experience is relevant to their current industry

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A successful track record in their current industry, and

9

A management team that thoroughly understands the industry.

Management Team Remember, investors take every precaution to minimize risk, and if a company looks too risky, they will simply move on to the next company. A company with a strong management team minimizes risk. At a minimum, investors will want a management team that has four players:

9

A president and CEO who is a strong leader who makes things happen, rather waits for things to happen.

9

An experienced CFO, usually they will demand one who has an MBA or CPA or both. They will want a CFO who can track company operations in a quantitative manner and be an honest broker of information and advice.

>

A marketing vice president experienced in the industry, which already has a rolodex of customers and contacts, and does not have to build a contact list with investors' money.

9

A production vice president to produce the product or service who is a self-starter, who knows how to acquire facilities, equipment and materials, efficiently manage people, and deliver a quality product.

Raising Capital

SUMMARY An entrepreneur must have a well articulated and acceptable goal when raising capital. Otherwise, investors won't invest and lenders won't lend. Goals that will help the company grow or which will help the investor exit the investment on favorable terms are more likely to be funded than other goals. Goals such as payment of old bills or compensation for the business owners will not get funded. Understanding a company's business model and developing business and marketing plans to exploit that model is critical before talking to investors. Among the things that an entrepreneur must understand is the type of market the company is competing in: monopoly, oligopoly, monopolistic competition or pure competition, and the strategic implications of these types of markets. The entrepreneur must also understand where the product is in the product life cycle and the implications for pricing and other strategies. Investors want realistic forecasts of revenue and expenses. Most forecasts are based on profound optimism and few facts. The more systematic the approach to forecasting, the greater the forecast's credibility will be. One of the most important aspects of revenue forecasting is to make sure all revenue streams are considered, including revenue from sales and service, replacement parts, upgrades, and consulting. Expenses can be modeled using a modified break even analysis. The important components of expense modeling are overhead, financing costs, gross margin and Sales Cost%. Target Profit can also be modeled by treating it as a fixed cost. The output of the expense model is Required Sales that is the sales necessary to reach the target profit. If Required Sales are greater than Forecast Sales, goals will not be achieved and the company must rework its financial model. There is always some uncertainty in forecasts because plans never unfold exactly as predicted. Since expenses are usually more controllable and easier to predict than sales, it is prudent to model a number of sales levels and assign a probability to each. These probabilities can be used to estimate the cumulative probability of achieving a specified sales goal. The marketing plan must detail how customers will be found and made aware of the product. It should also detail what will be done to close the sale. The entrepreneur must show appropriate experience, preferably in the new company's industry and must have an experienced management team that can back him or her up. The entrepreneur must be prepared to open his or her personal finances to inspection, and experience to evaluation. The aforementioned preparation is important for all entrepreneurs, but critical for those dealing with sophisticated investors.

Business Models, Business Plans

DISCUSSION QUESTIONS What goals will an investor look favorably on, and what goals do they disfavor? Why? What factors should be considered in determining how much capital to raise? What are the risks of trying to raise too much or too little capital? Why is it important to assess a company's market? What are the four main types of markets? What are the implications of each? What are the four phases of a product life cycle? What is price elasticity? What are the implications of these concepts? What is a business model? Why is it important? What questions does a business model answer? What is meant by multiple revenue streams? What are common revenue streams? How would you estimate revenue? How can focus groups be used to forecast revenue? How do focus groups work? Is there a way to estimate the required revenue to make a given profit? What should a company do if the required revenue is more than the revenue forecast? Since revenue is usually the hardest variable to estimate, are there any probabilistic methods that can be used to gain a better understanding how to make sure profit targets are met? What elements should a marketing plan address? What kind of experience do investors expect of an entrepreneur and his or her senior management?

Raising Capital

ENDNOTES --

' Campbell R. McConnell and Stanley L. Brue. Economics, Principals, Problems and Policies, 1.5'~ Ed, McGraw-Hill Irwin, 2002, p.438. Campbell R. McConnell and Stanley L. Brue. Economics, Principals, Problems and Policies, 15jhEd., McGraw-Hill Irwin, 2002, p.495-497. Brandenburger and Nalebuff. T h e Right Game: Use Game Theory to Shape Strategy," Harvard Business Review, July August 1995, p58 The profit model can be derived from the break even equation 0 = Sales -Variable Costs -Fixed Costs Overhead, Financing Costs and the Profit Target are treated as fixed costs. Cost of Goods Sold and Sales Cost% time Sales are treated as variable costs. Cost of Goods Sold can be found from the equation: Cost of Goods Sold = Sales - Sales x Gross Margin Where Sales times Gross Margin is equal to gross profit. 0 = Sales - (Sales - Sales x Gross Margin) - Sales x Sales Cost% - Overhead - Financing Costs - Target Profit Factoring sales out of variable costs give the equation: 0 = Sales x (1 - (1 - Gross Margin)) - Sales Cost%) - Overhead - Financing Costs - Target Profit and equation 0 = Sales x (Gross Margin -Sales Cost%) - Overhead - Financing -Target Profit. Adding Overhead, Financing Costs and Target Profit to both sides of the equation yields: Overhead +Financing + Profit Target = Sales x (Gross Margin -Sales Cost%) Dividing both sides by the term (Gross Margin - Sales Cost%) yields: Sales = Overhead + Financing Costs + Tarpet Profits (Gross Margin -Sales Cost %) This is the minimum sales necessary to reach the Target Profit, which makes it the Required Sales. David Vance Financial Analysis & Decision Making, McGraw-Hill, 2002, pp.67-86.

Chapter 7

ANGEL INVESTORS

INTRODUCTION Angel Investors provide capital to a segment of the risk-reward spectrum that institutional investors overlook, or will not consider. In this chapter we will discuss who angel investors are, where they can be found, when an entrepreneur should consider using an angel investor, the stage of development angels prefer, and some of their criteria for making an investment decision. Angel investors often provide more than money and we will discuss how finding and engaging the right angel can have a multiplier effect on invested capital. This chapter will explain angel investor expectations about the reward they expect, their time to exit, how angel investors fit into the broad spectrum of capital sources, how angel capital can be leveraged to raise capital from other sources, and how and entrepreneur can find and capture an angel.

WHAT IS AN ANGEL INVESTOR? Angel investors are private individuals who invest their own money in someone else's business. They are called "angels" because they invest in companies that don't qualifjr for other types of investment. Angel investors are usually one of the first funding sources an entrepreneur receives after

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exhausting self help sources such as credit cards, investments from friends and family, and home equity loans.' Some angels are professionals and some have inherited wealth. Many angels are business people who have built their own companies and taken them public or sold them. As a result, they bring both money and business experience to entrepreneurs. Angels who have such experience and want to invest their time, talent, and advice as well as their funds are called warm money." Angels with experience in an entrepreneur's industry are especially valuable because they can (i) mentor the entrepreneur and help avoid costly mistakes, (ii) introduce him or her to potential clients, (iii) help identify and recruit new employees, and (iv) make contacts needed for further rounds of funding. Such advice is particularly important for pre-profit or prerevenue development stage companies, which have high risk.2 GC

ANGELS GO WHERE OTHERS FEAR TO TREAD Except for the entrepreneur, friends and family, every capital source except angel investors is institutional in nature. What does that mean? Banks are institutions that must answer to depositors, shareholders and regulators. Venture capitalists, commercial lenders and asset based lenders must answer to the pension funds, insurance companies and corporations providing capital. Answering to someone else can make an investor timid. Angel investors, by contrast, invest their own money and answer to no one. While they minimize risk every way they can, they still have a greater risk tolerance than other capital sources and this leads to a risk-reward profile that has a different from other investors. Consider some of the alternatives to angels. Banks want to know that a company is making steady and predictable profits and they want collateral. Few start-ups have high value, unencumbered assets, and predictable profits. Many start-ups have no profits, and some have no revenue. Clearly banks won't consider such companies. Asset based lenders and commercial credit companies have a higher tolerance for spotty earnings, but still want assets to secure a loan. Again, something a start-up is not likely to have. Relatively few venture capitalists invest in early stage companies. They want a company with demonstrated high growth and large potential markets. Many early and development stage companies just can't make the case that they will be high growth. Avoidance of such companies by institutional investors leaves an opening for angel investors whose objective is to get in on the ground floor of potentially high value companies.

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How significant are angels to the economy in general and entrepreneurs in particular? In 2000, 400,000 active angels invested about $40 billion in nearly 50,000 companies. Venture capitalists, on the other hand invested about $90 billion in about 5,500 deals. The average angel back investment was about $800,000 with the average angel investing about $100,000. By contrast the average venture back deal was for about $16.4 million. Through the first three quarters of 2001, the average venture capital deal dropped to about $12.1 million. Despite this recent drop, there is a significant gap between the size of the average angel deal and the average venture capital deaL3 This contrasts with 1997, where angels invested between $20 and $30 billion as compared to $14 billion for venture capital firms.4 One of the difficulties in determining how much capital angel investors provide is that they generally invest personally, and not through regulated organizations, making the data on their activity difficult to collect on a systematic and comprehensive basis.

WHAT IS THE PROFILE OF AN ANGEL? The average angel investor is 47 years old, has a post graduate degree, and management or entrepreneurial experience. Angel investors are typically people who take prudent risks in hopes of creating new wealth for themselves and others. They tend to get little satisfaction from traditional investments like stocks and certificates of deposit. Their tolerance for risk is generally somewhat higher than others. This might play out in their lifestyle as well as in their investing and may provide an important clue as to who is a potential angel. A person who has been an angel investor in the past is more likely to be an angel in the future. They are usually, but not always, "accredited investors." An accredited investor is defined by SEC regulations as having a sufficient level of wealth that they can afford to invest in unconventional situations. Specific criteria for an accredited investor are discussed in chapter 11. If qualification as an accredited investor is used to estimate the number of potential angel investors, then about one of every of 250 adults is a potential angel. This means they are everywhere and everyone probably knows one or knows people who know one. Typically, angel inve~tors:~

>

Invest as individuals, not through a corporation or partnership

Raising Capital Invest $25,000 to $250,000 ($50,000 to $1,000,000 in some markets6, and $250,000 to $3,000,000 for angels that invest together.7) Invest in convertible preferred stock because it provides some investor protection in distribution of profits and liquidation, while providing unlimited upside potential. Invest in early or development stage companies, which are likely to be pre-profit, and perhaps pre-revenue. Have an investment horizon of about five years, meaning they will want to exit their investment in about five years.8

ANGEL INVESTMENT CRITERIA If an entrepreneur wants an angel investor to provide funds to his or her company, the entrepreneur needs to understand what angel investors are looking for, their investment criteria, and the payoff they need to justify an investment. Angels invest in early or development stage companies, and for taking the risk of investing early, they expect to acquire a substantial interest in a company at relatively low cost. Should the enterprise thrive, that investment will pay off several times over. On the other hand, many investments will become a total loss. So from an angel investor's point of view, investing is an exercise in risk management. Since angels are individuals, each approaches their investment a little differently. However, four groups of criteria have been identified: (i) characteristics of the entrepreneur, (ii) characteristics of the company, (iii) characteristics of the deal, and (iv) angel specific preferences. Each has implications for pitching a company.9

Characteristics of the Entrepreneur By far, the most important factor an angel investor considers is the entrepreneur and his or her characteristics. If the entrepreneur does not meet expectations, it does not matter how brilliant the company concept. The angel will pass on the investment.

Angel Investors Personal Knowledge of Entrepreneur The primary criterion that angels use to screen proposals is whether the entrepreneur is previously known by the angel or one of their trusted associate^.'^ This sound like the medical advice that says the best way to avoid cancer is to carefully select your grandparents. Nevertheless, this is an uncomfortable truth entrepreneurs must deal with. How? Become a connector, a person with associations in a broad array of social and business organizations. The chamber of commerce, professional societies, and civic associations are all places where people with common interests meet. The lesson is that anyone who wants to be an entrepreneur someday should cultivate relationships with a lot of people today. Some of the people in these organizations are likely to be angel investors, though they've never said so. Others may know angels and can make introductions.

Terrifically Smart There is always the question: If this is such a good idea, how come no one else is doing it? Part of the answer is that the entrepreneur is smart enough to see things that others cannot, such as how to fill a recognized need in a novel way. But the requirement to be terrifically smart goes beyond just the product idea. It extends to the ability to be flexible, adapt to new circumstances, acquire new information, and have knowledge of products, services, customers, and competitors at their finger tips. l1

Brilliant Manager It's not enough to have a good business idea on paper. It takes skill to pull together people, money, raw materials and convert them into something customers will buy and it's important to be able to do that in a pressure cooker environment where time to market and getting customers is balanced against quality and cash bum rates. A brilliant manager must keep all the balls in the air while moving the company forward on schedule. 12

Facile With the Intricacies of Cash Flow Cash is oxygen to a company and running out of cash can be fatal. Angels and other investors want to make sure the entrepreneur has a mastery

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of cash flow, so that he or she will not run out of cash before reaching the company's goal, whether that is cash flow break-even, next round funding, IPO or some other exit strategy. Knowing the intricacies of cash flow means knowing the difference between profit and cash flow, knowing the amount of cash needed to support growing inventories and accounts receivable, and to expand sales, marketing, and advertising. l 3

Good People Jeff Seglin interviewed angel investors in New Hampshire, Michigan, and Massachusetts and to a person, they all said it was a mistake to think angels invest in businesses. They invest in people. The brilliant idea isn't enough to interest most angel investors. They want good people, who work hard, and can execute business plans. They also want people of integrity, that is people who won't see the company as their personal piggy bank, people who are thrifly, hard working, driven to succeed and toughest of all, willing to take advice. Many investments have been lost because the brilliant entrepreneur ignores the sound advice of his or her investors and

counselor^.'^ Proven Management It's not enough to be honest and hard working. The experience of the entrepreneur and his management team is very important to an angel investor because investors don't want entrepreneurs to learn about business with their invested capital. On the other hand, since they invest at an early stage, they understand that the whole management team might not be in place at the time they make their investment decision. Some angels start by asking whether the management team has the desire and work ethic to make the business a

Characteristics of the Company Many bright, hardworking, knowledgeable entrepreneurs have failed because they didn't have the right concept, at the right time and in the right place. The world is complicated and fiercely competitive. So to make sure the companies they invest in have the best chance of succeeding, sophisticated angels screen companies on a number of criteria.

Angel Investors

Business Built Around Some Leading Edge Technology Not every angel wants to invest in a technology company. Some are afraid of investing in technology because they don't understand it or worry about technological obsolescence. On the other hand, it's easy to see why angels want to invest in technology. New, innovative products often have niche markets to themselves for a while, which means they have no meaningful competition and they can charge premium prices. Leaders in new fields often get essential patents blocking entry of others, and even if they can't get patents, they often get to set technical standards that can have a payoff in terms of an installed customer base.16

In a Market No Other Company Dominates Few start-ups or even middle market companies have the time, energy and resources to go head to head with IBM, ExxonMobil, or Microsoft. On the other hand, that doesn't mean a company has to be the only firm in its industry. Many industries are highly fragmented, with no clear industry leader. Such fragmentation provides an opening for a company with a unique product, service, channel of distribution or method of delivery.17

High Growth Potential There are three elements to high growth potential. The first is the size of the market. If the total number of customers is low, and the number of units each will purchase limited, then the total market might not be large enough to support continued, high growth. The second element of high growth is competition. If competition is intense, it may be difficult to extend a company's reach beyond the local market in which the entrepreneur has personal relationships. The third element of growth is scalability. Companies that rely for their success on the skills, personality and connections of an individual entrepreneur, as for example, an architect, are less likely to be scalable than a company that relies on standardized products and mass markets.

Raising Capital Data Entrepreneurs heap otherworldly praise on their products, but all the praise in the world weighs less than a single fact. One entrepreneur claimed to have technology to extended laptop and cell phone battery life, but when asked for experimental data, he had nothing. Angel investors expect entrepreneurs to have done their homework. If he or she has not done his or her homework by the first meeting, the entrepreneur will not give them a second meeting.

Sufficient, Reliable Information About the Company Sufficient information goes far beyond financial statements and proforma financial projections. It also includes information about the marketplace, customers, competitors, and the product. Forecasting the size of the market, and possible penetration using the techniques discussed in chapter 6 (Business Modeling) is going to be much more persuasive than numbers plucked out of the air. The source of data input to the business model should be documented. If there are two or three ways to estimate the size of the market and possible penetration rates, they should all be presented. Such cumulative evidence gives weight to forecasts and builds your reputation for diligence and thoroughness.

Sales Pipeline Sophisticated angels increasingly want to see a revenue or sales pipeline. A sales pipeline is a schedule of prospects in different stages of the sale: first contact, second contact, interest expressed, under evaluation, likelihood of closing the sale, date contract signed, delivery date, and when revenue can be booked. Remember, under Generally Accepted Accounting Practices (GAAP) revenue can't be booked until services have been rendered or the title for the goods have passed to the customer. A sales pipeline implies the product is past development stage and has been successfully commercialized.

Angel Investors Sustainable Competitive Advantage

Investors want to know whether a company has a significant competitive advantage and whether it can sustain that advantage over time.'' Competitive advantage is a very broad topic, but unless a company can find, and document, that it has a competitive advantage, an edge, a way to harvest superior profits, the company is going to look like an also-ran to the investor.

Characteristics of the Deal Angel investors what to know that their deal with the entrepreneur is clear and that it has a chance of producing a yield that would justify the risk of investment. The following are a few of the characteristics of the deal that an angel investor will evaluate.

Return 5 Times Invested Capital in 5 years

Five times return of invested capital in five years is a general rule of thumb as to the return angels want. However, when the stock market is doing well, investors are likely to demand a higher return on their investment than when the stock market is sluggish. Why? The stock market is an alternative use of the angel's funds. Since the market has much lower risk than a start-up company, the start-up must offer the investor a premium of 10% to 15% over the market to entice the investor into investing. The entrepreneur must be able to show the angel how they will make their target rate of return.19

Clear Exit Strategy

Closely allied with investment return is the issue of how the angel will exit the investment and get the promised return. No angel wants to invest his or her money in a company and leave it there indefinitely.20 A number of exit strategies will be discussed in the chapter 8 (Venture Capital.)

An "Investible" Deal

An Investible deal is one in which (i) both the entrepreneur and the investor can share in long term financial rewards, (ii) there is a significant

Raising Capital concept or proprietary asset, (iii) entrepreneurial talent, and (iv) the entrepreneur puts the good of the company ahead of his or her own personal good. 21 Each element of the Investible deal has implications for the pitch to the angel investor. For example, the entrepreneur should be prepared to explain how the angel will reap their long term financial rewards. Without a significant concept or proprietary asset, the company will look like a "me too" also-ran, undistinguished from its competitors. Of the three elements of the Investible deal, entrepreneurial talent is the most difficult to assess. Prior entrepreneurial experience is a plus, but such talent also manifests itself by the preparation prior to meeting with the angel, which shows drive, intensity and thoroughness. Angels avoid deals in which management is looking for a comfortable lifestyle with little left over for the investors.22 There are several ways an angel might detect this. They will analyze executive compensation for whether it is inappropriately high for a company's stage of development, look at the number of relatives on the payroll and their salary, and self dealing, for example, if the company is paying above market rent on a building owned by the entrepreneur.

Realistic Valuations If entrepreneurs are unrealistic about the value of their company, investors won't be able to purchase a large enough stake to meet their return goals. More details on valuations are included in chapter 9 (Structuring The ~eal).~~

Governance Mechanisms Angel investors usually want to participate in the governance of the company. They may do this by asking for a seat on the Board of Directors and negotiating for other governance rights, such as the right to approve additional corporate indebtedness. Angels will also want mechanisms to align the entrepreneur's interests with those of the investor, including things like employment contracts, limits on salary, and bonus plans for meeting certain mi~estones.~~ If the entrepreneur is not willing to cede such rights to the angel investor, he or she may pass on the deal. See chapter 9 for more details.

Angel Investors Available Later Stage Funding Most angels are smart enough to understand that their investment will not take a company all the way to a successful exit. Later stage funding will be necessary to grow the company to a size where it becomes attractive as an acquisition target or it can go public. Angels want to know whether their investment will carry the firm to a milestone that will make next round of financing possible at rates that will not dilute their stake to nothing.25

Angel Preferences Every angel has well defined preferences as to the type of company they want to invest in. It is important to identify those preferences early and see whether they match the characteristics of the company before too much time is wasted. For example, some angel investors invest only in high-tech companies, others avoid high-tech altogether claiming they are far too risky. The following are the most common types of angel preferences.

A Company Within a One-hour Drive of the Angel's Location Most angel investors want to see what they are investing in, not just prior to investing, but for as long as their money is at risk. If an entrepreneur wants "warm money," that is money that comes with the angel's involvement, the angel should be less than an hour's drive from the company. This onehour drive time limit is mentioned by many angels and in the ~iterature.~~ However, more sophisticated angels with multiple company portfolios invest in companies with a half day's travel time.27 The implication for raising capital is to seek out angels close to home. If you are in Milwaukee, don't look for angel investors in New York. There are plenty of angels close to home. The art form is finding them.

Industry Preference Some angels favor certain industries, such as, industries in which they have personal experience, or industries they have successfully invested in before. Other angels are open to investing in all but selected industries. If your company is in an industry the angel disfavors, don't bother with the pitch. Rather, use your meeting to ask whether he or she knows angels who

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invest in your industry, and ask whether they can make an introduction. If they don't know angels in your industry, ask for their advice as to how to find an angel in your industry. People love to give advice and asking for advice will mark you as a mature and thoughtful person. Who knows, they may meet an angel in your industry the next day and if you've left a good impression, the angel may pass your name along.

Intellectual Reward By definition, angel investors don't have to invest. So why do they take the risk? One big factor is the intellectual reward that comes from being in on the ground floor of an enterprise. Another factor is the reward they get being the mentor and coach of some young business person.28 These rewards will only come if the entrepreneur is willing to listen to the investor. If the investor perceives the entrepreneur has an ego that compels him or her to dominate every conversation, or is so brittle that they can't take constructive criticism, the investor will just step away. Such non-financial factors should not be overlooked when dealing with angels and may mean the difference between closing a deal and not.29

WHAT RATE OF RETURN DO ANGELS WANT? There are few comprehensive studies of the returns that angels earn, partly because angels value their privacy. Another factor that makes measuring return difficult is that the true return can only be measured after an angel exits an investment. Since many active angels are still invested in most of their portfolio, they have no objective measure their performance. Though angels do everything they can to minimize risk, most investments become worthless. The rule of thumb mentioned earlier, five times investment in five years, is just that, a rule of thumb. Returns will vary with circumstances. The University of New Hampshire, Center for Venture Research estimates that return on angel capital overall has ranged between 20% and 40% for the 20 year period ending in 2000.~'

DUE DILIGENCE Even after applying all the screening criteria listed above to both the entrepreneur's presentation and business plan, sophisticated angel investors

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will want to do more. They will conduct what is known as a due diligence review which has three objectives: (i)

Confirm that the information provided by the entrepreneur is true and accurate.

(ii)

Look for undisclosed, adverse information.

(iii)

Determine whether articulated plans are consistent with the facts on the ground.

A good due diligence review can help an angel avoid getting into bad situations. One angel investor invested $30,000 in a company with a "neatidea," but found at his first advisory board meeting that the company was two weeks from filing for bankruptcy and only survived due to last minute investment^.^' In another company, an early round angel put up $1 million as a loan on the condition that subsequent investors pay him out. Those next round investors backed off when they found a significant portion of their money wasn't going to grow the business, but only to "buy out" a prior investor. With no new capital to fuel it, the company ran out of cash and collapsed.32 A due diligence review is especially tricky for a start-up which may not have a chief financial officer to organize and classify data in a meaningful way. From the entrepreneur's point of view, it is important to know what an angel is likely to ask and look for, so that he or she can be prepared.

ANGEL INVESTOR ADVICE The literature suggests that angel investor advice adds as much or more value to an enterprise than their invested capital. But what kind of advice do angels give that proves so valuable? Examples of angel advice culled from the literature should provide some idea.

Effective Team Building The entrepreneur must understand that he or she cannot do it all. The entrepreneur must find a team of professional advisors with a mix of backgrounds and bring them together to discuss products, markets, strategic and business plans and day to day company operations and should meet with

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them on a regular basis. Annual or even quarterly planning sessions are not enough for a company on a growth trajectory. If a company is at a very early stage of development, it should consider bringing on a part time chief financial officer to help with cash flow and financial projections, and a part time marketing consultant and production manager to test the market and launch new products.33

Focus on Marketing, Not Technology Some entrepreneurs focus on perfecting a technology and adding as many features as possible, instead of focusing on their customers and market.34 The greatest technology in the world won't raise a dime of capital until investors can clearly see how that technology translates into customer demand. This is a hard lesson for tech-savvy entrepreneurs to digest. But as Thomas Watson, Sr. said, "Nothing happens until a sale is made." Thomas Watson, Sr. was the man who began the transformation of IBM from a sleepy office machines manufacturer to the computer giant it is today.

Focus On The Product Everything in life is balance and angel investors can help the entrepreneur achieve the right balance. One start-up company, NetFax, focused the bulk of its start-up resources on obtaining patents on key technology rather than on developing a product. The result was that it ran out of money before it had either a commercial product or a patent and couldn't raise further funds. In the case of NetFax, the key angel investor had the right advice on balance, but the CEO / entrepreneur ignored it. In another case, Elcom, a company that made it possible to broadcast phone and radio over electric power lines brought its product to market before all the bugs were worked out. Sales peaked at $10 million then crashed because of product returns and negative brand awareness. One of Elcom's primary angel investors advised the company to refine the product before going to market. The advice of the angel was ignored and the company collapsed.

Angel Investors

WHERE ARE ANGEL INVESTORS FOUND? This segment of the capital market is very inefficient because there are few, well defined markets in which companies in need of capital and investors can come together. One of the reasons for this inefficiency is that traditional markets depend on standardized commodities such as barrels of oil, bushels of wheat, or carloads of pork bellies. On the other hand, every start-up, every mix of business deal, entrepreneurial talent and product is different. Other factors that militate against a well defined marketplace for angel capital include the fact that angel investors prize their privacy and do not want to be known, and angel's preference for dealing with people they already know. Angels for their part, lament the fact that there is no straightforward way to generate quality deal Nevertheless entrepreneurs and angels do find each other, though the process isn't always straightforward.

Personal Network Angel investing is very personal. Angels are looking for entrepreneurs who are strong managers and have strong management teams. They want to know as much about the people running the company as possible. Therefore, the first place to look is close to home: friends and business acquaintances, suppliers, customers, community leaders, and successful entrepreneurs in the immediate area. Even if there are no angel investors among the entrepreneur's business contacts, he or she should ask for referrals. Business contacts may know people who have invested in startups before. In addition, personal referrals are a powerful way to quickly gain credibility with an investor.

Forums for Emerging Growth Companies Forums for emerging growth companies are non-profit organizations that bring together emerging growth companies, across industries, for the purpose of discussing common problems. They usually have monthly meetings. Programs that concentrate on "how to," developments in taxes and regulation, intellectual property issues and raising capital. The more the programs concentrate on raising capital and meeting investors, the more actual investors will attend.36

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Guidancefor Angel Investors Experience is the best reacher and experienced angel investors have some guidance to share with theirfeflow angels about how to avoid troz~ble. I . Onlv Fools Rush In - Take time to get to know the company, its management, and its customers. Is the company steadily progressing? Is it meeting the goals the entrepreneur laid out at the first meeting? One experienced angel has watched some companies more than a year befae investing.

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2. Charm Wears Thin Don't invest in people who are charming, invest in people who are hardworking. Look for a good business proposition backed by frugal, industrious people who are passionate about their business.

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3. There Is Safety In Numbers Don 't be the only investor in a company. Invest in companies (hat have won support from other angel investors with a record of picking winners. 4. Invest in What You Know

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g y o u want to be able to monitor the company and give constructive advice. you have ro know the business of the business.

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5. Invest Onlv What You Are Prepared To Lose Many angels see only the upside potential of their investments and never think about losing it all. Most companies that angels invest in crash and burn. Even angels who invest in theform of secured debt canfind themselves holding worthless paper. 6. Beware O f The Demo - Products may look good in a demonstration because it does something novel. Bur doing something, is a long way from having a commercially viable product. The little glitches in the demo product will come back to haunt a company fi it goes to market before the product has been perfected, Norhing will kill a product, a brand, a company quicker than selling a bad product. Rules 1, 2 & 3 from Stephanie Gruner, "Avoid Angel Investments from Hell," Inc.; Boston, Vo1.20, lssue 8, June 1998, p106 Rules 4, 5 & 6 from Silvia Sansoni, "Burned Angels," Forbes; New York; Vo1.163 lssue 8. April 19, 1999, pp. 182-1 86.

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Rules for Angel Investors - continued 7. Don't Go It Alone - Angel groups systemaficallyjind deals and vet companies. They also facilitate Due Diligence, which can be tricky. Experienced angels can help guide novices and this collaborative approach helps reduce risk

8. Agree With The Entre~reneuron How To Value The Com~anv- The entrepreneur m v talk a good garne, but at the end of the day, company valuation is going to significantly afeci the investors return on investment.

- Know how you are going to harvest your investment and make sure the entrepreneur understands and agrees with your exit goals and timing. Typical strategies include: /PO,selling out to a larger compay, management buy out, or recapitalizing the company.

9. Knav The Exit Stratem

10. Minimize Risk - Sh-ucturing the investment as preferred stock or debt

can reduce risk somewhat in liquidation, and provide a preferential claim on current income. Also recognize that a seat on the Board of Directors confers responsibility and liabilityfor corporate misconduct. Rules 7, 8, 9 & 10 from Lisa Reilly Cullen, "Are You Ready for Wings," Money, 12,Dec. 1998, p133. Also see: Business Angels: A Guide To Private Jnwsring, published by the Colorado Capital Alliance (303-440-1356) New York, Vo1.27, Issue

Investors find forums an attractive place to network and search for investible deals. Factors that make forums successful include (i) frequent meetings (more than quarterly), (ii) member introductions and the opportunity to network, (iii) current, relevant topics to keep members coming back, and (iv) a non-profit structure, not dominated by service providers. 37

Venture Fairs and Company Showcases Venture Fairs are one or two-day events for high growth companies that want to make presentations to an audience of qualified, active investors. Successful venture fairs are usually run by a regional consortium of

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universities, venture capital funds and service providers or venture trade groups. They showcase as few as 15 and as many as 60 companies per day. Companies are usually screened so that only the best get to present. Most fairs provide a conference book including the background of each presenting company. Companies seeking investors pay fees of $250 to $500 for the privilege of presenting and investors pay $300 to $1,200 to attend. Most regions run one event per year.38The Greater Philadelphia Venture Capital Group has an annual fair. See their website: www.apvp.com Other large fairs also have websites.

Technology Showcases Technology showcases are usually two hour to one-day events in which very early stage technology companies set up booths and invite people to discuss the merits of their idea, invention, or product, or to discuss ways in which their technology could be commercialized. Companies that attend technology showcases may still be working out of a garage, and probably haven't had their first round of outside funding. Showcases are usually sponsored by universities, chambers of commerce, or other non-profit institutions. There are usually no fees for attendees, but there may be fees for exhibitors, and attendance may top 200 if well a d ~ e r t i s e d . ~ ~ The New Jersey Technology Counsel, for example, sponsors several technology fairs per year throughout the state. Regional chambers of commerce also sponsor such fairs. These fairs are open to all companies, whether or not they are technology based. In most urban areas of the country, there are also other organizations that sponsor technology showcases. The factors that make Fairs and Showcases successful are (i) aggressive outreach to the investing community by the sponsoring organization(s), (ii) clarity of purpose, (iii) reasonable pricing, and (iv) good conference facilities with state of the art media support.40

Investor - Entrepreneur Matching Services Matching services build an inventory of start-up companies and an inventory of qualified investors and match them. Matching can be active or passive. Active matching screens deals to a limited degree. Passive matching involves posting a summary of the company or idea on the Internet where investors can peruse and select companies that meet their criteria.

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Matching services teach entrepreneurs the importance of communicating, in one or two pages, that they have an "investible deal." The Small Business Administration has such a service known as ACE NET. Others can be found on the web. Investors usually pay a subscription fee to access these networks, and or to view detailed information on companies that meet their investment criteria.41 Entrepreneurs may be charged fees as well. The downside of these networks is that few screen the quality of businesses and business plans to any great degree. It is therefore left to investors to screen companies, either by using selection criteria, or some other method. The management team at Garage.com screens deals and actively promotes deals to investors for a fee. Garage.com only works with companies that meet the following criteria (i) high technology, which includes communications, network infrastructure, security and storage, enterprise software, wireless and emerging technologies, (ii) large market with higher than average profitability and (iii) United States based. They do not work with consultants and service companies. Garage.com has a three step process: (i) companies submit a 100 word description of the business concept, the team's background and other information on their application form, (ii) if meets the Garage.com selection criteria, the company is invited to make a presentation to a Garage.com panel that further screens companies and their plans, and (iii) assuming the panel accepts the company, it signs a series of legal agreements with Garage.com for access to their resources and services.42 There is NO guarantee a company will receive funding from any of these matching services, so caution is indicated. Whether or not on-line matching services will prove valuable has yet to be seen. However, key success factors will include (i) high quality deal flow, otherwise investors will quit visiting these sites, (ii) a critical mass of deals and investors to make accessing the systems worthwhile, and (iii) some method of replicating the "human" element in evaluating a company. 43

Caution: These services usually make their money by charging fees, vat by getting results. Before an entreprenetrr pays hard cash for finding an investor, he or she shozrld ask how many deals the sewice has closed, the average deal size, how many deals if has closed in entrepreneur's industry, get a list of references of companies that have actually received finding through the service, and call the companies to confirm, and benefitfrom their experience.

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Angel Funds and Angel Clubs and Private Investor Networks (PINS) There are a variety of organizations that cater to the needs of angel investors in terms of deal flow and deal screening. These organizations go by a variety of names including Angel Funds, Angel Clubs, and Private Investor Networks. By pooling resources they can invest in bigger deals, and obtain professional assistance in research, management and negotiation.44 These organizations provide an opportunity for the entrepreneur to identify angels, aggregate the investment of several angels, and overcome the reluctance of any one angel to be the first to invest. Angel Clubs and Private Investor Networks (PINS) are investor-only organizations that associate for the sole purpose of screening and evaluating deals brought to them by entrepreneurs. A key feature of this group is that all members are accredited investors. They usually meet monthly over a meal to listen to 5 to 15 minute presentations by two to five entrepreneurs. The companies that present are pre-screened by a committee or by a designated individual. PINS are usually based in metropolitan areas and their members usually live within a one-hour drive of the meeting place. Entrepreneurs are only considered if their business is within one or two hours of the meeting place. Angel Clubs and PINS do not invest as a group. Rather, angels followup with entrepreneurs individually if they are interested in investing.45 The critical mass of members needed to attract a stream of deals seems to be about 25 active investors. Dues for PIN members range from $500 to $1,000 per year plus the cost of meals. Key success factors include a core of experienced angels rather than just a collection of wealthy individuals trying to learn how to invest in equity.46Angel Clubs may or may not charge dues. These clubs obtain deals from members, other investment groups and professional service providers such as lawyers and accountants. Typical investments range from $250,000 to $750,000. The rules of some of these clubs dictate that they co-invest with venture capital funds to reduce risk and take advantage of their management expertise.47 They often have a limited geographic or market focus. Since they are early stage investors, they can profit from lower valuations and negotiate more favorable terms from entrepreneurs who are hungry for money and have no other funding sources at hand.48

Angel Investors

Angel Funds Angel Funds are usually organized like venture capital funds with a general and limited partners, but are not institutionally backed. Instead, the funds come from angel investors. Funds are usually $5 million and up, and invest from $250,000 to $1 million in 8 to 12 companies at a time. These funds usually have first time fund managers or professionals who manage the fund along with other private equity activities. The manager gets a fee of 2% to 3% of assets under management and 20% of profits, after the return of the investor's capital. The investors are all accredited investors who agree to pledge $50,000 to $100,000 to the club's treasury. Membership in these clubs may range from 25 to 99. Once they have paid money into the treasury, they have a real stake in the outcome of investments. Companies approaching an Angel Fund organized along these principals know that there is a substantial pool of money, ready to be tapped.49

* Take Away Lessons: I ) Angel Clubs, Funds, and PINS provide a forum in which an entrepreneur can raise a subs!antia/ amount of capital af one time. 2) Such organizations use much of the same selection criteria as individual angels such as investing "close to home. " 3) Such organizations are likely to employ professional investment managers to screen opportunities.

Angels in Action A hotel ballroom in Conshohocken, Pennsylvania is the home of the Pennsylvania Private Investor Group (PPIG), an informal, ten-year-old group of angel investors working together to find and screen investible deals. They have monthly meetings at which two entrepreneurs present a multi-media pitch to raise money for their companies.50 Angels are given a "package" describing the company, management, and a summary of the entrepreneur's business and marketing plan. After the entrepreneur's presentation, investors pummel him or her with questions designed to test whether the entrepreneur has overstated his or her case, and whether they have thought through their business model.

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One entrepreneur claimed to have the New York Yankees as a client, when in fact only one ball player was a client. Another claimed there was a $10 million market for his product in the package and a $40 million market in his presentation.51 Such inconsistencies call into question the amount of research that underlies a company's business model. Other issues that angel investors questioned entrepreneurs about included:52 How the entrepreneur knew the product would work in practice, not just in the lab? Whether there were any patent or technological barriers to entry to prevent others from entering the market? Whether the entrepreneur was targeting the right market: high-end custom verses the mass market? What would keep an 800 pound gorilla from entering the market tomorrow and dominating it? Why wouldn't a customer just use an existing, competing product? Whether the entrepreneur could get to market and attain a dominant market position before other companies jumped in? After the presentation, the entrepreneur is asked to leave the room and the investors discuss the opportunity, after which the moderator asks the bottom line question: "Is anyone interested in investing?'If no one is, the entrepreneur is thanked for their time and dismissed. However, if there is interest, entrepreneurs are asked to return for follow-up questions. Entrepreneurs who bring financial, technical, marketing and other support staff generally fair better in these intense question and answer sessions. If those questions are satisfactorily answered, the interested investors schedule a visit to the company to gather additional information. Not every company that wants to pitch to the group gets an opportunity to do so. As a general rule, PPIG only considers companies within 150 miles of their location. They also require companies to provide detailed business and marketing plans. These plans are screened by one or two investors for a threshold level of merit. A typical entrepreneur pitching to PPIG is looking for a million dollar investment in exchange for 25% of the company.53If a company needs

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significantly more money, it might try a different Angel investor group, or they might consider raising capital from multiple Angel investor groups. Depending on the opportunity, investors may or may not be willing to invest a million dollars for 25% of a company and may demand more or offer less.

SUMMARY Angel investors are often the first people to invest in a business after friends and family. Usually they invest in companies that are pre-profit and often pre-revenue. Some companies might not even have a commercial product. Angels fill a funding gap between friends and family, who trust in the entrepreneur personally and banks, which look for things, like a continuous revenue stream and collateral. Angel investors are less risk averse than most other funding sources, but that doesn't mean they invest blindly. Sophisticated angels have detailed investing criteria. Angel investors are wealthy individuals who invest their own money in start-up and early stage companies. Most are professionals or experienced business people willing to tolerate the risk of a start-up or early stage enterprise in return for acquiring a significant equity state at a low cost. Some simply invest and wait to see what happens. Others want to actively participate in a company by giving advice and helping the company make connections to potential customers, suppliers, lawyers, accountants and other investors. Those who want to participate are called "warm money." Warm money can multiply the effectiveness of funds invested, especially if the angel is experienced in the company's industry. The typical angel invests between $25,000 and $250,000, as convertible preferred stock. Most want to exit their investment in about five years. Angel investors invest more in individual entrepreneurs than they do in products or technology. Angel investors prefer to invest with someone they know, or someone known to a trusted associate. The implication for the entrepreneur is that he or she should make connections with as many people as possible through trade, professional, civic and charitable organizations. Other characteristics angels look for include: (i) an entrepreneur with insight and the ability to see opportunities others do not, (ii) people skills, (iii) facile with intricacies of cash flow, (iv) leading edge technology, (v) a market not dominated by other companies, (vi) return of five times capital in five years, (viii) clear exit strategy, (ix) an entrepreneur who is thrifty and a hard worker, (x) a good management team, (xi) high growth potential, (xii) reliable company information, (xiii) within a one hour drive of the angel's location, (xiv) an investible deal, that is one in which both the entrepreneur and

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investor can prosper, (xv) a scalable concept, (xvi) a sales pipeline, (xvii) a realistic valuation, and (xviii) a match to the investor's industry preference. Theoretically, angel investors are everywhere. If those who fit the SECs definition of an accredited investor are considered, then one of about every 250 people is an angel or potential angel. However, the angel capital market is the least structured of all capital markets, because, unlike banks or venture capital firms, there are no directories of angel investors. This is true partly because angels work to protect their privacy. The first place to look for an angel is in the entrepreneur's own network of contacts with business and community leaders. They may, in turn, be able to put the entrepreneur in contact with angels in their network. There are some angel netwdrks and angel clubs that work together to create deal streams by systematically screening proposals and investing together. When angels band together investments of $1 million are not unheard of. The important thing is to match the right angel with the company's profile. Many important elements of the matching process are outlined above, but two high level matching parameters that are fairly easy to gauge are the angel's industry preference and proximity to the entrepreneur.

Angel Investors

DISCUSSION QUESTIONS Who are angel investors? What is their typical profile? How much do they typically invest? Where do angel investors fit in the risk-reward spectrum? At what stage in a company's life should an entrepreneur consider looking for an angel investor? What is an investible deal? How can both an entrepreneur and an investor share long term rewards? Isn't this a zero sum game where one party can only prosper at the expense of the other? What does scalability mean and what are some examples of scalable and non-scalable companies? What are the three most important criteria an angel investor is likely to consider in deciding whether they even take a meeting, let alone invest? What are some of the characteristics an angel investor looks for in an entrepreneur? What are some of the characteristics an angel investor looks for in a company and its products? What are some of the financial characteristics an angel investor looks for in terms of return and length of investment? What is an exit strategy and why is one important, and to whom? What is a sales pipeline? How does it work? Why is it significant? What is due diligence? What are angel investors trying to find out through due diligence? What are some examples? How many angel investors are there and how can an entrepreneur find them?

Raising Capital ENDNOTES Miriam Hill. "Start-ups Put Faith in Power of 'Angels'," The Philadelphia Inquirer, March 16, 1999 D l . 2 John May. "Private Investor Community Building - How to Dance with Angels: Best Practices and Critical Success Factors of Forums, Fairs, Networks and Funds," by New Vantage Partners for Virginia's Center for Innovative Technology, April 1999. Jeffrey E. Sohl. "The U.S. Angel and Venture Capital Market: Recent Trends and Developments," The Journal of Private Equity, Spring 2003, p.8-12. Hill. Dl. 5 John May. p. 1 6 Stephen Prowse. "Angel Investors and the Market for Angel Investors," Journal of Banking & Finance; Vo1.22, Issue: 6-8; August 1998; Amsterdam; pp.785-792 7 George Moriaty. "Angel Investors Step Away From Concept Stage Deals," Private Equity Weekly; April 5, 1999. 8 Stephen Prowse. pp.785-792 May p.2. Stephen Prowse. pp.785-792 l 1 Jeffery L Seglin. "What Angels Want," Inc., Boston, May 19, 1998, pp43-44 l2 Jeffery L Seglin. pp.43-44. 13 Jeffery L Seglin. pp.43-44. 14 Jeffery L Seglin. pp.43-44. 15 Roger Barnes. "Touched by an Angel," Black Enterprise; New York; Vo1.3 1 Issue 1 1, Jun 200 1, pp.242-247. 16 Jeffery L Seglin. pp.43-44. 17

Jeffery L Seglin. pp.43-44 Roger Barnes. 242-247. l 9 Jeffery L Seglin. pp.43-44. 20 Jeffery L Seglin. pp.43-44. 18

21 May 22

p.9. Stephen Prowse. pp.785-792. 23 Mark Walsh. "Wary Angels Investors Answer Fewer Prayers," Crain's New York Business; Vol. 17, No.3, June 18,2001. 24 Stephen Prowse. pp.785-792. 25 Walsh. 26 May p.7 27 Jeffrey E. Sohl. "The US Angel and Venture Capital Market: Recent Trends and Developments," The Journal of Private Equity; Spring, 2003, p. 15. 28 John W. Holaday, Steven L. Meltzer and James McCormick. "Strategies for Attracting Angel Investors," Journal of Commercial Biotechnology; London, Vo1.9 Issue 2; Jan 2003, pp. 129-133 29 Jeffery L. Seglin. pp.43-44.

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30 Jeffrey E. Sohl and Bruce Sommer. "Angel Investing: Changing Strategies During Volatile Times," a working paper, Center for Venture Research, University of New Hampshire, Durham, received 9/24/2003 31 Stephanie Gruner. "Avoid Angel Investments fi-om Hell," Inc.; Boston; Vo1.20 Issue 8, Jun 1998, p. 106 32 Silvia Sansoni. "Burned Angels," Forbes; New York; Vo1.163 Issue 8, Apr 19, 1999, pp. 182-186 33 Lawrence H. Gennari, Esq. "Angel Investing & the Early Stage Enterprise," Angel downloaded Investor News; www.ange1-investor-news.com/ART-angelinvest.htm, 513 112003. 34 Gennari. 35 Jeffrey E. Sohl. "The U.S. Angel and Venture Capital Market: Recent Trends and Developments," The Journal of Private Equity; Spring 2003; p. 14 36 May. p.13. 37 May. p. 14. 38 May. p.15-16. 39 May. p.16-17. 40 May. p.17. 41 May. pp.18-19. 42 May. p. 19 43 May. p.21 44 May. p.29 45 May. pp.22-23. 46 May. pp.23-24. 47 May. p.27. 48 May. pp.25-26. 49 May. p27. 50 Joseph DiStefano. "Angels at the Breakfast Table," Philadelphia Inquirer, June 6, 1999, Dl. 51 DiStefano. D9. 52 DiStefano. D9. 53 DiStefano. D9.

Chapter 8

VENTURE CAPITAL

INTRODUCTION The venture capitalist has a unique role in capital formation. At one level they are financial intermediaries bringing together institutions with capital to invest and companies that need capital and cannot get it from other sources. At another level, they drive companies to push harder and faster than they ordinarily would, sometimes creating substantial wealth and value. A venture capitalist can make an entrepreneur tremendously rich or he or she can take an entrepreneur's company away from him or her, or the venture capitalist can do both. So who are these people and what do they want? If we want venture capitalists to 'invest in our companies, we must understand how they operate, how they think, their goals and their expectations. This chapter discusses who venture capitalists are, how venture capital firms are structured, what they want, when a company should consider venture capital, and how to find the right venture capital firm. This chapter will also analyze the types of firms venture capitalists invest in, explore their investment criteria, discuss the benefits of and drawbacks to using venture capital, and contrast venture capital with angel investors. One study suggests that the more an entrepreneur knows about the venture capital process, the greater their relative bargaining power.' More power means an entrepreneur will have more control over the terms, conditions and the amount of the investment and he or she can minimize the relative cost.

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RISK VERSUS REWARD Two of the overarching factors that organize capital markets are the tradeoff between risk and reward. Each source of capital has a different risklreward profile. Broadly speaking, venture capitalists are more risk tolerant than banks, bondholders, and thoughtful investors in publicly traded companies. This risk tolerance springs from two sources. Their first is the need to generate superior rewards for their investors and superior rewards usually accompany increased risk. The second is their belief their superior skill and knowledge will enable them to safely select and manage investments bearing substantial risk. Broadly speaking, they are less risk tolerant than the majority of angel investors, friends, family and entrepreneurs. These groups accept more risk than venture capitalists, not because it is their intention, but because the lack the skills and experience to prudently evaluate risk in a meaningful way. Venture capitalists face several kinds of risk, of which agency risk is one of the most important. When a venture capitalist commits funds to a company, the entrepreneur becomes in some sense the agent for the venture capitalist, responsible for prudently managing his or her company, and thereby managing invested capital. One way to control this risk is through an investment agreement that gives the venture capitalist the right to replace an underperforming, incompetent or dishonest entrepreneur. Another way venture capitalists protect themselves is through a stringent analysis of the business and its prospects prior to committing funds. This analysis involves a detailed assessment of the marketplace, competitors, threats and opportunities and exit strategies. For example, the venture capitalist might identify two or three companies that might be interested in purchasing the portfolio company prior to making a commitment of funds. This analysis is followed by a due diligence review. Due diligence is designed to confirm that everything an entrepreneur has told them about the company is true and accurate and that no material facts have been omitted. It also involves a check into the entrepreneur's personal background and credit history. If they see downside risk during this review, and can't come up with a plan to manage it, they may simply step away from the deal. Another strategy is to share the risk with other venture capital firms. If other firms join in, less capital is at risk and collaboration provides confirmation that the venture capitalist has not overlooked some key weakness in the deal. Finally, they require sufficiently high rates of return so that if some of their portfolio companies collapse, the others will generate enough of a return to prop up the venture capital firm's overall return2

Venture Capital

WHO NEEDS VENTURE CAPITAL? Venture capital is intermediate financing for start-ups between the entrepreneur's own capital and angel investors on the one hand, and an IPO or acquisition by a larger company on the other. But why not rely on angel investors or banks? Angel investors typically:

9 9

Invest under $100,000 though Angel Clubs or Angel Funds can invest up to $3,000,000 Often can't provide the level of management advice and expertise needed to drive high growth and returns

Banks won't lend to companies with:

9 9 9 9

Unproved products in untested markets Little or no collateral to secure loans No profits and no prospect of profits for years No ability to pay interest

Venture capitalists provide funding in larger blocks than are available through angel investors. Venture capitalists are sophisticated and can provide advice that most angels cannot and venture capitalists are willing to take prudent risks on entrepreneurs long before their company has the documented track record that most banks require.

SCOPE OF VENTURE CAPITAL INVESTMENTS The National Venture Capital Association estimated that between 1970 and 2000, venture capitalists have created 7.6 million jobs and $1.3 trillion in company sales. They do this by filling a capital gap between companies that have successfully raised money on their own, from friends and family, and angel investors on the one hand, and banks, corporate bonds and public stock issues on the other. Figure 8.1 Average Size of Venture Capital Deals provides some indication as to the number of deals and average deal size3. The number of deals is somewhat related to the probability of any one company getting funding. Average deal size sets expectations as to the minimum amount of investment opportunity needed to attract a venture capitalist's attention.

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Figure 8.1 Average Venture Capital Deal Size (Dollars in Millions)

Year

Number of Deals

Total Invested

Average Deal Size

This table tells us two things. First venture capital deals tend to be much larger than angel deals, which rarely exceed $1 million. Second, the number venture capital deals and the amount of capital invested rises and falls with the economy. As the economy recovers, entrepreneurs should expect the number of deals and average deal size to rise beyond year 2000 levels. The lesson for the entrepreneur is that timing is critical.

THE STRUCTURE OF VENTURE CAPITAL FIRMS Venture capital funds are typically structured as a limited partnership in which the venture capitalist is the general partner and is responsible for management of the fund.4 The general partner usually puts up 1% of the value of the fund, and the limited partners provide 99%.5 Venture capitalists get most of their money from institutional investors such as life insurance companies, pension funds, and other institutions such as college endowments. See Figure 8.2 Sources of Venture Capital, below? Figure 8.2 Sources of Venture Capital Pension Funds Foundations/Endowments Banks/Insurance Companies Corporations All Other

Venture Capital

143

By raising funds from one group and investing them with another, venture capitalists act as financial intermediaries. However, they differ from financial intermediaries like banks or insurance companies in the degree to which they are involved in managing invested funds. Most venture capital firms specialize in a limited number of industries, or a limited number of stages company development. Some specialize geographically. Such specialization enables them to develop expertise in identifling investee companies with the potential for high growth. Industry or other specialization gives them the experience to mentor companies and maximize their performance. Venture capital firms invest an enormous amount of time monitoring investee performance. If events take a company off plan, or if a plan is fatally flawed, venture capitalists are usually able to spot these adverse conditions early and recommend or take corrective action. Venture capital limited partnerships have a fixed maturity, usually 10 years, with an option to extend for 3 years. The right to extend the life of the fund usually rests with the limited partners. At maturity, the fund is liquidated and all assets are paid out to investor^.^ This means an entrepreneur shouldn't think of venture capital as permanent financing in the same way that common stock is permanent financing. Entrepreneurs must understand that venture capitalists are strongly driven to exit an investment as soon as the value of their investment is maximized. This fact should be considered in every strategic plan, every strategic decision. Venture capitalists are paid 2% to 3% of invested assets plus 20% of the fund's profits. Limited partners get return of invested capital plus 80% of the venture fund's profits.8 The fees and profits a venture capitalist earns are not directly born by the entrepreneur in whose company capital is invested. The investee company pays for use of venture capital through preferred and common stock, preferred and common dividends, interest payments, and stock appreciation. The form, amount, and timing of the payment are subject to negotiation. See chapter 9 Structuring the Deal. The fees on invested capital and 20% share of profits are born by financial institutions that provide capital to the venture fund. A natural question might be: Why don't institutional investors deal with companies directly? There are three widely accepted reasons. First institutional investors lack expertise in specific industries and technologies, so it would be difficult for them to provide the level of scrutiny required to separate companies with potential from those that have none. Second, institutions manage huge sums of money. Arguably, it would be difficult for them to find hundreds or thousands of companies in which to invest. Each

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venture capital fund, on the other hand, can aggregate the capital demand of a few dozen to a few hundred companies. Finally, institutional investors don't have the time or staff for detailed oversight of the companies they invest in. Venture capitalists provide this expertise and oversight.

VENTURE FIRM OPERATIONS Typical venture firms are small partnerships with a professional staff of less than a dozen people including a couple of partners. In 1996, nearly three quarters of venture capital firms managed between $25 and $250 million. Each partner in a firm might receive 100 proposals per year, of which 90% are rejected after cursory review. Of those remaining, only one or two per year might be funded? One of the primary factors in deciding which companies to fund is the rate of return. A higher rate of return is required for seed and early stage companies because less information is available to judge performance and may be as high as 60%. Companies in a later stage, growth or expansion companies, have less risk and require less of a return on capital to meet threshold criteria.'' An entrepreneur should expect a Venture Capitalist to demand at least a 30% return on investment.

GENERAL CRITERIA FOR MAKING AN INVESTMENT It is difficult to generalize about the factors that are most important to a venture capitalist because different studies have come to different conclusions. Wright and Rubin analyzed the literature and found that MacMillian identified the entrepreneur's personality and experience as the most important factor in making an investment decision. Fried, determined that venture capitalists were more interested in market acceptance than in high returns and a quick exit. Both the MacMillian and Fried studies were focused primarily on early stage companies. Fired and Hisrich, surveying venture funds investing in companies in all stages of development found the most important screening criteria were the (i) integrity, leadership and track record of management, (ii) viability and novelty of the project, and (iii) the possibility of high returns and a smooth exit. Finally, Muzyka listed the top venture capitalists criteria as (i) a good management team, (ii) good market characteristics for the product or service, and (iii) a reasonable financial return."

Venture Capital

145

Take Away Lessons: I ) Screening criteria change over time, so the prudent thing to do is to meet or exceed as many criteria as possible, None of the siudies mentioned technology per se as the key 2) criteria. Rafher they spoke in terms of market acceptance and a good business model 3) The experience, integrity and personaliq of the entrepreneur and his management ream was a recurring theme.

OVERSIGHT Venture capitalists are unique as intermediaries because they act as consultants and provide an active governance role throughout the life of an investment. The scientist, engineer, or entrepreneur that "invents" a product may lack experience in strategic analysis, planning and goal setting, management, marketing, and production. His or her concept as to how the invention, idea or product should be marketed might be totally unrealistic.12 To drive a company to its full potential, venture capitalists invest a significant amount of time in corporate oversight. One study indicates that venture capitalists spend 7 to 36 hours per month with each portfolio company. They spend more time with seed stage and early stage companies and less time with more mature companies.'3 It wouldn't be unusual for a venture capitalist to visit a company 20 times a year and spend 110 hours in direct contact with a company's management, either in person or over the phone.14

* Take Away Lesson: VenIw e capital is inappropriate for !he entrepreneur who does nol like fo answer to others.

COSTS OF USING VENTURE CAPITAL Venture capital is generally the most expensive source of capital. Firms that seek venture capital usually can't finance themselves through bank or other debt because of their risk, and they have an insufficient track record

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to finance themselves through the public equity markets. Both of these situations can be seen as the result of severe information problems. Information problems go far beyond lack of financial statements and lack of financial history. They may also include information about technology, product development, market acceptance, the competition and experience of the entrepreneur and key managers.15 In short, the firms that seek venture capital are the ones that are unable to raise capital elsewhere. As the sources of funds for a firm are cut off, the remaining sources of capital are in a position to demand a greater and greater return. Lack of information means that venture capital firms will have to conduct extensive and expensive due diligence reviews to make sure they are taking prudent risks while weeding out companies with obvious flaws. The cost of due diligence must be recouped through their return on investment. Venture investments are usually for a period of years, meaning it may be a long time before investments can be realized. Therefore, the return must be sufficient to justify the wait. Finally, relatively few of the companies venture capitalists invest in will pay off with large returns. Many more will be become worthless so the return on winners must be able to cover the losses on the losers.

The Cost In Money The rate of return a venture capitalist needs to justify an investment usually depends on the stage of company development. While there are no uniformly accepted definitions for stages of development the ones most commonly used are those defined by PricewaterhouseCoopers in their MoneyTreeTMreports. These stages are: (i) SeedIStart-Up, (ii) Early Stage, (iii) Expansion, and (iv) Later Stage. The earlier the stage of development, the higher the required rate of return because there is much less information about seedlearly stage companies, their products and management and much more information about expansion or later stage companies. A study by the Federal Reserve found that the required rate of return for seed and early stage companies was as high as 60%.16 However, a study by Elango, Fried, Hisrich and Polochek found the required return of seedlstart-up companies averaged 42.2% whereas the required return for later stage companies was only 33.5%; this is less of a spread than other researchers have found." In informal discussions with venture capitalist they talk about the goal of getting five times invested capital in five years, which is about 38% a year on a compound basis.

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147

There are a number of lessons in these figures. First, expect to pay much more for venture capital than for bank capital, at least 30%. Second, different venture firms have different return expectations. Third, some of the return expectations may be based on a "what the market will bear," view. If a venture capitalist asks for a 40% return and the entrepreneur is in no position to object, that's what the venture capitalist will get. Finally, returns are based on a number of factors: the amount of money invested, the payoff at exit and any payments, whether in the form of dividends or interest before the exit. In Chapter 9, Structuring The Deal, we will discuss these factors and provide formulae to compute yield. It may be that the venture capitalist is asking for a lot because he or she does not understand the yield the entrepreneur is offering.

"Take Away Lesson: A five times return in fwe years means a venture cayitalisr investing $1 ndfion now will want $5 r~ziflionin 5 years. H o ~ m wa- venture capitalist who demands a 60% latzrrn will put up $ I rniNion now for about $10.5 million in jyears. An enfrepreneur who uses ventwe capiral should plan lo work at a dead run until the venture capitalist exits.

Securities Held By Venture Capitalists Venture capitalist usually request convertible preferred stock.I8 Preferred stock pays dividends, at a stated percentage of the face value of the stock. For example: If a share of preferred stock has a face value of $1,000, and a stated dividend of 6%, then the company will pay the shareholder $60 per share ($1,000 x 6%). Preferred dividends must be paid before dividends are paid on common stock. This puts the venture capitalist ahead of the owner 1 entrepreneur who usually takes common stock. With Cumulative Preferred Stock, if there are not enough earnings to pay the preferred shareholders a dividend in a particular year, preferred shareholders' dividends have the first claim on the profit earned in subsequent years. With Non-cumulative Preferred Stock, if a company has insufficient profits to pay the preferred dividend in any given year, those dividends are lost forever. Whether a preferred stock is cumulative or non-cumulative is an issue for negotiation. In

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the worst-case scenario, in which the company must be liquidated, holders of preferred stock are paid before holders of common stock. While the venture capitalist wants to be protected from adverse events, they also want to participate in a firm's upside potential. A convertibility feature helps them do that by allowing them to convert preferred stock to common stock in a stated ratio. Suppose a venture capitalist purchased a number of $1,000 shares of 6% preferred stock, convertible to common stock at a ratio of 500 to 1. If the company went public and its shares traded for $20 per common share, the venture capitalist could convert his $1,000 preferred stock to 500 common shares, and at a market value of $20 each, he or she could sell them for $10,000, ten times his or her investment. This convertibility feature helps align the interests of both the entrepreneur and the venture capitalist in high stock values. This potential payoff also serves to prevent the venture capitalist from cutting and running too soon if the company hits a bumpy patch. As an alternative to preferred stock, a venture capitalist may want to structure the deal as convertible bonds. The advantages of convertible bonds are (i) interest on bonds is paid before preferred dividends or other dividends, which is important if the company issued preferred stock in prior rounds, (ii) in liquidation, bond holders are paid before those holding common equity or preferred stock, (iii) interest paid on bonds is tax deductible, which is important when the company becomes profitable because tax deductibility reduces the cash necessary to pay interest, and (iv) bonds usually have a maturity date. This maturity date provides a date certain on which a venture capitalist can exit the investment. Convertible bonds can be converted into common stock in the same way that preferred shares are converted.

The Cost in Control To a venture capitalist, managing an investment in a start up or early stage company can seem like riding a bucking bronco. In addition to market and technology risk, challenges from competitors and a management team that may lack experience, the venture capitalist must deal with the ego of the entrepreneurlowner. Managerial incompetence is cited by venture capitalists as the number one reason companies fail, ranking far above technological problems. Other major problems are the inability to identify the right client, and inappropriate market strategies.19

Venture Capital

Levers of Control To control these risks, venture capitalists usually negotiate for a series of rights in the investment agreement. One of the most important is a seat on the board of directors. A seat on the board provides access to "inside" information, information that banks, bondholders and shareholders rarely see. Once on the board, they can observe management and its decision making process at close range. Do entrepreneurs fly by the seat of their pants? Is all relevant information discussed? Is bad news given short shrift? Is management decisive? Or do they dither when time is at a premium? As a board member, they can participate in the decision making process, raising issues, consequences and alternatives the entrepreneur may not have though of. Finally, a board seat puts them in a stronger position to remove some or all of management if that becomes necessary. The investment agreement may also provide the venture capitalist with rights to approve certain decisions, for example to change or limit the compensation of corporate officers, prevent sale of some or all of a company's assets or technology, approve the budget, prevent the company from incurring additional debt, or approve any merger or acquisition. The scope of a venture capitalist's powers is negotiated as part of the investment agreement, which is sometimes called the stock purchase agreement. The specifics of this agreement will be discussed in more detail in chapter 9 Structuring the Deal. As a general rule, venture capitalists don't exercise their more draconian powers unless a company fails to meet its agreed milestones. From the Venture capitalist's point of view, his or her interventions are a means of managing the risk that the company won't meet long run performance objectives.

Staged Financing Rather than give an owner 1 entrepreneur all the funds he or she needs at once, investments are staged, with incremental funding based on meeting milestones. For example, a venture capitalist might provide enough funds to build a prototype device and demonstrate the technical feasibility of a product. If the prototype works as expected and other milestones are met, the venture capitalist will fund the next phase of product's introduction like construction of a pilot plant or market tests.20

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Failure to Meet Objectives

Venture capitalists have high return expectations. But what if it becomes clear those expectations won't be met? If performance objectives are not met, the Venture Capitalist will ask themselves several questions. Should they:21

9

Reconsider the firm's strategy?

9

Replace management?

9

Cut off future funding?

If the venture capitalist provides further funds after milestones are missed, he or she is likely to demand a greater share of equity in return. This has the effect of decreasing the entrepreneur's ultimate payoff and influence, and increasing the influence of the venture capitalist.22 Penalties for failing to meet performance goals provide the venture capitalist with the power to influence the firm's direction. It also provides entrepreneurs with a strong incentive to meet goals.23

" Take Away Lessons: I ) An entrepreneur should not over commit to rniJestones just because that is what he or she thinks the venture capitalist wants to hear. 2) Use venture capital with afull understanding that failure may mean loss of control of your business.

VALUATION Venture capitalists are concerned with valuation at three points in time. The first point is when making the initial investment because he or she does not want to overpay for an equity position in a company. Overpayment could destroy his or her return on investment. For example, if a venture capitalist pays $3 million for an investment in a firm and he or she gets $5 million on exit four years later, the return on investment would be 13.6%. If

Venture Capital

151

$2 million were invested and $5 million were received four years later, the return would be 25.7%24 Second, venture capitalists are concerned with a company's valuation on exit because they want to maximize their return. It they overestimate exit value, no one will want to buy them out. If they underestimate exit value, they will leave unharvested money on the table. Finally, venture capitalists are concerned with valuations of portfolio companies as well as their performance in ongoing reports to the institutions that provide their funds. Ongoing evaluations affect the flexibility of venture capitalists to invest in future rounds of a portfolio company. Valuation is not a simple task and is based on subtle judgments about a large number of variables. However, there are some objective guideposts that can help frame valuations. The value of a publicly traded company is easy to find. It is the number of shares outstanding times the market price of a single share. But what is the value of the privately held companies in a venture capitalist's portfolio? Without a market, it is hard to determine. There are valuation models based on things like revenue, net income, and cash flow. However, each of these rests on somewhat subjective factors. For example: the price earnings ratio for airline stocks might be 3:1, and for software companies might be 25: 1. But what industry PE ratio should be used for a company that only makes software for the airline industry? Not all companies go public. Many are acquired by larger companies. Such acquisitions provide another basis for evaluating a portfolio company. But, sales of companies comparable to those in portfolios are relatively rare. While a private sale of a company provides some measurement data, taking a company public usually puts a premium value on the company. An IPO is therefore, both the gold standard against which to measure a venture fund's performance, and is often the process for creating the maximum wealth for the venture capitalist and his or her limited partners. Each of the valuation issue faced by the venture capitalist has implications for the entrepreneur. At initial investment, the entrepreneur wants to value his or her company as high as possible so he or she gives up the minimum equity to obtain needed funds. On the other hand, if an entrepreneur places an unrealistically high value on his or her company, no one will invest. Proper valuation at the venture capitalist's exit is important to the entrepreneur because it sets a value on their share of the enterprise. Obviously, entrepreneurs want to maximize that value, because, in the case of a sale, it may be their only chance to get a payoff for the years spent building

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his or her company. However, if the valuation is set too high, no one will buy and there will be no payday. Intermediate valuations are more a problem of the venture capitalist than of the entrepreneur except to the extent that (i) it limits a venture capitalist flexibility in funding future rounds, or (ii) it influences the venture capitalist's decisions regarding continuation of staged funding, removal of management or abandonment of the portfolio company.

EXIT STRATEGIES How do venture capitalists get their invested funds out of a portfolio company? Venture capitalists think about this before returning an entrepreneur's first phone call. The exit strategy along with exit value can reasonably be thought of as the key drivers of venture capital actions. Why? Venture funds have a limited life. At the end of that life, they must dispose of portfolio assets and disburse limited partners' capital and profits.

Exit Preference Not every company can use every exit strategy. Some strategies are dependent on size, others on stage of development, industry, or even regulation. For example, a defense company generally can't sell to a foreign corporation for security reasons and a television station can't sell to a network that already owns the maximum legal limit of stations. Some large companies can't sell to larger companies in their industry without FTC approval and that approval will not be forthcoming if the merged company has the characteristics of a monopoly. An entrepreneur's optimum exit strategy and an investor's might not be the same. An investor might want to sell a company outright, whereas an entrepreneur might only want to sell an interest in the company but retain his or her controlling interest. Assume for a moment that both the investors and the entrepreneur agree to exit in the way that maximizes company value. As a general rule their preferred exit strategy in descending order will be:25

P

Initial Public Offering - Going public provides a premium on the investment and liquidity to investors because shares can be easily resold.

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153

Sale to a publicly traded company. The premium a publicly traded company will pay is a function of its strategic objectives. It is more likely to pay a premium if its objective is to (i) consolidate an industry and it believes that by dominating the market, it can control price, (ii) increase efficiency through economies of scale, or (iii) achieve a critical mass, some studies have shown that the market puts a premium of about 10% on companies above a critical size. Publicly traded companies are probably going to buy through an exchange of stock. The publicly traded stock will provide investors with liquidity and such sales are generally tax deferred transactions. Sale to a privately held company. The premium a privately held company will pay is a function if its strategy, but a more important consideration is how they will pay. A venture capitalist will decline an offer of stock because share of non-public companies aren't easily traded. Cash is acceptable to the venture capitalist, but will trigger tax liability on the gain on sale for the entrepreneur. Sale to a buy-out specialist. This may be another venture capital company, private equity firm, a leveraged buy-out company or a company that specializes in distressed properties. Such buy-out specialists are interested in solid companies that have run into difficulty and can be acquired at a discount. Sale to management. At the time the fund shuts down, there may be no corporate buyers. An alternative exit strategy would be for the venture capitalists to help management structure a leveraged buyout where financing comes from an external source. Investment bankers and companies that specialize in leveraged buy-outs may assist in this transaction. Discontinue and write off the investment. Some companies will never become viable, i.e. generating enough cash to cover operations. The question becomes whether the venture capitalist should continue supplying funds. Their decision will be based on the payoff for future invested funds, not how much money has been invested to date. Past investments are sunk costs and are not considered in the analysis. If the fund is winding up operations, additional funding may not be a viable option. Discontinuation of support, which often leads to the bankruptcy of a portfolio company is not uncommon.

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The best-case scenario is that one of three companies will pay off 20: 1 and two of three companies will become w ~ r t h l e s s . ~ ~

Likelihood of Exiting Via Initial Public Offering The likelihood of exiting via IPO is dependent on a number of factors including the size, industry, and the track record of the portfolio company. Important external factors include the state of the economy and the market for IPOs. Figure 8.2, Analysis of Venture Capital Exits via IPO was based on statistics collected by the National Venture Capital Association. Figure 8.2 Analysis of Venture Capital Exits via IPO

Q1

Total

Exits via

Year

Exits

Ipo

2000 200 1 2002

530 361 64

230 37 4

Percent of Exits via IPO 43.4% 10.3% 6.3%

This figure shows that exiting via IPO was a highly favored option when the economy peaked during the dot.com, take-anything-you-can-public stock market boom. However, when the dot.com bubble and wide spread corporate corruption was revealed at some of the countries fastest growing companies, the ability to exit via IPO dropped from 43.4% to 6.3% in the first quarter of 2002.~" These data are interesting because they provide perspective on how realistic it is to expect to take a company public. Only 43% of venture firms exited their investment via IPO under the best possible market conditions. Yet even in the worst circumstances, a few companies were still able to use this exit strategy.

* Toke Away Lesson: Manage yozrr bzrsiness and cash flow so that you are not forced into an exit by your Venture Capifalisfunder adverse conditions.

Venture Capital

Likelihood of Exiting via IPO for a Particular Company The fact that an IPO is the favored exit strategy of venture capitalists raises several questions. For example:

9

Will the company ever be big enough to justify an IPO? Except during the dot com bubble, many underwriters suggested that $100 million in revenue was a threshold for taking a company public.

9

Is the company growing fast enough to attract the attention of investors? Revenue growth of 15% to 20% per year might not be enough for a successful public offering. In 1998, the average revenue growth rate of non-financial firms that went public was 25.5%.

9

Is the technology sustainable? Changing technology, customs, trends, regulations, etc. might make prior growth rates unsustainable. The market will evaluate the potential for future rapid growth and that evaluation may make an IPO difficult.

9

Is the entrepreneur / owner / CEO that grew the company to the stage wherein it could be taken pubic, the right person to grow a public company. The skills needed to run a private company and those needed to run a public one are different and can impact valuation.

* Take Away Lessons: I ) Understand that the Venture Capitalist'u job is to exit the

investment, with all the uncertainry that that entails for the owner/entrepreneur, including the possibility that the company will be sold. 2) If the IPO end garne does not fit a company's goals, strategies and personalities, then perhaps venture capital isn't a wise choice.

VENTURE CAPITAL SEARCH Don't settle for the venture capitalist that is available. Target a venture capitalist that can add the maximum value to the enterprise.

Raising Capital

What a Venture Capitalist Can Bring in Addition to Capital Venture capitalists can:

9 9 9

9 9 9

provide introductions to other investors who may be called upon to participate in the current or future rounds of funding. provide contacts and introductions to customers, clients and suppliers. help recruit the appropriate individuals for a company's management team and they can help identi@ non-performing or under performing managers. provide guidance on product development, packaging and channels of distribution. help an entrepreneur connect to seasoned advisers such as outside accountants and lawyers. provide intensive coaching and mentoring to an entrepreneur helping them think through strategic alternatives that can make or break a company.

The challenge for the entrepreneur is how to find a venture capitalist that can bring the right skill set to the company and not just the best deal.

Selecting the Right Venture Capitalist A first level screening can be performed in the library or on the web. Unlike Angel investors who must be identified through networking and a variety of formal and informal organizations, venture capitalists are listed in a number of commercially directories organized by industry and location. A web based source of information on venture firms is the PriceWaterhouseCoopers MoneyTree TM reports which can be found at www.pwcmoneytree.com. Geography is important because many, but not all, venture capitalists prefer to invest close to home. This preference makes perfect sense if a venture capitalist is going to invest a hundred hours a month working with an investee company and not everything can be done through phone, fax or email. Sometimes venture capitalists want to walk around a company's facility, talk to people and sniff for problems that do not appear in progress reports. Sometimes venture capitalists have to confront entrepreneurs with

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hard truths that company employees are reluctant to share. Such issues are better discussed in person. So the general rule for most companies is to look for venture capital close to home.28 Venture capitalists have other preferences that must be considered as well. For example, some, but not many, favor seed and early stage investments where relatively small investments can grow into large rewards. Others favor expansion stage investments, leveraged buyouts (LBOs), or management buy outs (MBOs). Pitching an early stage investment to a firm that specializes in leveraged buyouts is as pointless as pitching a furniture company to a firm that specializes in communications. Another preference is for deal size. Some small firms are only willing to risk a limited amount of capital on each investment. On the other hand, large venture capital firms don't want to be bothered with investments below a threshold size. Most of the directories mentioned above provide venture firms' preferences in these and other areas. To close the deal, there must be a good fit between the company seeking funds and the venture capital firm it is pitching to.

Contacting Venture Firms A few accept cold proposals, that are proposals from people they don't know, most do not. Venture firms get so many proposals it is difficult to find time to give each of them a minimal level of scrutiny. That is why it is important to find your way to a venture firm through networking or a source the firm trusts. The question becomes how an entrepreneur can put themselves and their proposal in front of a venture capitalist in such a way that it will receive serious consideration. One study indicated that few entrepreneurs sought advice on how to find venture capital until late in the process. However, those that sought advice early, were much more successful than average at closing a financing deal. On the other hand, those that relied on bankers or public agencies for connections were less successful than those who sought no advice.29 Advisors that are highly effective include lawyers, accountants, board members, other entrepreneurs, and angel investors. Arguably, advisors who are willing to introduce an entrepreneur to a venture capitalist have a level of confidence in the entrepreneur's drive and integrity or they wouldn't provide the introduction. Angel investors who have invested in your company carry the most weight because they have already vetted your idea and have put their own funds at risk. Action and commitment go a long way with venture capitalists.

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Another place to look for venture capitalists is at venture fairs. While these are in some sense cattle calls where large numbers of entrepreneurs make presentations one after another, the potential deal density makes them attractive to venture capitalists. The better venture fairs, like the Greater Philadelphia Venture Group (GPVG), limits participants to entrepreneurs who have a well thought out business strategy. The fact that GPVG lets you present tells venture capitalists there is enough merit to your idea to give it at least a cursory review. The Greater Philadelphia Venture Group can be contacted through their website: www.gpvg.com. An emerging trend in finding venture capital is use of "venture catalysts" individuals and companies that work with entrepreneurs to refine their business model, recruit people for their advisory board, and coach them on their presentation. Venture catalysts request a retainer fee and a substantial number of shares in return for their introductions. The ordinary entrepreneur is often out of his or her depth in the highly driven, take-noprisoners world of venture capital. The benefit of venture catalysts is that they provide a road map and help entrepreneurs avoid problems. The drawbacks are that not everyone is convinced of the substance behind venture catalysts because an entrepreneur can hand over precious cash as a retainer fee plus a piece of their company with no guarantee of success. So while venture catalysts might be useful to some, caution is advised. Finally, if a company has an unworkable business model, poor products or an entrepreneur without the requisite drive and intelligence to make a company work, no amount of venture catalyst help is going to convince a venture capitalist to invest.30 Lists of venture capitalists are included in Pratt's Guide to Venture Capital Sources, available in most libraries, the National Venture Capital Association website: www.nvca.com and PricewaterhouseCoopers ~ o n e ~ ~Survey r e eat~www.pwcmoneytree.com. ~

SUMMARY Venture capitalists play an important role in the economy and in helping entrepreneurs grow their companies. Many seed, start-up and early stage companies don't have enough of a track record to attract debt capital from banks, or investments from the general public. Other problems may include undemonstrated market acceptance of the product or service and unproven management. Venture capitalists believe they have the skills necessary to compensate for this lack of information through a highly detailed screening process that rejects about 99 of every 100 deals they evaluate.

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The one percent of deals that venture capitalists accept meet a number of criteria including location, industry, stage of development, deal of size, novelty of product or service, management experience and the entrepreneur's personality. Venture capitalists expect much higher rates of return than banks or most other sources of capital. Generally target rates of return are above 30% and may range up to 60%. The earlier the stage of development the higher the yield demanded because early stage companies tend to be riskier than later stage companies. The primary factors determining yield to the venture capitalist are: (i) the amount of invested capital, (ii) the payoff on exiting the investment, and (iii) any dividends or interest the venture capitalist receives during the time they hold the investment. The payoff at the exit is affected by the type of exit. Initial public offerings (IPOs) place a premium on company value and are therefore the preferred exit strategy. Whether or not this route is feasible for a particular company will depend on factors such as size and the performance of other IPOs in the stock market. In recent years, exit via IPO has ranged from a high of 43% to a low of about 6%. Other exit strategies include sale to a larger public or private company, leveraged buyout, sale to other investors, or a management buyout. Sometimes companies fail to thrive and venture capitalists abandon their investment. While venture capital can be right for a company under certain circumstances, it is not right for every one. Venture capitalists will demand terms that severely limit an entrepreneur's flexibility. They demand a seat on the board of directors and agreed targets that, if unmet, could result in the entrepreneur's removal as president and chief operating officer.

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DISCUSSION QUESTIONS How is a venture capitalist different from an angel investor? What is the risk / reward profile of a venture capitalist? How does it fit within the spectrum of capital sources? How are venture capital firms organized? Where does their capital come from? How does a venture capital firm get paid? How are profits split with its investors? What does a venture capitalist provide in addition to capital? How do venture capitalists generally structure their investments in portfolio companies? What types of securities do they want? Why? What types of controls do venture capitalists use to minimize risk? What can be the adverse consequences of such controls for the entrepreneur? What are the circumstances under which a venture capitalist be concerned with company valuation? Why? What are the implications for the entrepreneur? What is meant by an exit strategy? List six exit strategies that a venture capitalist might use. Rank and discuss them. What are some of the issues an entrepreneur should consider when deciding whether an exit via IPO is appropriate? Why is it important for an entrepreneur to identi9 the right venture capitalist for his or her firm versus the venture capitalist who offers the best deal? What are some of the factors to consider in choosing the right venture capitalist? What are the steps in finding a venture capitalist and closing a deal?

Venture Capital

ENDNOTES Mike Wright and Ken Robbie. "Venture Capital and Private Equity: A Review and Synthesis," Journal of Business Finance & Accounting, JuneIJuly 1998 pp.560.561. Wright and Robbie. pp.53 1-533. "Latest Industry Statistics," National Credit Venture Association website: ~.nvca.org/ffax.html William A. Sahlman. "The Structure and Governance of Venture Capital Organizations," Journal of Financial Economics, (1990) pp.473-521. Mitchell Berlin. "That Thing Venture Capitalists Do," Business Review, JanuaryIFebruary 1998, pub. by Federal Reserve Bank of Philadelphia, p. 18 Berlin. p. 19 Berlin. p. 18 8 Berlin p. 18 Berlin. pp.17-19 lo Berlin. p. 19 l 1 Wright and Robbie. pp.538-539. l2 Several years ago, I consulted to an Internet start-up that developed a technique for projecting high bandwidth video over dial up lines as a distance-learning vehicle. Their plan was to start a college so they could use their invention. My suggestion was to bypass all the regulatory, accreditation, faculty and student recruiting problems of starting a college and simply sell the technology to existing colleges trying to break into distance learning. Inventor entrepreneurs don't necessarily understand business. l3 B. Elango, Vance H. Fried, Robert D. Hisrich and Amy Polochek, "How Venture Capital Firms Differ," Journal of Business Venturing, Vol. 10 1995, p165. l4 Berlin. p.20. Daniel Covitz and Nellie Liang, "Recent Developments in the Private Equity Market and the Role of Preferred Returns," Division of Research and Statistics, Board of Governers of the Federal Reserve System, Washington, D.C. 2055 1, Draft of Jan. 2002, p. 1 l6 Berlin. pp. 17-19 l7 Elango. p.167. l 8 Berlin p.21 l9 Berlin, p.22 20 Berlin p.20. Berlin, p20. 22 Berlin, p20-2 1. 23 Berlin, p.2 1 24 Compound annual yield on an investment where a sum is invested one time, and there is one payout can be derived from the Future Value formula: FV = PV * (1 + i)" where FV, future value is the payout on exiting the investment, PV, present value, is the amount invested, i is the yield, and n is the number of years between investment and exit. This equation can be rewritten as (FVIPV) = (1 + i)" . Taking the nth root of each side and subtracting 1 gives the formula: (FV / PV) ('I") - 1 = i.

'

''

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John Culbertson, Jr., partner Gamma Investors, from his speech to the Rutgers University MBA course Raising Capital, 1/8/2002. 26 Culbertson, 1/8/2002 " Laurie Heller. "Liquidity Options Remain Limited for Venture Capitalists," Venture Economics, republished on the National Venture Capital Association web site www.nvca.org/nvca05~13~02.html downloaded 5/29/2002. 28 The exception to this rule involves venture capitalists who invest nationally. These investments tend to be large in size, justifjring the cost of travel and remote monitoring, tend to be in late stage, expansion stage or levered buyouts where a company's financial model is established, product acceptance is given and close monitoring not required. Venture capitalists in New York, Chicago and Los Angeles are more likely to invest nationally simply because they are centers of commerce, finance and accumulated capital. 29 Wright and Robbie. p.529 30 Nick Wingfield, "'Venture Catalysts' Help Start-ups Start --- Guides Bring Expertise, Contacts, Peace of Mind," Wall Street Journal, Feb.26, 1999. p.B5A.

Chapter 9

STRUCTURING THE DEAL

INTRODUCTION Some investors want to get everything, and give nothing. Some owner-entrepreneurs want to take everything and give nothing. Sometimes owners, and to a lesser extent investors are naive about the terms, conditions and fate of transactions made in good faith. Where the entrepreneur may believe "we are all in this together," investors are strictly motivated by return on investment. These differing points of view may contribute to a deal in which the investor demands and gets extraordinary concessions. This chapter explores private investment deal structure; the variables that influence the bargaining position and relative strengths of the parties; the life cycle of a deal; the Term or Deal Sheet which is an investor's opening offer; ways to value a company and the investor's payoff. Venture capitalists are focused on high value exit strategies as are other sophisticated investors. Therefore, it is likely they will reserve the right to force an exit in the investment agreement. This chapter also discusses terms that investors might use to acquire control over the company and limit entrepreneurs' control. The more an entrepreneur knows about venture capital, the stronger his or her bargaining power. The same could be said when dealing with family, friends, angel investors, Small Business Investment Corporations and others. If the entrepreneur knows what to expect, he or she will have

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considerably more bargaining power than someone who merely focuses on the amount an investor is willing to invest.

Variables That Affect Deal Structure Deal structure is driven by five sets of variables. By understanding them, the entrepreneur can shape the terms of the deal. These include: (i)

The relative needs and or bargaining power of the parties.

(ii)

How payoff expectations are driven by alternative deals and the deal environment.

(iii)

Investor risk minimization

(iv)

Exit strategy, and

(v)

The relative sophistication of the parties.

Term Sheet or Deal Sheet The Term Sheet or Deal Sheet provides the highlights of what the investor wants and is a starting point for negotiations. It probably won't appear until the investor is fairly certain they want to invest. That means that an ownerlentrepreneur will have had to pitch the investor and provide them with a summary business plan. It also means the investor has done some level of due diligence. At that point, the investor is interested in maximizing the return and minimizing the risk on the funds they plan to commit. An investor may reserve the right to perform much more thorough due diligence once the deal terms are agreed. If the thorough due diligence is satisfactory, then the actual investment documents will be drawn and executed. A sample deal or term sheet is available from the National Venture Capital Association at their website: www.nvca.org/model~documents/model~docs.html.

Structuring the Deal

INVESTMENT AGREEMENT The investment agreement, sometimes called the stock purchase agreement, sets forth the terms and conditions under which the investors will invest, the amount invested, the percentage of ownership and shares of stock the investors will receive, convertibility provisions, dividends or interest payable, the rights of the investor and the obligations of the entrepreneur. There will be one investor agreement per financing round. A sample investor agreement is available at the National Venture Capital Association website: www.ncva.orr,rJmodeldocuments/modeldocs.htm1. The Small Business Administration's ACE-NET has a model stock purchase agreement available at: acenet.csusb.edu/inv/termcond.html. Neither the National Venture Capital Association's investment agreement nor the ACE-NET model agreement is a final document, rather they are starting points for negotiation and provide the entrepreneur with information on the reasonable range of demands he or she might face during negotiations. The parties generally retain legal counsel to make sure the expectations of the parties are embodied in legally cognizable language. One attorney has estimated it costs between a few thousand and about $30,000 for private placement legal costs, depending on the complexity of the deal. These fees include completing securities law filings. 1 Legal fees for private placements are paid for by the company, even though the company may pay for legal fees with investors' money. The significance of shifting the fee burden to the company is so that the investor's entire contribution goes toward purchase of securities, and nothing is consumed as transaction costs.

VALUING THE COMPANY Valuing the company is always the first issue to be addressed if an investor finds the company an interesting prospect. If a company is worth $50,000 and an investor puts up $25,000, they reasonably expect to own half the company. If a company is worth $2,500,000 and an investor contributes $25,000, the owner may expect to give up only one percent of their equity. Investors are wary of owner's inflated assessment of firm value and look for some rational basis for valuation. In discussing valuation, it is important to make sure everyone understands the valuation date in play. A company's valuation at the time it seeks investors will be small compared to the time of exit. No investor is

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going to pay exit valuation years before a company has proven itself or grown to warrant such valuation.

EBITDA Multiplier Method EBITDA is Earnings Before Interest Taxes Depreciation and Amortization. It is used to estimate the amount of cash generated by operations independent of its financing or tax strategy. For a profitable company, a value can be estimated by benchmarking the ratio of market value to EBIDTA. Equation 9.1 gives the formula for finding the EBITDA multiplier.2 EBITDA Multiplier

= C Benchmark Company Market Value

Eq 9.1

C Benchmark Company EBITDA

To compute the multiplier, a company would: Identify its top ten competitors among publicly traded companies, Download the latest Form 10-K for each benchmark company from the Securities and Exchange Commission (SEC) w e b ~ i t e . A ~ Form 10-K contains a company's annual financial statement and management's discussion of operations. Compute each benchmark company's EBITDA. On the Income Statement find the earnings before interest and taxes, then add back depreciation and amortization which can be found on the Statement of Cash Flows. Find the number of shares outstanding in the reconciliation of shareholder's equity following the Income Statement. Find the price of shares in the Wall Street Journal or some other reputable source. Multiply shares outstanding by the market price per share to find the market value of the company as a whole. Sum the EBITDAs of the benchmark companies.

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(ix)

Sum the market values of the benchmark companies

(x)

Divide the sum of the market values by the sum of the EBITDA to get the ratio of market value to EBITDA.

Figure 9-1 is a Sample EBITDA Multiplier Calculation. It shows how to set up data in a tabular format for ease of computation. Figure 9-1 Sample EBITDA Multiplier Calculation (Dollar values in millions except share price) Shares Price Per Market Company EBITDA Outstanding Share Value Green Mountain $20.0 10,000,000 $1 1.OO $1 10.0 Enerex 190.0 13,333,333 60.00 800.0 Davo Corp. 35.1 6,000,000 25.00 150.0 Solaris 75.0 7,500,000 40.00 300.0 Ultimate E! 14.5 7,500,000 8.00 60.0 Totals $334.6 $1,420.0

EBITDA Multiplier

=

Market Value / EBITDA

With the EBITDA Multiplier the value of a company can be estimated using equation Eq. 9.2. Company Value

= EBITDA x EBITDA Multiplier

Eq 9.2.

For a company with an EBITDA of $2,000,000, the value would be:

This method is useful for companies that are going concerns, but is not much help to early stage companies.4

Raising Capital

Revenue Multiplier Method Companies can generate revenue at a time when they still have minimal or negative cash flow. The revenue valuation method is based on a ratio of the market value to revenue for comparable companies. Equation Eq. 9.3 is the formula for computing the Revenue Multiplier. Revenue Multiplier

= C Benchmark Company Market Value

Eq. 9.3

C Benchmark Company Revenue

Data for benchmark companies are gathered obtained from the SEC and processed in much the same way as for the EBITDA Multiplier Method with revenue used in the place of EBITDA. A sample calculation for the Revenue Multiplier is shown in Figure 9-2. Figure 9-2 Sample Calculations for the Revenue Multiplier [dollar values in millions except share price] Shares Price per Market. Company Revenue Outstanding Share Value Green Mountain $125.0 10,000,000 $1 1.OO $1 10.0 Enerex 950.0 13,333,333 60.00 800.0 Davo Corp. 150.0 6,000,000 25.00 150.0 Solaris 400.0 7,500,000 40.00 300.0 Ultimate E! 100.0 7,500,000 8.00 60.0 Totals $1,725 .O $1,420.0

Revenue Multiplier

= $1.420.0

$1,725.O

Equation Eq.9.4 can be used to estimate the value of a company using the Revenue Multiplier Method. Company Value

= Company x Revenue Multiplier

Eq. 9.4

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Suppose a company had sales of $11,000,000. What would its value be for an industry with a Revenue Multiplier of 0.82? Company Value = $1 1,000,000 x 0.82

Both of these methods are fairly straightforward comparisons to publicly traded companies. However, Angel Investors and Venture Capitalists are not investing in a publicly traded company. By definition, they are investing in a private company. Public companies sell at a 20% to 30% premium over comparable private companies because shares in public companies are more liquid. That is fractional shares can be bought and sold without legal restriction. Equation Eq.9.5 shows how to discount a valuation based on public company comparables to a private company value. Private Company Value = Comvanv Value Based on Public Comvarables Eq.9.5 1 + Public Company Premium Suppose a company were valued at $8,750,000 based on comparable publicly traded companies and that public companies trade at a 25% premium to non-public companies. Such a company's private value could be estimated using equation Eq.9.5. Private Company Value = $8,750,000 1 + 25%

Discounted Cash Flow Another method of valuing a company is to compute its discounted cash flow for five to ten years. This methodology involves forecasting revenue and expenses for the relevant period and then discounting the related cash flows back to the present. Discounted cash flow is the theoretically correct method of valuing a company because cash provides the motive power to acquire resources, hire the best people, bring new products to market, out advertise and outsell competitors. For a pre-revenue company this might be one of the few ways of estimating a value.

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Investors will be skeptical of any entrepreneur who tries to place a value on a company before its products or services have been tested in the marketplace. However, by basing revenue and expense estimates on information discussed in chapter 6, the credibility of the estimate will rise. A company's value will be the present value of its cash flows during its period of rapid growth plus the present value of its value when its growth rate becomes steady. Equation Eq.9.6 provides a means of computing the value of a company when it reaches its steady growth stage. Steady Growth Value

=

CF Kr- g

Where: CF is the cash flow for the year prior to steady growth, Kr is the rate of return required by the investor and g is the steady state cash flow growth rate. Suppose an entrepreneur forecasts the cash flows of $100,000, $200,000, $300,000, $400,000 and $500,000 for years one through five. Starting in year six, the entrepreneur estimates cash flow will increase by 15% per year into the foreseeable future. Suppose the investor's required rate of return is 40%. Discounting the cash flows generated in years one to five plus the steady growth value back to the present gives the discounted cash flow value for the company. Equation Eq.9.7 gives the formula for computing present value.

Where: FV - is the future value to be discounted, Kr is the discount rate, and is the number of periods the future value must be discounted. nApplying Eq.9.6 and Eq.9.7 to the facts of this example we get: Company Value = $100,0001 (1+ 40%) + $200,0001 (l+40%)

Structuring the Deal

While calculators and spreadsheets can compute the discounted cash flow value of a company to the penny, it is important to recognize that this and other valuation methods are only estimates. For example, the discounted cash flow method is built on estimates of future revenues and expenses which won't be know with precision until after revenue is earned and expenses incurred. In this example, the best we can say is the discounted cash flow is about $2,480,000. The traditional definition of cash flow is net income plus depreciation. However, this formulation has been criticized as overstating a company's ability to generate cash because it doesn't take into consideration cash used for capital expenditures, dividends as well as changes in accounts receivable and inventory.

Similar Companies Comparison to comparable early stage companies provides another way for owners and investors to value a company. For companies that have gone public, one approach might be to find their value at the date of the IPO and then discount that back to the first year in which they had sales to get a relationship between sales and market value. If the company being valued is pre-revenue, an estimate will have to be made as to how long it will take for it to have revenue and how much first year revenue might be. Example: Acme, a maker of high end furniture, had first year revenue of $1,500,000 and went public six years later with revenue of $30,000,000. At the time they went public, their market value was $20,000,000. Baker is a company started to make expensive, high style furniture. They have no revenue as of yet. They are still in the product development phase. They believe it will take them one year to finalize the design of furniture, subcontract out production, and sign up ten of the right sort of furniture stores to sell their products. In their first year, they expect revenue to be $600,000. They believe they can grow as rapidly as Acme. What is their present value? The first step is to find out how rapidly Acme's sales have grown. Compound annual growth rate can be calculated by modifying the future value equation 9.8 to get a formula that gives growth rate directly.

Raising Capital

Eq. 9.8 Where: FV - is the future value, PV - is the present value, is the growth rate and gnis the number of periods the value is allowed to grow. Dividing both sides by PV, then taking the nth root of each side and subtracting 1 gives the growth rate, g. Dividing both sides of this equation by PV gives equation Eq.9.9

Taking the nth root of both sides of the equation gives equation Eq.9.10.

Subtracting 1 from both sides gives the growth rate, g, as shown in equation Eq.9.11. (FV / PV)'"") - 1

=

g

Eq.9.11

Moving the growth rate, g, to the right side of the equation and applying the facts of this case, the future value is the amount that Acme's sales have grown to, the present value is their first year sales, and n is the number of years it took them to grow.

This is annual compound growth rate of almost 65% per year is a steep growth rate for a company to credibly forecast. However, if other

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companies in a particular industry have done it, then it is in the realm of possibility. The next step is to compute the ratio of market value to revenue. For Acme the ratio was about 0.67 ($20,000,000 market value / $30,000,000 in revenue). The next variable to consider is how long the investor wants to tie up his or her investment. Suppose the investor in Baker is willing to wait eight years to exit. We can use the future value equation Eq. 9.8 along with the growth rate for Acme, Baker's first year sales estimate of $600,000, and the number of years the investor is willing to leave their capital in the deal, to get the future value of sales. Recall Baker won't produce any revenue for a year, which means once they start booking sales, they will only have seven years left on their investor's clock to grow the company.

If the ratio of market value to sales for the high end furniture industry holds up at 0.67, then the market value of the company at the time should be about $13,384,871 ($19,977,420 x 0.67). This is the estimated value at the time the investor exits. Finally, there is one other adjustment an investor would have to make to his investment calculation. In calculating the yield to the investor, the ultimate payoff must be discounted eight years rather to determine the value of the company today. Assume that the estimated company value is rounded to $13,400,000 and the investor's required rate of return, Kr, is 40%; we can use Eq.9.7 to compute the value of the company today. Pre-Investment Company Value = Exit Value 1 (1 + Kr) "

= $907,988 or about $908,000.

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The problems with this method include (i) differences in management experience and quality, (ii) timing differences, products introduced during different parts of a product life cycle have different pricelprofit profiles, (iii) changing technology, benchmark companies may,have been successful with early technology, but less successful with more advanced, more capital intensive technology, (iv) as markets change the ratio of market value to sales may rise or fall, (v) there may be a very limited amount of data on similar companies that have gone public, (vi) the growth rate of one, two or even three companies may not be indicative of the growth rate of all companies in an industry, and (vii) in many industries the first movers are able to set standards and may be able to acquire such a large market share that it is difficult for competitors to follow their growth trajectory. On the other hand, this provides an analytical method for estimating future company value. As with all these valuation methods, assumptions should be carefully scrutinized and a range of parameters tested. For example, suppose Baker only grew at half the rate of Acme, would the deal still be worthwhile for the investor, and under what circumstances?

Modeling Sophisticated investors might model a number of valuation assumptions including sales growth and expenses, time to market, and the ability of management to meet, exceed, fall short of, or completely fail to meet goals. In modeling, an investor might start with management's forecast of sales and gross margin and then compute the expected value of a number of alternatives. Anyone who has managed a project of any complexity realizes that unanticipated problems arise and the likelihood of doing worse is greater than the likelihood of doing better. Therefore, significant weight should be given to the possibility that sales and other targets will not be reached. Suppose management forecasts revenue of $100 million at the time a venture capitalist or angel plans to exit. An investor would model the consequences if revenue exceeded or fell short of management's forecast by stated percentages. They might also assign a probability to each revenue amount. Figure 9-3 is an Analysis of the Expected Value of Revenue.

Structuring the Deal Figure 9-3 Expected Value of Revenue Percent of Forecast 115% 110% 105% 100% 50% 25% 0%

Revenue $115 M $110 M $105 M $100 M $50 M $25 M $0

Probability of Occurrence 5% 10% 20% 35% 20% 5% 5% Expected Revenue

Expected Value $5.75 M $11.00 M $21.00 M $35.00 M $10.00 M $1.25 M $0.00 M $84.00 M

In this example, the investor believes there is only about a 35% probability of the company actually hitting its revenue target of $100 million. There is a slight chance, 5% that the company will reach 115% of target or $1 15M, and a 20% chance they will reach only half their target, or $50M. The revenue at each level of performance is multiplied times the probability of occurrence to get an expected value for that level of performance. All the expected values are summed to get the expected revenue. The amount in this example, $84.0 million does not represent the exact amount of the revenue the company will generate, but it is what we can expect, statistically speaking. Gross margin is another important variable to model because it addresses both the ability to produce goods or services at forecast costs, and the ability to maintain the forecast pricing structure. Suppose management forecasts a 40% gross margin. An investor might want to model the effect of an increase to 42%. On the other hand, deteriorating margins are also possible, so an investor might look at a drop in margin to 20%, as well. Figure 9-4, EBITDA Model with Varying Gross Margins shows how revenue and gross margin models can be used to build an EBITDA model. In this example we assume expected revenue is $84.0 million and fixed overhead is $2 1 million.

Raising Capital Figure 9-4 EBITDA Model with Varying Gross Margins (dollars in millions) Gross Gross Overhead less Revenue Margin Profit Depreciation $84.00 44% $36.96 $21.00 $84.00 42% $35.28 $2 1.OO $84.00 40% $33.60 $2 1.OO $84.00 30% $25.20 $2 1.OO $84.00 20% $16.80 $2 1.OO Total EBITDA All Gross Margin Scenarios

EBITDA $15.96 $14.28 $12.60 $4.20 -$4.20 $42.84

Average EBITDA = $42.84 / 5 = $8.57

In the above example, we assumed that each of the gross margins in the model had the same probability of occurrence so we could simply average EBITDA across of all possibilities. The output of this two stage model (stage one modeled revenue and stage two modeled gross margin) was a forecast of a company's likely EBITDA at exit. To get the company value at exit simply multiply the modeled EBITDA times the EBITDA Multiplier.

Intellectual Property and Other Assets Sometimes a company's intellectual property is an overlooked, but valuable asset. The value of a brand name can be a huge asset. Do things go better with Arnold's sweet, brown, drinkie stuff, or do thing go better with Coke?TMThink about Reebok'sTM,NikesTM, CartierTM the power of brand is the power to differentiate a products in the market place and exert pricing power, which translates to superior profits. While start-ups rarely have brand power, expansion phase companies may have an established and valuable brand in their niche market. Other intellectual property has value, though that value many not be reflected in a company's revenue or cash flow. Licenses can have value. Copyrights to books, movies, and television programs have value. Patents have value, especially patents involving medicine or technology which allow the patent holder to dominate a market. Valuing a company for its intellectual property is a highly specialized activity requiring the assistance of experts.

Structuring the Deal

SECURITIES An investor's stake in a company will be represented by some type of security and the type of security has implications for the entrepreneur's cash flow as well as the investor's rate of return.

Convertible Preferred Stock Convertible Preferred Stock is the most common form of investment. The advantages of convertible preferred are that it: (i) can be converted to common stock which allows an investor to participate in upside potential, (ii) has preference in bankruptcy over the owner's common stock, (ii) will pay dividends on an on-going basis as either cumulative or non-cumulative preferred,5 and is subordinate, in terms of claims on assets, to unsecured debt, so that banks and vendors treat it like capital. Convertible preferred stock carried dividend of about 8% when the prime rate was about 4.75%, the discount rate was 1.25% and the yield on 10 year Treasury Notes was 5.15%.~As benchmark rates rise and fall, investors will either demand higher dividends or settle for lower dividends.

Common Stock Some investments are structured as the purchase of common stock. Common stock participates in the upside potential of a company. The disadvantages to the investor are that common stock usually do not provide current income to investors and it does not have the preference in liquidation that preferred stock enjoys.

Convertible Bonds Convertible bonds represent debt that is convertible to equity on the basis of a fixed number of shares of common stock per $1,000 face value of bonds. The advantages are that bonds provide current interest and the investor can participate in the upside potential of the company. The interest is tax deductible which is an advantage to the company if there is any taxable income. Preferred dividends are not tax deductible.

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Convertible bonds carried interest rates of about 10%' when the prime rate was about 4.75%, the discount rate was 1.25% and 10 year Treasury Notes yielded 5.15%. As these benchmark rates rise, the entrepreneur should expect investors to demand higher, or accept lower rates. Figure 9-5, Preferred Dividends and Relative Interest Rates, shows the relationship between benchmark rates and rates typically demanded on preferred stock and convertible bondsS8

Figure 9-5, Preferred Dividends and Relative Interest Rates

Benchmark Preferred Rates Dividends

Preferred Bond Rate Differential Differential Over Convertible Over Benchmark Bond Rates Benchmark

Discount Rate

1.25%

8.00%

6.75%

10.00%

8.75%

Prime Rate

4.75%

8.00%

3.25%

10.00%

5.25%

10 Year Treasury 5.15%

8.00%

2.85%

10.00%

4.85%

Bond Rate

Debt with an Equity Kicker Another form of capital investment is in the form of straight debt for the amount of the investment, plus a share of the company equity often equal to 2% to 3% of the value of the investment. For example, if a $25,000 investment were made in a company valued at $500,000 that had 100,000 shares authorized, and a value per share of $5 ($500,000/100,000) the investor would get a loan note for $25,000 plus stock valued at $500 (2% x $25,000 / $5 per share) or about 100 shares. The advantages to the investor include ongoing interest payments, a well defined exit strategy (i.e. they are paid off when the loan matures), preference in bankruptcy over preferred and common stock, and some participation in the firm's upside potential. This form of debt usually bears about the same interest as convertible bonds.

Structuring the Deal

Participating Convertible Preferred With this form of investment, the investor gets preferred dividends during the period of the investment, his or her invested capital back dollar for dollar at the sale of the company, plus a percentage of the remaining sales price. The percentage taken at the end is a matter of negotiation. The issue(s) with this form of investment are (i) whether the investor is over reaching and (ii) the level of desperation of the ownerlentrepreneur. This form of investment also assumes selling the company is the exit strategy. But what if the entrepreneur doesn't want to sell the company? In this form of investment, the investor will negotiate sufficient powers to force the sale of the company no matter what the entrepreneur wants to do. It is therefore very important that the entrepreneur know the form the investment or security is going to take, before the deal is signed.

Stage of Investment If those taking the greatest risk should get the greatest reward, then early stage investors should command a higher return than later stage investors. John Culbertson of the Gamma Group Venture Funds suggests that it is reasonable for Angels Investors funding early stage investments, to ask for the market rate plus 10% to 15%.~Historically, the stock market has returned between 10% and 15% which would peg the Angel early stage rate between 20% and 30%. However, he thinks later stage investors, for example those providing Mezzanine financing (short term junior debt financing) should only get about 15%, or about the high end of the long term average market rate.'' The tug of war over the amount of equity and return an investor will get is an eternal struggle. The best defense against over reaching by either side is to thoroughly understand the relationships among investment, payoff, time to payoff, interest or dividends and required yield.

PAYOFF ANALYSIS Assume for a moment the entrepreneur and investor have agreed on the company's likely value at exit and the time to exit. The investor's problem is that he or she wants to make sure they ask for a large enough share of equity to make his or her target return. However, if they ask for too large a share, they will lose the deal. The entrepreneur has a similar problem. If he

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or she offers too little, they risk losing the deal. If they offer too much, they will be giving away the fruit of their hard earned labor. The entrepreneur's dilemma is further complicated if he or she attracts two competing investors who offer deals that are structured differently. How does one compare a simple common equity investment to a convertible bond? With one, there is no visible cost to the entrepreneur until exit, with the other there are on-going interest payments, plus a cost in terms of equity if the conversion feature is exercised. Payoff analysis addresses these issues by providing a way for the entrepreneur to compute an investor's yield from any form of investment. These yields can be directly compared to reasonable expectations as well as offers of other investors.

Payoff at Exit The simplest yield to calculate is one in which an investor invests a given amount of money at the beginning, and receives nothing until the exit. Just as the future value equation, Eq.9.8, can be used to derive an equation for sales growth, Eq.9.11, it can also be used to derive equation Eq.9.12 which is the equation that gives the yield on an investment. k

= (FV /

PV)

'""'-1

Eq.9.12

Where: kis the investor's yield FV - is the dollar amount the investor will realize at exit. PV - is the dollar amount of the initial investment nis the number of years the investor's funds will be in the company. Suppose an investor wants to invest $25,000 now, in exchange for a payoff $100,000 in five years. What kind of a return is he or she asking for?

= 0.3 195 or about 32%

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A better way to approach the negotiation might be to agree with the investor on the value of the company at exit, and then ask him or her for his or her threshold rate of return. The future value equation, Eq.9.8 can be used to determine the investor's required payoff at exit and equation Eq.9.13 can be used to estimate the percentage of equity the investor will need to reach that threshold payoff. Suppose an entrepreneur needs an investment of $25,000 for eight years, the investor needs a 30% return on his or her money to justify the investment and the entrepreneur and investor agree the company will be worth $4,000,000 at exit. Using equation Eq.9.8 the dollar payoff needed by the investor would be:

Payoff Required by Investor

= $25,000 x (1 + 30%)

8

The percent of common equity needed to provide a given payoff can be determined by dividing the payoff value by the value of the company at the exit as shown in equation Eq. 9.13. Equity Required by Investor

= Payoff Required by

Investor

Eq.9.13

Exit Value

If the exit can be reached earlier, the dollar value of the payoff needed by the investor to reach a 30% return is lower. For example, if the exit could be reached in 6 years instead of 8, and the company's value at exit was still projected at $4,000,000, the payoff required by the investor would only be $120,670 ($25,000 x (1 + 30%)9, and the equity the entrepreneur would have to give up drops to 3% ($120,670 / $4,000,000).

* Take Away Lesson: Time is money. The longer it takes to reach an exit, the larger the share of equiw an investor will demand

Raising Capital

Complex Capital Structures What about more complex capital structures in which a company is expected to pay dividends as well as providing a payoff at exit? Dividends become part of the investor's overall return. The question for the entrepreneur is how to account for dividends so that different proposals, from different investors can be evaluated. Any type of an investment can be made equivalent to a single payoff investment. This is so because the total payoff an investor needs is really composed of two parts: the payoff at exit, plus dividends and accumulated interest on those dividends as shown in equation Eq.9.14. Total Payoff = Payment x FVIFA (krf, n) + Exit Payoff Where: Total Payoff Payment FVIFA krf Exit Payoff -

Eq. 9.14

is the payoff that an investor would demand if he or she got a single payoff at exit is the preferred dividend payment is the Future Value Interest Factor for an Annuity, see Appendix B is a substantially risk free rate of return like the yield on TBills or on a bank CD is that fraction of the Total Payoff not returned through dividend payments.

Suppose the investor requires a 30% return on investment; the entrepreneur needs $25,000 for 8 years and there was only a single payoff at exit. That payoff would be $203,925. But, suppose the investor demands preferred stock paying 8% per year. That means that for eight years, the investor will receive $2,000 per year in dividends ($25,000 x 8%). Assume the investor can invest his or her preferred dividends at 5%. If we substitute the single payoff at exit into the term Total Payoff in equation Eq.9.14, we can compute the exit payoff. FVIFA (5%, 8) + Exit Payoff

$203,925

= $2,000 x

Exit Payoff

= $203,925 - $2,000 x 9.549

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If the exit payoff is only $184,827, then using equation Eq.9.13 we find that the entrepreneur has to give up less equity to meet the investor's objectives. Continuing the prior example we find the required equity can be computed as follows: Equity Required

=

$184.827 $4,000,000

-

4.6%

This is down from the 5.1% if we think in terms of a single payoff model. If greater dividends are demanded, then the percentage of equity that must be given up for an investor to reach their target yield drops further. While half a percent of the exit price might not sound like a lot, consider this: suppose the entrepreneur has ten investors each putting up $250,000. The amount given up at exit would rise to $200,000 (0.5% x 10 investors x $4,000,000.) This analysis could also be used if an investor insisted on convertible bonds instead of preferred stock. Interest payments would simply replace dividends in the foregoing equations.

Take Away Lesson: Once an investor and entrepreneur agree on a firms ' likely value at exit, time to exit, and the investor's required rate of return, the entrepreneur should do a payoff analysis to make sure he or she is giving up the minimum equity n e c e s s q .

EXIT PROVISIONS Some Angel Investors and all Venture Capitalists plan their exit strategies at the inception of the investment. The exit strategy can be a point of friction between the entrepreneur and the investor because entrepreneurs often see starting a business as a lifestyle choice whereas investors see it in strictly financial terms. Not every company can avail itself of the most profitable exit strategy and the entrepreneur might resist a strategy that will cause him or her to lose control of their business. The type of exit an investor has in mind should be explicitly discussed as part of the deal package.

Raising Capital

Right to Put Shares The right to put shares is the right of the investor to force the company to buy back equity. The buy-back price is usually the invested value plus some percentage representing interest. Puts are exercisable at certain dates, usually 5 to 7 years after the investment is made. As a general rule, exercising puts is a backup plan in case the company has not generated enough value to warrant exit via a public offering or sale. The exercise of puts may also be conditioned on management's failure to meet agreed milestones. For example, puts dated mmlddlyy may be exercisible if management fails to meet revenue targets for two consecutive quarters. At some level, puts represent the investor's threat to withdraw his or her capital if entrepreneur fails to create the value needed for another exit strategy. Unless the company has excess cash, the sudden withdrawal of significant funds could send a company into bankruptcy. Puts are also problematic because subsequent round investors won't want their money used to fund the buyout of a prior investor. Such a buyout will add nothing to the value of the business. Under some conditions a put in one round may be fatal to getting funding in future rounds.

Right to Register Shares Investors may negotiate the right to force a company to register shares that is to go public. Going public is a means of providing liquidity to the investor. Until a company registers its shares, the investor is extremely limited as to whom he or she can resell their investment. See Chapter 11 Securities Regulation. Entrepreneurs may oppose going public for fear of losing control of the company or because of the time and expense involved. Publicly traded companies are also required to make extensive disclosures about their operations. These disclosures are posted on the SEC website where they may be accessed by regulators, investors, or competitors. Some company owners are uncomfortable with such public scrutiny.

Right to Force a Sale Investors may negotiate for the right to force the sale of a company. This right is usually contingent on management's failure to achieve agreed

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upon milestones or to create adequate value to protect the investor's investment. This right may take several forms. For example, the investor may have the right to solicit buyers. If the investor finds a buyer, the owner will be obligated to cooperate in due diligence and closing the sale. The investor may provide that the ownerlentrepreneur may solicit buyers if the price is over a certain amount, for example $10 million, and the sale is for cash. If a buyer is found, the ownerlentrepreneur and investor get to participate on a pro-rata or some other basis. This right is created at the time the investment is made, after appropriate negotiation.

Partial Buyer Suppose a buyer wants to take a substantial position in a company without purchasing it outright. This might occur when a company wants to secure an interest in a key supplier or when a target company is developing a key technology. It may also occur if an investor or investment bank believes the target company is ripe for an IPO. Since investors at all stages invest in the entrepreneur as much as in the service or product a company provides, they don't like to see the entrepreneur bought out, and potentially walk away from the company. Therefore, they often demand that if the entrepreneur gets an offer to purchase some or all of his or her shares, the investors get to participate in that offer on a pro-rata basis. For example, suppose the entrepreneur owns 5,000 shares of stock, an investor owns 5,000 shares, and the total number of shares issued and outstanding is 10,000 shares. If a buyer wants to buy a 40% interest in the company, he or she would have to purchase 2,000 of the investor's shares and 2,000 of the owner's shares even if the owner found the buyer. It is important to distinguish between a buyer purchasing shares already owned by someone else, and an investor purchasing equity in a company. If an investor buys newly issued shares and the company can use that money, allocation of shares on a pro-rata basis would not apply. However, a buyer purchasing shares owned by one of the company's principals would have to purchase shares on a pro-rata basis.

Raising Capital

Designing Your Own Exit for the Investor Investors want to take their investment and profit out of a company in a limited period of time. They have a number of ways to force this exit, some of which will cost the entrepreneur control of his or her company, for example if it is sold to a larger company. A strategy to meet an investor's exit demands while preserving the entrepreneur's independence and flexibility is to negotiate for the right to buy out the investor, in whole or in part, at any time provided that the investor gets a yield equivalent to a high rate of interest. For example, suppose an investor is only interested in investments that are likely to yield 30%. The entrepreneur might negotiate for a clause that says he or she can buy out the investor for 20% on a compound annual basis. An investor who invests $100,000 planning to exit the investment in five years with a 30% per year compound annual return will expect to receive about $371,283 ($100,000 investment x (1 + 30%)~).This assumes the investment is in common stock and the payoff at exit is the only payoff the investor receives. This exit payoff will translate into a percentage of company ownership as we have seen in previously in this chapter. Now suppose the entrepreneur negotiates for the right to buy out some or all of the investor's stake in the company for the equivalent of 20% compound interest. Further assume that the stock is sold for $1 per share. What would be the result if an entrepreneur bought out $10,000 of the investor's interest at the end of one year and $20,000 at the end of the second year? At the end of one year, a total buyout of the investor would cost $1.20 per share ($1 x (1 + 20%). If, at that point, the entrepreneur bought back $10,000 worth of the investor's stake, he or she would repurchase 8,333 shares ($10,000 / $1.20 per share). This would leave the investor with 9 1,667 shares. At the end of the second year, the buyback cost of each share of an investor's remaining stock would cost $1-44 ($1 invested x (1 + 20%)~). If at that time, the entrepreneur bought back $20,000 of the investor's common stock, they would repurchase about 13,889 shares ($20,000 / $1.44 per share.) If the entrepreneur makes no further buy backs then the investor's remaining 77,778 shares (100,000 original investment less buy backs of 8,333 and 13,889) will be cashed out at exit. If the company is sold for $3.71 per share, the investor's expectations will be met. (If there were no buy backs, the investment of 100,000 shares for $1 each would have sold for $371,283 or about $3.71 per share.) What about the entrepreneur? Since the entrepreneur has reduced the investor's stake by 22,222 shares, the

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entrepreneur's payoff will be increased by about $52,444 (22,222 shares x $3.7 1 - repurchase costs of $10,000 and $20,000.) There is at least two other reasons that an entrepreneur would want to negotiate a buyback clause. First, two or three years into the venture, he or she may find the company's track record is good enough to replace expensive venture capital with lower cost bank financing. Second, the entrepreneur may find that the investor is too intrusive, disruptive, or that there is bad chemistry between him or her and the investor. Why would an investor agree to negotiate 20% partial buyback clause when they see the prospect of getting a 30% in five years? First, a partial buyback represents cash in hand. All risk is eliminated for the portion of their investment bought back. Second, the 20% offered is substantially greater than could be achieved in a conventional investment. Third, investors may appreciate the opportunity to generate cash flow prior to exit. So what are the drawbacks for the investor? One is that the entrepreneur may buyback an investor's stake just before the entrepreneur goes public or finds a buyer and thus the investor would be forfeiting their expected 30% return at the last minute. In the above example, the buyback price of a share of common stock after one year is $1.20 ($1 invested x (1 + 20%), and the buyback price of a share of common stock after two years is $1.44 ($1 x (1 + 20%)~). Suppose the entrepreneur got an offer to buy his or her whole company for $5 per share in two years. Under a buyback agreement, the investor could be forced to sell his or her shares for $1.44, knowing that the entrepreneur would immediately resell them for $5. Alone, this prospect would kill a buyback clause. However, there is a solution. To make sure the investor's shares aren't bought back in contemplation of a quick sale, the buyback clause could be structured to grant the investor options to repurchase his or her shares at the buy back price for some limited period of time. The effect of such a provision is to protect the investor if the entrepreneur were able to exit his or her investment on favorable terms shortly after the buy back provision was exercised

OTHER INVESTMENT AGREEMENT ISSUES Sophisticated investors will insist on an investment agreement that codifies their rights and the entrepreneur's responsibilities. Such rights and responsibilities are designed to reduce the risk that the investment won't turn out as expected.

Raising Capital

Dilution Most companies require several rounds of financing. One risk for the entrepreneur and early round investors is dilution. Dilution occurs because stock issued to new investors reduces the percentage of the company held by preexisting owners. First round financing by friends and family is usually not heavily negotiated which means there are few protections for these early investors. Second round financing is usually from angel investors who range from rich but nayve to very sophisticated. The more sophisticated the investor, the more he or she will demand in terms of protection for his or her investment. Third round financing usually comes from Venture Capitalists who are by definition sophisticated since they professionally manage other people's money. They demand income and profits, strong protection of invested capital, and perform extensive due diligence. Consider Clark Superconducting Materials, Inc. which was formed with 1,000 shares of stock. The founder, Clark issues herself 700 shares and sold 100 shares to each of three friends for $10,000. At this point, each friend owns 10% of the company and Clark owns 70%. Clark spends the $30,000 she raised on a prototype device and needs another $100,000 to build her first marketable product. Since she is prerevenue, she will not be able to get a bank or SBA loan. She finds an Angel Investor willing to put up the money, but the Angel wants one-third of the company in return. Clark authorizes another 2,000 shares of stock, sells the investor 1,000 shares of stock for $100,000 and grants herself options on 1,000 shares as a management bonus. Figure 9-7 is an Analysis of Dilution. Figure 9-7 Analysis of Dilution Ownership Entrepreneur Friends Angel

-----Before Dilution----Shares Percent 700 70% 300 30% 0 0% 1,000 100%

* Including shares optioned

------After Dilution-----Shares* 1,700 300 1.000 3,000

Percent 56.7% 10.0% 33.3% 100.0%

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This dilutes the friends' collective ownership from 30% of the company to 10%. If their investment was based on owning 30% at the time of exit, their expectations will be disappointed. However, investors have a number of anti-dilutive strategies.

Preemptive Rights

Preemptive rights are legal rights granted by the corporation law of most states. The law provides that if a corporation issues new shares, the existing shareholders may purchase enough shares at the price new shares are being sold, to maintain their percentage of ownership. The problem from an investor's point of view is that the investor may not want to be "forced" into making additional investments, to preserve their prior share of equity.

Puts as an Anti-Dilution Mechanism

Some investors demand puts that are triggered by issuance of additional stock. In the prior example, the corporation is selling the new investor 1,000 shares of stock. If the friends had bargained for puts, they would have the right to demand the new investor purchase up to 300 of their shares before purchasing 700 newly issued shares. Subsequent investors hate puts because their invested capital is being used, in part, to buy out earlier investors. Buying out prior investors adds no value a company. Even if early investors demand puts as an exit strategy, the entrepreneur should negotiate for a clause that says puts expire if later money is invested. Maintenance Of Ownership - Issuance of New Shares

Investors may negotiate a provision that if new shares are issued to subsequent investors, the company will issue additional shares to pre-existing investors at no cost so that their percentage of ownership is maintained. Since the no-cost shares are likely to come out of the entrepreneur's share of the company, this is a fairly burdensome demand.

Raising Capital Employee Stock Options and Dilution

How do employee stock options figure into dilution issues? Since stock options are a common form of compensation in start-up and early stage companies, a provision should be made in investor agreements that employee stock options representing up to some nominal percent, perhaps lo%, may be issued without triggering anti-dilution remedies.

Investor's Control Mechanisms Investors often negotiate a number of mechanisms to control the entrepreneur's behavior. Friends, family, and Angel Investors may trust the entrepreneur to run the company. But sophisticated Angels and all Venture Capitalists will demand management rights. Each of these rights is subject to negotiation, though failure to agree on some of these rights may be a deal killer for some investors.

Seat on the Board of Directors

All venture capitalists and many angel investors demand a seat on the board of directors as a condition of investment. A seat on the board is important for a number of reasons. First, it provides an inside look at how the company is operating. Second, it provides an opportunity to object to, or point out the flaws in an ill considered strategy. Third, state statutes invest a great deal of power in corporate directors, including the power to remove the owner 1 entrepreneur from leadership of the company. Having experienced investors on the board is a double edged sword. It can provide the company with perspective. It can also be fatal to an underperforming management. Venture capitalists often want more than one seat on a board, and sometimes structure investment agreements so that if milestones are missed, they automatically get an additional board seat. For example, they may negotiate for two seats on a five person board in exchange for their initial investment, but may stipulate they get a third seat if for example, products are not shipped as planned or revenue falls 20% below targets for two quarters.

Structuring the Deal Staging Investments The opposite of exit strategy is the investment strategy. Investors frequently stage investments over time and on the condition that management meet stated goals or milestones before each cash infusion. If goals are not met, the investor may not be obligated to invest additional capital. If the entrepreneur needs this capital to reach another round of funding or cash flow break even, or just to stay alive, the balance of power shifts to the investor. At that point, the investor may demand additional concessions in the form of equity or other rights before making the next incremental investment. The entrepreneur should scrutinize the investment agreement to determine the consequences of failure to meet goals. He or she should also make sure that impossible or unrealistic goals are not included in the investment agreement.

Strategy Investors may demand the right to approve the annual plan and the annual budget. They may also demand the right to veto business plans, marketing plans, mergers, acquisitions or divestitures.

Hiring, Firing and Salary Decisions The investor may demand the right to appoint, or approve a company's senior officers, especially the Chief Financial Officer, and to a lesser extent, the Marketing and Manufacturing Vice Presidents. They may demand the right to control the salaries of the top five officers of the company. Investors may also demand the right to veto hiring anyone over a certain salary level, for example, $40,000. They may also demand the right to set, or limit the amount the owner / entrepreneur can take as salary and bonus.

Accountants and Auditors Investors may demand the right to select the company's outside accountants and law firm. This is one means to assure that the owners / entrepreneurs are fairly reporting the operations of the company, and that all legal problems are timely and effectively addressed.

Raising Capital Purchases and Sales Investors may demand the right to veto purchases of real estate, patents, trademarks, capital equipment, and other companies. They may demand the right to veto sales of real estate, assets used in the production of revenue, accounts receivable, stocks, bonds, patents, trademarks, copyrights, or licensing key technology. They may demand the right to veto loans to officers, and to sign checks over a certain amount, for example, $5,000.

SUMMARY In this chapter we have seen that knowledge increases bargaining power. Venture capitalists usually have more knowledge and therefore more bargaining power than other parties. However, an entrepreneur's relative bargaining power can improve by understanding the issues raised during negotiations. One of the most important bargaining points is company valuation. The primary methods used to value a company are the (i) EBITDA method, (ii) revenue method, (iii) discounted cash flow, (iv) similar companies, (v) modeling, and (vi) intellectual property and other assets. The securities an investor chooses to represent their ownership has an impact on both cash flows and the payoff they should expect at exit. If ownership is in the form of convertible bonds or preferred stock the company will have to budget for periodic payments to the investor over the life of the investment. Interest on bonds is deductible, but preferred dividends are not. A company has no obligation to pay an investor dividends on common stock. The amount of equity an investor will demand is determined by the investor's required rate of return, the time to exit, the form of security the investor elects, and the value of the company when the investor exits. For a one time infusion of capital with no dividends paid, the payout at exit is the amount invested plus compound interest at the investor's required rate of return to the date of the exit. The percentage of equity an investor will demand is equal to the payment divided by the company's value at exit. If dividends are paid over the life of the investment, the payoff at exit will be reduced by the dividends plus interest on those dividends to the exit date. Since the payoff at exit will be reduced, the share of equity demanded by the investor will also be reduced. Investors are concerned with exit strategies because the form of exit affects company value. An initial public offering is usually the preferred

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route of exit because there is usually a liquidity premium attached. Other preferred exit strategies, in descending order are: selling to a publicly traded company in an exchange of stock, selling to a publicly traded company for cash, selling to a privately held company, sale to another investor such as a levered buyout company, or a management buy-out. Investors frequently bargain for rights that guarantee they can exit, for example, the right to force a company to go public. All venture capitalists and many angel investors bargain for management control. One or two seats on the board of directors is common, as is the right to stage funding and cut off capital contributions if management fails to meet agreed upon goals. They can also bargain for the right to veto sale of some or all of a company, or its core assets such as patents and technology. Other rights can be bargained for as well such as the right to approve corporate officers and their pay. Whether is obvious or not, investors are bargaining for enough control to remove the entrepreneur as CEO. The entrepreneur who understands how the relationship of these issues to one another will be in the best position to be reasonable enough to close a deal, yet smart enough not to leave too much extra on the table.

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DISCUSSION QUESTIONS What are the variables that shape deal structure? significance of each?

What is the

What is the Term or Deal Sheet? Who usually prepares the Term or Deal Sheet? When will a Term or Deal Sheet appear in a discussion with an investor? What is the EBITDA method of valuing a company? What are the mechanics of estimating valued based on the EBITDA method? What is the revenue method of valuing a company? What are the mechanics of estimating value based on the revenue method? When might the revenue method be used instead of the EBITDA method? What is the Discounted Cash Flow (DCF) method of valuation? What are the mechanics of preparing a DCF valuation? When might the DCF method be used instead of the EBITDA or revenue methods? If an entrepreneur were trying to value a company based on the value of similar companies, how would they do it? What is the formula for computing the growth rate of similar companies? How would revenue be converted to company value using this method? What are some of the problems in using this method? What is the investor's objective in modeling a company? What are the mechanics of modeling? What are some of the most important variables to model? What is payoff analysis and what is it used for? How would an entrepreneur or investor use payoff analysis to determine the share of equity an investor should get for a given investment? Suppose, in addition to a payoff at exit, an investor insists on convertible preferred stock or convertible bonds that pay dividends or interest prior to exit. What would be the impact on the amount of equity an entrepreneur should give up? How would it be computed?

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Name four exit related rights an investor might negotiate for. Describe each and their implication for the entrepreneur.

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What is dilution? Describe three anti-dilution strategies.

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What are six rights an investor might demand in order to better monitor and control his or her investment in a portfolio company? Why would an investor ask for each of these rights?

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What is and investment agreement, sometimes called a stock purchase agreement? What are its purposes?

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ENDNOTES 1

Mark Roderick, of Flaster Greenberg, P.C. Attorneys at Law, Cherry Hill, New Jersey speaking to the Rutgers University "Raising Capital" course, January 10,2002. Equation Eq.9.1 contains the summation symbol "C" which simply means add up all the items that fit in the category designated. In this example, if there are three companies A, B, and C with market values of $10M, $20M and $30M, the summation symbol, pronounced sigma, would simply mean add $10M + $20M + 30M to get $60M. The SEC's website is www.sec.gov, click Forms Look-up; enter the company name and click search; enter 10-K in the form type box and click search; click on the most recent Form 10-K. 4 Cash flow break even is the point at which a company generates as much or more cash than it needs to operate. A company can need additional capital to grow, but may have reached the point at which they can be self sustaining at or near their current size. See David E. Vance, Financial Analysis & Decision Making, pp.221-222. Non-cumulative preferred dividends are permanently foregone in years when there is no profit to pay dividends. Cumulative preferred dividends are only deferred if there is no profit to pay dividends in a particular year. Mark Roderick, Esquire, Flaster Greenberg, P.C., in a lecture to Rutgers University's "Raising Capital" course January 10,2002; "Money Rates," Philadelphia Inquirer, May 24,2002, p.C3. 7 Todd Pietri, "Obtaining Venture Capital in a Horrible Market," American Venture, spring 2002, p.26. "Money Rates," Philadelphia Inquirer, May 24,2002, p.C3. 9The market rate of return is the return of the entire stock market. 10 John Culbertson, speaking to the Rutgers University, "Raising Capital" class January 7,2002.

Chapter 10

THE PITCH: LANDING THE INVESTOR

INTRODUCTION Pitching is the term used to describe the art of asking investors for money. There are formal pitches, scheduled in advance, with time, format, and other constraints, and there is informal pitching. Informal pitching is the entrepreneur talking up his or her company at networking events, business and social gatherings, at ball games and anywhere two people meet. Entrepreneurs should be ready with an informal pitch anytime and anywhere. The key to an effective informal pitch is the fact gathering and preparation for a formal pitch. What makes an investor likely to invest? What can an entrepreneur do to increase the likelihood of success? How long will it take to find funding and to how many investors will a company have to pitch? Who should pitch to Angel Investors, and who should go directly to Venture Capitalists? How long does it take to close a deal and get funds? How are deals screened? How can the entrepreneur get his or her proposal to rise above the noise of all the other proposals that an investor sees? The answers to these questions have one purpose, to close the deal on the best terms possible. Venture capitalists, as professional investors, are much more sophisticated and driven than most other investors. They set the toughest standards and ask the hardest questions. This chapter focuses on what it takes to close a deal with a venture capitalist on the theory that if the

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company's preparation and presentation are good enough to meet their criteria, it is good enough for the most other investors. This chapter will also discuss a couple of keys to pitching. For example, it is important to think like an investor and put oneself in the investor's point of view. The entrepreneur, who understands investors' needs and wants, is more likely to close a deal than one who focuses on his or her own needs and wants. Another key is to have a well thought out business plan. Finally, the entrepreneur should develop evidence that confirms he or she knows what he or she is doing. A brilliant idea by itself, is never enough. Investors want to be shown, not told.

THRESHOLD CONDITIONS To have a chance of raising capital, the following basic conditions are usually required:'

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Proven management skills and a competent management team

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Scaleable business model

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Compelling, quantifiable value proposition

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Proprietary technology, if your business model rests on technology

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Customers with real pain, and

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Customers with the money to pay

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Not entering a crowded or over funded market

There are important implications to each of these threshold requirements.

Proven Management There is a widespread belief among entrepreneurs and would-be entrepreneurs that investors invest in ideas, the brilliant concept, the novel invention, the keen insight. This is wrong. Research shows that the most important factor in making an investment decision is the quality of

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management. For an early stage company, this means the management skills of the entrepreneur, because a management team might not be complete.2 How do investors judge management? From the investor's point of view, the best evidence that an entrepreneur can start a company is the entrepreneur's past success in starting a company in the same industry. This demonstrates both entrepreneurial ability and industry knowledge. If an entrepreneur has started a successful business in a different industry, the investor will probe industry knowledge. Does the entrepreneur understand the nature of the marketplace? What channels of distribution are ordinarily used? What are typical gross margins? Price points? Does the entrepreneur know his or her customers through industry contacts, trade associations, etc.? If the entrepreneur knows the industry, the investor will probe entrepreneurial skills. Another element of management is the entrepreneur's leadership style. Does the entrepreneur have what it takes to gather experts more brilliant than him or her self? Is the entrepreneur threatened by brilliance, or does he or she create a workplace where that brilliance can shine? Has the entrepreneur picked people whose skills complement his or her own? The investor will evaluate the entrepreneur's ability to lead by looking at the background of the people he or she recruits as well as the progress made on the company's business plan. One venture capitalist said he looks for a management team the works with a sense of urgency; not to act rashly, but to have an inventory of options based on thoughtful evaluation of internally driven objective^.^ Team building is a way to manage risk. Is the entrepreneur building the kind of organization that would continue to grow if he or she got hit by a bus? Or is the company so dependent on the skills of the entrepreneur, that if the entrepreneur walks away, the company will collapse? The entrepreneur's personality is a significant factor in making an investment decision. An entrepreneur must be driven. The company should be on their mind when they wake up in the morning and when they go to bed at night. They should be the type of person who wakes up at 3:00 A.M. thinking about how to land the next customer. There should be a joy in the entrepreneur's voice when talking about their company. It should be a passion, not a job. The entrepreneur should also be totally committed to making the company work. One indication of commitment is whether they have quit their day job. On the other hand, he or she must be easy to get along with. An actively involved angel or a venture capitalist is probably going to spend several hours per week with the entrepreneur and his or her company over a period of several years. If the entrepreneur is an ego maniac, authoritarian, unwilling to share information, unable or unwilling to take

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suggestions, or is inflexible, the investor is not going to want to work with him or her. The investor has also got to evaluate whether the entrepreneur is willing to step aside if the company grows to the point where it need3 a more experienced CEO. The entrepreneur's ego is going to be an important factor in an investor's decision. One investor asks himself if he would want to work for the entrepreneur. If the answer is no, he doesn't invest. Every question, every element the investor looks for in terms of management has implications for the first pitch meeting. Suppose an entrepreneur is entering a new industry, do they know the major trade associations? Do they know the industry's trade magazines? Do they know their competitors? No matter how many meetings an investor has with an entrepreneur, the investor's knowledge about the entrepreneur as an individual will be limited. Therefore, an enormous amount of weight will be place on the amount of preparation the entrepreneur has done, both for the pitch and in developing their company to the stage at which investor capital is required. At some level, the preparation will be used as a surrogate for management drive and ability, so it is important to get the details right.

Scaleable Business Model Can the success of the business be attributed to a particular: location, customer, relationship, or individual? If so, the business might not be able to grow beyond a particular opportunity. For example, suppose 4,000 square feet of space became available across the street from Independence Hall in Philadelphia and an entrepreneur wanted to open a colonial theme restaurant. Even if it were successful, the question an investor would ask is: Is it scaleable? That is can the success of this restaurant be replicated in, for example: Baltimore, Chicago, Los Angeles, or Kansas City? If the driver of success is proximity to colonial landmarks, it might not be scaleable. If it is not scaleable, it may be difficult or impossible to meet investor expectations for returns. Lack of scaleablity will also limit exit strategies because most exit strategies contain the implied assumption of continued growth. While no business is perfectly scaleable forever, it doesn't have to be to attract investors. It just has to be scaleable over a sufficient range that the company has continued prospects for growth long after the investor exits. One example of a highly scaleable business model is McDonalds. Every store has the same format, menu, and economic model in terms of price points, fixed and variable costs. The management and sales skills are also standardized to a high degree and there are programs to identify and train store managers. There are also highly developed systems for monitoring

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store performance. While McDonalds is reaching market saturation, for a very long time all they had to do to expand was to find a site with suitable demographics and let it be known they were seeking a franchisee. Amazon.com is another example of a business that is scaleable over a wide range. From a small start-up in the mid 1990's it has grown to a multibillion dollar corporation today. Sales have grown along with the Internet and there is no end to growth in sight. Competing book sellers Barnes & Noble and Borders also have scaleable models. They search for locations with the right demographics and erect a store. However, Amazon.com is more highly scaleable because they aren't investing in brick and mortar facilities, sales staff, and the inventory that must be placed in those stores. Amazon.com has no sales staff and, theoretically, only has to have inventory in one location. The implication for the pitch is that the entrepreneur must have a well thought out growth strategy, not just a sales forecast, but a scaleable business model that explains how sales growth will be achieved.

Compelling, Quantifiable Business Proposition What are customers being offered? Is it something as good as other products? Or is it slightly better than average in some way? If the entrepreneur cannot articulate a compelling reason for a customer to buy his or her product or service, an investor won't invest. Unsubstantiated, undocumented assertions like better product, better service, better, better, better is just baffle gab and boosterism carrying no weight with an investor. If the entrepreneur's service is better, he or she must explain in detail how it is better with facts to back up every claim. The bottom line is an entrepreneur can't expect to get funding if he or she has a "me too" product or service.

Proprietary Technology Investors like proprietary technology. Why? They want protection from second movers, large companies that wait for a small company to develop a product and test it for market acceptance, and then use their superior marketing power and production capabilities and take the market away from the smaller company. Some would argue that the second mover phenomenon is what happened to Netscape. For a while, Netscape dominated the market for Internet browsers. Microsoft, a much larger company, saw public acceptance of browser technology and brought out Internet Explorer, which it then bundled with its operating system and gave away for free.

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Faced with such competition, Netscape was headed toward demise when they were acquired by AOL. If a technology is proprietary and if there are few alternatives investors will be shielded from the second mover phenomenon. Another reason investors like proprietary technology is that it is usually scaleable. The real intellectual content is in the design and development of the product. Manufacturing, sales, and distribution can then be done by a less skilled, more widely available workforce. The implication for the entrepreneur is to look for some proprietary element in the company, its product or service and be prepared to tell the investor why it is difficult to replicate. The entrepreneur should also be prepared to discuss how the intellectual property rights in that proprietary technology will be protected.

Customers with Real Pain It is axiomatic that entrepreneurs can get rich by finding a problem and fixing it. And, it is true. But the more pain a customer is in, the more willing he, she or it will be to part with hard earned cash. Pain comes in a number of forms. It could be that there is no economical way to fix certain problems. It could be that fixes are too labor-intensive, too regulated, too complicated, or just take too much time. There may be no way to fix certain problems. Consider this, we are talking about customer pain, not a customer want, or need, or even preference. Customer pain is an order of magnitude more serious. Pain creates an opening for an entrepreneur to find a solution and charge for it. When pitching to investors, the entrepreneur should be able to articulate their customer's pain and how they can stop it. If the pain is time, then the entrepreneur should be prepared to say "current solutions take Y hours which translate into a loss of productivity of Y hours times W per hour. Our solution takes ten percent as much time which translates into a savings of 0.9 x Y x W." Whatever form the pain takes, the entrepreneur should be able to quantifL and put a dollar amount on it. Do not leave it to the investor to guess the value of your solution.

Customers with Money to Pay There are a lot of great products and services that never make it to market because the target market can't afford them. Wouldn't it be great if every village in Africa had a solar array with enough power to pump water, provide electrical lighting and electric heat so the forest would not get cut for

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firewood? Yes. Is this something people need? Yes. Is it good for the environment? Yes. Are people in real pain because they don't have clean drinking water, electric lights and they have to chop down forests to provide heat? Yes. Are solar arrays coming to every African village soon? No. Why? Customers don't have enough money to pay for the product. This happens in the U.S. as well. One aerospace company I audited acquired a ski lift manufacturer and their engineers redesigned the ski lifts to aerospace specifications. Where the ski lifts great? Yes. Did ski resorts need ski lifts? Yes. Were any sold? No. The reason was that ski resorts did not have the money to purchase such highly engineered lifts. The ones they had been buying for years were perfectly adequate, and cost much less. The entrepreneur's market research should consider whether customers have money to spend on his or her product or service. This is particularly important for business to business sales in highly competitive industries, depressed industries, or in times of economic downturn when all companies are trying to cut costs.

Not Entering a Crowded or Over Funded Market If anyone can do something, everybody will. Restating this as an economic proposition, if there are no barriers to entry, a lot of companies will enter a market which means companies will begin to compete on price. Price competition puts pressure on profits reducing a company's value, and the value of all the companies in an industry which will make an exit through a buyout or IPO more difficult. If an industry is over funded, that is if a lot of investment capital is flowing into a particular industry that industry will soon be overcrowded. So, the entrepreneur has to assess both the level of competition now as well as the likely level of competition when the company begins operations. He or she must be able to discuss these issues at a fairly detailed level and provide as many facts as possible in the discussion.

SALES Do you want to build confidence that there is a market for your company's product? The only real test is customers, people willing to part with hard cash for a company's product or service. The more detailed a sales

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history you can present to an investor, the better. Sales should be summarized by product, over time and by customer over time. These reports should be sorted in descending order. For example, the customer accounting for the most sales should be first on the list; the second largest customer should be second, and so forth. The percentage of sales to each customer and of each product should also be available.

Collections If the test for market acceptance is what customers are willing to pay for, the entrepreneur must provide information on collected sales versus credit sales. The best way to summarize this information is with an aged accounts receivable. Such a report will show credit sales outstanding 30,60, 90 and over 90 days. If accounts receivable are large and old, the investor will conclude that customers are not willing to pay for the product or service. Therefore, the entrepreneur must be diligent in collecting outstanding accounts. Those that can't be promptly be collected should be written down and turned over to a collection agency. If an investor is interested enough in a company to perform due diligence, he or she will find out about uncollectible accounts anyway. It is therefore better to deal with these issues prior to making a pitch.

Pre-production Sales Strategy Suppose a company is still in the research and development or product development stage and has no sales. What can it do? It should try to generate revenue through consulting or other services related to their product. For example, if their product is a new type of phone system, it should consult on phone system design, or provide maintenance to other vendors' phone systems. This does five things, it:

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Establishes a revenue stream, which is going to reduce the burn rate of invested capital

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Demonstrates the entrepreneur's ability to sell. Many entrepreneurs with brilliant product ideas, cannot sell

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Demonstrates technical expertise in the chosen market

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Begins to develop a presence in the market place, and build a potential customer list, and

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Establishes a list of references that the investor and other potential customers can contact

Flagship Customers The job of the entrepreneur during a pitch is to make the company sound as credible as possible. Nothing does this as well as flagship customers. These are customers with their own brand power. Investors and other customers will assume that if flagship companies are buying, the product or service is good. Examples of flagship customers include General Electric, Sears, Lord & Taylor, and IBM. Companies should decide who they want as a customer and target them, rather than simply relying on the customers that walk in.

New Business Schedule Entrepreneurs should maintain a detailed schedule of the deals they are working on, including a proposal date, an expected closing date, contact information, deal value, and the probability of closing the deal. This provides the investor with assurance the company is actively prospecting for sales, and provides a rational basis for revenue forecasting. Entrepreneurs should be conservative in preparing this schedule because investors are likely to compare schedules from month to month to assess whether entrepreneurs are successfully following through and closing deals.

Market Size & Growth Rate Sales potential is intimately related to sales. If the total market is small, investors will not be interested in funding a company. Venture Capitalists usually look for a market of $500 million or more. They are also interested in growth rates of 30% or better.4 One way to estimate the size of a market is to list the revenue of the company's top twenty competitors. The Dun & Bradstreet (D&B) Million Dollar Directory, available electronically through most university libraries can be searched by SIC (Standard Industrial Code) to identify competitors.

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Large companies are rarely "pure plays" in any one industry. If competitors are publicly traded, access their Form 10-K, available on-line through the SEC's website: ~ w w . s e c . ~ o and v , ~ look for segment information. Management's discussion of operations in the 10-K may provide insight into market dynamics. A company's growth rate can be estimated using the following variables: (i) the company's sales history, (ii) the growth rate of the target market based on the sales growth rate of the company's top competitors, and (iii) the company's new business schedule. Another approach to estimating sales and sales growth is presented in chapter 6, Business Models, Business Plans. Remember, a successful pitch must be grounded on well researched facts.

TIME AND CONFIDENCE BUILDING Finding investors is a journey, not an event. An entrepreneur raising capital from institutional investors should plan on four to eighteen months of inquiries, pitches and due diligence.6 Some entrepreneurs say they spent 50% of their first eighteen months looking for capitaL7 During that time the entrepreneur is doing three things:

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Identifying those investors whose criteria in terms of industry, return, risk tolerance, and so forth exactly match those of the entrepreneur's company, Refining the pitch, which by definition means refining the marketing and business plans, and

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Building confidence by: 1. Getting customers 2. Getting other investors 3. Setting and reaching realistic milestones 4. Building strategic alliances so that the company can focus on those things it does best and rely on partners to provide support for other things. 5. Demonstrating expertise in the field, and 6. Developing a realistic company valuation.

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Confidence building takes time and patience. Few sophisticated investors are willing to consummate a deal after one or two meetings. If funds are being raised from friends and family, the time between the first pitch and receiving funds can be days or weeks because friends and family rarely have the sophistication to negotiate complex agreements like the ones discussed in chapter 9, Structuring the Deal; they rarely conduct due diligence; and they aren't investing other people's money. Venture capitalists, on the other hand, are going to conduct extensive due diligence along with their own, independent market research. They will negotiate a detailed and complex deal. While venture capital deals were closing in as little as two months during the dot com bubble, deals are now returning to a more typical six months. The time between the pitch and closing a deal with an angel investor will vary widely depending on their sophistication. The greater the sophistication, the longer it will take to close the deal.

FINANCING ROUNDS Few growing companies can find a single investor who will meet all their capital needs. Capital infusions should be staged across a number of years, based on meeting given milestones. For example, one round might take a product from concept to commercialization, another round might take it from subcontracting out production to in-house production, and another round of financing might take a product from a regional market to a nationwide market. For each of these rounds, the criteria that triggers fundraising should be well defined as should the uses of that capital. The company should know with relative the amount of money to be raised in each round. Some suggest that small rounds of capital should be raised c o n t i n u ~ u s l ~This . ~ would involve setting up a standard "deal" for everyone in a round. Relatively small investments, perhaps $25,000 each could then be aggregated to reach capital targets. Just as it would be imprudent to discuss financing with only one bank, it would be imprudent to discuss financing with only one venture capitalist or angel investor. One reason is that only a fraction of the investors who like the company will actually invest. Companies, cannot afford to pin all their hopes on a path that may ultimately be a dead end. For another thing, having several funding options shifts bargaining power to the entrepreneur which means he or she is likely to get a better deal. On the other hand, at some point, a venture capitalist or sophisticated angel is going to want a "lock-up" agreement that states the company will not

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seek other funding until they have completed their due diligence and made a decision on investing. The "lock-up" is prudent from the investor's point of view because he or she does not want to invest the time and effort in due diligence only to find some other investor has snatched the deal. Make sure any "lock-up" agreement has a well defined termination date. The entrepreneur doesn't want an investor to sit on a deal while looking for a better one. If the investor wants three months to consider a deal he or she probably is not interested in it. Due diligence should take considerably less than three months. If competing venture capitalists are interested in investing, bring them together to share due diligence and pool capital which reduces transaction costs and risks for everyone. As mentioned in chapter 9, The Deal, the entrepreneur should pay careful attention to the terms and conditions of the investment. There are certain clauses, such as puts and buy out agreements that may be a deal breaker in future funding rounds. The entrepreneur cannot get so caught up in the pitch that he or she forgets to look at the terms of the deal.

PITCH FORMAT Opinions about the format of the pitch vary widely, but there is consensus on a few elements. One is that there should be different length pitches depending on whether the company is going through an initial screening process, in which case it should be very short, perhaps two to three pages, or whether investors have expressed interest in the company, and now want to dig deeper.

Short Pitch Piece The short pitch piece should be two to three pages and briefly cover the following:

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The value proposition: What is the company going to do? How will it be of value to the customer? In what way will it ease the customer's pain?

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A brief statement of the entrepreneur's background and anything that qualifies him or her to grow a company in this field.

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The market's size and the competition.

The Pitch: Landing the Investor

9

Sales history, and flagship customers, if any.

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Proprietary technology, if any

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Business Model: - Price, costs of goods sold, gross margin - Channels of distribution - Advantages that your business model has over competitors

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How much you need and what you want to do with it.

An entrepreneur should be ready to make an oral pitch covering these issues at a moment's notice.

Detailed Pitch Piece Once beyond the initial cut, investors will demand more detail on every point in the pitch. For example, they will want to know how the size of the market was estimated. You should be prepared with a more extensive, well indexed, package that provides the facts supporting your pitch points. Included in this more extensive package should be:

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Summarized Business and Marketing Plans

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Sales forecasts

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Budgets

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Competitive analysis: Who are your competitors? What is their size? What are their strengths and weaknesses?

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Brief resumes on the management team showing their background in the company's field of specialization.

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If the company is a technology company, provide a more detailed description of how the technology works and why the technology qualifies as proprietary

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Information on prior financing rounds, this shows confidence by others, and planned financing rounds.

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Basis of company valuation

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Exit strategy for the investor including both the time to exit and method of exit.

Doubtless individual investors will ask for more detail in areas of specific interest to them. However, the foregoing package should be enough to separate investors who are shoppers from investors who are buyers.

Pitch Piece Style No matter how brilliant the company concept, a poorly done pitch piece is enough for an investor to reject a proposal. First, last and always, brevity is the soul of wit. An investor is not going to be impressed by a river of words. In fact a river of words might drown out your brilliant idea. Make your points as briefly as possible. Charts, graphs and tables can often convey more information, more quickly than a narrative description. This is not an essay contest so don't be afraid to use bullet points. Write in simple language. Avoid technical terms. Don't assume the investor has knowledge about technical subjects. Use footnotes to define and explain technical terms if they are absolutely necessary. Spell check and check for correct grammar and word usage. Have someone else proof read you pitch piece. A clean neat pitch piece is the first opportunity an investor is going to have to test your diligence and thoroughness. Investors read a lot of proposals every month. Don't give them a chance to reject yours before they get to the merits.

THE DEAL SHEET If the investor is still interested at this point, they will present a deal sheet, which is a summary of the terms of their investment. It will cover things like the amount they want to invest; the form of the investment; the length of time they are willing to wait before forcing an exit; and the amount of management control they want. Remember, this isn't the final offer; it is simply the investor's opening bid.

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If the investor doesn't present a deal sheet, the entrepreneur should be prepared to present one. Preparation of a deal sheet forces an entrepreneur to think through the terms and conditions of a deal before serious negotiations begin.

SUMMARY The pitch is the art of asking an investor for money. To close a deal, the entrepreneur must meet a number of threshold conditions. These include proven management skills, a scaleable business model, a compelling quantifiable value proposition, proprietary technology, customers with real pain and money to pay, and an industry that is not overcrowded or over funded. Of these conditions, the quality of management is the most important. Sales, to actual customers who are willing to pay for the product, is the best test of whether a product or service will be accepted in the market place. For pre-production products, the company should attempt to generate revenue from consulting or other services to establish themselves in the marketplace and begin to build a book of potential customers. An entrepreneur should try to get flagship customers, customers with their own brand power. The assumption is that if high profile customers are willing to buy the product, it must have a certain level of quality. The entrepreneur should research the size of the market and the total market growth rate. One way to do this is to find data on the company's twenty largest competitors and use that as an estimator of the total market. Depending on the sophistication of the investor, it may take a few days to eighteen months between the time a pitch is made and a deal is closed. The more sophisticated the investor, the longer it will take to close a deal. Before the pitch, the entrepreneur must know how much he or she wants to raise in the current round and what he or she plans to use it for. The pitch format should vary depending on whether the entrepreneur is making an initial contact or a more extensive presentation. Initially, a two to three page summary addressing the threshold conditions such as management skills, market size, scalability of the business model, value proposition, technology, customer need and whether the market is overcrowded or over funded should be sufficient. If the investor is still interested and asks for more detail the entrepreneur should have a presentation includes s summary business and marketing plan as well as more detail on the entrepreneur and his or her management team. If the investor is still interested, they may offer a deal sheet and conduct due diligence. The deal sheet is an opening statement of what the

Raising Capital investor wants, but it is not the last word as to what they will take. If the entrepreneur is properly prepared, he or she will be able to negotiate terms that work for everyone.

The Pitch: Landing the Investor

DISCUSSION QUESTIONS What are seven threshold questions an investor considering a technology company will consider? What can an entrepreneur do to assure an investor that he or she has what it takes to build a business? What are some of the personality traits an investor looks for in an entrepreneur? What is a scalable business model? What are some of the characteristics of a business model? How scalable does a model have to be to satisfy investors? What are meant by (i) a compelling, quantifiable business proposition, (ii) customers with real pain, (iii) customers with money to pay, and (iv) a market that is not overcrowded or over funded? What is the importance of sales? What are four things a company can do to assure an investor there will be a large and fertile market for its products? What is a financing round? What are some of the key milestones in a financing round? How long should an entrepreneur expect it to take from initial pitch to close a deal? What is meant by confidence building and what should an entrepreneur do with regard to confidence building? What types of information should be contained in an initial pitch piece? How long should it be? If an investor expresses enough interest in a company to warrant a second meeting and request more detailed information, what should be included in this more extensive pitch piece? What is a term or deal sheet? When will it make its appearance? To what extent are the terms and conditions of the deal sheet negotiable?

Raising Capital

ENDNOTES Todd Pietri. "Obtain Venture Capital in a Horrible Market," American Venture, spring 2002, p.26. Lynn Cowan and Cheryl Winokur Munk, "Venture Firms Grow More Inquisitive," Wall Street Journal, 7/17/2002, pB5A; Felicia Lowenstein, "Learn What It Takes To Get Noticed - and Funded - by High-Tech VCs!," New Jersey TechNews, March 2002, p.18. Edward F. Sager, Jr. and George P. Stasen. Mentor Capital Partners website www.mentorcapitalpartners.com downloaded 313011999. Pietri. p.26 The SEC's Edgar database is a database containing all the Form 10-K and other filings the SEC requires of publicly traded companies. Go to www.sec.gov and click on "Search for Company Filings," then click on "Companies & Other Filers," then enter the company name you want to look up and click "Find Companies." A list of all filings for the company will come up. You can refine your search results by entering 10-K in the box marked "Form Type," and clicking "Retrieve Filings." Pietri. p.26. 7 -"How To Capture The Elusive Angel," Technology Executive Roundtable meeting 2/28/2002 8 Pietri. p.26.

Chapter 11

SECURITIES REGULATION

INTRODUCTION Raising capital is highly regulated in the United States and penalties for violating securities laws can be severe. However, the law does not create insuperable barriers to raising capital if the entrepreneur understands how it applies. This chapter discusses federal securities law, the penalties for noncompliance, and exceptions or safe harbors in the law. Initial Public Offering (IPO's) will be discussed briefly in this chapter and more extensively in chapter 12 Initial Public Offerings. This chapter will also discuss private placements, which are much simpler than public offerings and are the vehicle used to raise capital from angel investors and venture capitalists. This chapter will also discuss how to find SEC required forms and regulations and provide some information on the key elements of those forms. Regulatory filings are a function of the amount raised and the sophistication of the company's investors. Those defined as accredited investors are assumed at law to be sophisticated and this chapter will discuss how to tell whether an investor is accredited.

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SECURITY DEFINED The Federal Securities Act of 1933, section 2(1) defines a security as: "Any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in profit sharing agreement, collateral trust certificate, pre-organization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil.. .'" and so forth for half a page. Almost any interest in anything can be construed as a security. The Securities Exchange Act of 1934 (SEA) has a similar definition of a security SEA section 3(a) (10)~. The Securities Act of 1933 requires every new issue of securities to be registered. The Securities Exchange Act of 1934 requires that every corporation with assets of more than $10 million, whose securities are held by more than 500 owners, shall make annual and other reports as outlined by the Act and by SEC regulations.3Unless otherwise indicated, section numbers in this chapter refer to sections in the Securities Act of 1933.

WHY ARE THERE SECURITIES LAWS? In the 1920s, companies old stocks based on promises of enormous profits but with little information that investors could use to determine whether promises were reasonable. The frenzy of uninformed investment fueled speculation that led to the stock market crash of 1929. In response, Congress passed a number of laws requiring "full disclosure" of all "material facts," about companies that people invest in. The two main laws were the Securities Act of 1933 and Securities Exchange Act of 1934, which are administered and enforced by the SEC. This regulatory scheme is not designed to evaluate the merit of an investment, but is only designed to make sure investors have the information to make their own judgment.4

WHY BOTHER WITH SECURITIES LAWS? Securities laws are complex and compliance is both time consuming and expensive, so why bother to comply? Section 12 of the 1933 Act imposes civil liability on sellers of securities under two independent circumstance^:^

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217

(i)

The security was not registered pursuant to Section 5 of the Act, and does not fall under an exemption to registration requirements, and

(ii)

The security was issued by a false or misleading statement or by an omission that might be misleading.

A finding of civil liability means that the seller will have to refund investors' money. With any new venture, there is a high probability that things won't work out exactly as investors thought they would. If securities are unregistered, investors can simply demand a refund of invested capital. Such a refund could be a disaster for the issuing company. The best defense against this type of liability is to register the security, or find an exception to the statute that does not require registration. The threshold for liability is only a little higher under the second branch of the Section 12 test. Under this branch of the test, any false or misleading statement or material omission of information can lead to liability. For this reason, it is important for issuers of securities to have an objective basis for everything they communicate about their company, to tell the company's whole story, not holding back anything that seems negative, such as dependence on a single customer, market uncertainties, or other risks.

OVERVIEW OF THE REGULATORY THICKET Securities laws have evolved over time into a regulatory thicket that is as much a legal exercise as it is an exercise in finding investors. In addition to federal laws discussed above, most states have securities laws called "Blue Sky" laws. As a general rule, both state and federal laws must be followed. However, there are a few circumstances in which there are exemptions from Federal law, and there are also circumstances in which Federal law pre-empts state law. Where Federal pre-emption is available, the state's authority to regulate securities is severely limited.

EXEMPTIONS FROM FEDERAL SECURITIES LAW Federal securities laws include all securities, except those specifically exempted. Exemptions are important to prevent regulation which would stifle the economy. Three common exemptions are for the secondary market, short term notes, and for financial institutions.

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The secondary market is where securities are sold other than by the issuer or someone operating on their behalf such as an agent, broker or underwriter. Securities bought and sold on the New York Stock Exchange (NYSE), American Stock Exchange (AMEX) regional exchanges or the National Association of Securities Dealers Automated Quote system (NASDAQ) are transactions in the secondary market. Section 4(3) exempts most transactions conducted by dealers in the secondary market.6 Short term notes are defined as those with a maturity of less than nine months and used for working capital. These notes are also called commercial paper and they are generally exempt from federal regulationm7 Banks and other financial institutions such as insurance companies and pension funds enjoy a wide array of exemptions from federal securities laws, but these exemptions are not relevant for most businesses.

PUBLIC OFFERINGS VERSUS PRIVATE PLACEMENTS If an exemption doesn't apply, then one of two groups of rules will govern. If securities are to be sold to the public, they must be "registered." If they will not be sold to the public, they may qualify for treatment as a "private placement." Private placements do not have to be "registered," but other statutory requirements must still be met. Large companies and most companies reported in the Wall Street Journal have used the S-1 Registration for their initial public offering. It is very complex, and expensive. We will discuss S-1 registrations in chapter 12, Initial Public Offerings. Federal law provides simpler registration for smaller companies that want to raise capital in the public market. In chapter 13 Small Public Offerings we will discuss use of Regulation A, SB-1 and SB2 registrations. Whether the securities are registered, or exempt, they must still comply with the statute's anti-fraud provisions. Companies seeking first and second round financing use one of the Private Placement exemptions listed below and most of those use one of the alternatives available under Regulation D. See Figure 11-1, Overview of Securities Regulation, which is a flowchart of regulatory requirements and Figure 11-2 which Forms of Registration for Publicly Traded Companies.

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Securities Regulation Figure 11-1 Overview of Securities Regulation

,

yes

1

,

o Stock, Bond, Debenture, Evidence of Indebtedness, o Certificate of interest, participation in profit sharing o Pre-organization certificate or subscription, o Investment contract, o Almost any interest can be construed as a security

IS there a private 0 Regulation D Yes placement b exemption? o Accredited Investor exemption section 4(6)

Registration Required Forms S- 1, SB- I, SB-2 or Form 1-A

Form D for Reg. D and adequate disclosure

Federal Preemption available? No state qualification. Yes

/ J

Notify states where required

State merit review and qualification where required

fi Finished

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Raising Capital Figure 11-2 Forms of Registration for Publicly Traded Companies

Form

Description

General form of registration used by large companies. Narrative very detailed and complex. Small business registration for sale of up to $10 million of securities. Simpler than S-1 or SB-2 Small business registration used by to raise an unlimited amount. Simpler than form S-1. Limits on company size. Used for securities offerings of $5 million or less. Simpler than SB-1 in some respects not in others.

Form 1-A

PRIVATE PLACEMENTS, NON-PUBLIC OFFERINGS Regulators recognized early that registration was sufficiently difficult that it would put a damper on small business capital formation. Rather than leave small businesses out of the regulatory scheme altogether, provisions were made for securities offered privately, that is through personal contact between an entrepreneur and an individual investor. Figure 11-3 lists Exemptions for Private Placements. Figure 11-3 Exemptions for Private Placements Section 3(a) (11) of the Securities Act

Used to $1 million or less per year.

Section 4(2) of the Securities Act

Used to raise an unlimited amount from investors.

Regulation D

Rules 504, 505 and 506 provides exemptions for raising $1 million, $5 million or an unlimited amount depending on the sophistication of investors.

Section 4(6) of the Securities Act

For sales of under $5 million to accredited investors.

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Section 3(a) (11) of the Securities Act of 1933 and Rule 147 Section 3(a) (11) of the Securities Act of 1933 and Rule 147 promulgated there under provides an exemption from Federal Securities registration and allows any amount of capital to be raised. However, this exemption is only available when the offering is made and sold to residents of a single state. That means the company must determine the residence of each purchaser. If it does not, and even one purchaser is a resident of another state, the company will lose its exemption. There are other requirements as well. The company must be organized in the state in which it sells securities and have its principal office there, it must also derive at least 80% of its revenue in that state and at least 80% of its assets must be located there.8

Section 4(2) of the Securities Act, Transactions Not Involving a Public Offering Section 4(2) of the Securities Act of 1933 provides an exemption from registration for transactions not involving a public offering. There are four requirements to fit within the confines of this exemption: (i)

Investors must have enough knowledge and experience in finance and business to evaluate the risks and merits of an investment. This is the so called "sophisticated investor" requirement. In the alternative, the investor must be able to bear the investment's economic risk.

(ii)

Investors must have access to the type of information found in a prospectus. See Chapter 12 Initial Public Offerings for more information on the prospectus.

(iii)

Investors and promoters must agree not to sell or distribute securities to the public.

(iv)

Public solicitation or advertisement is prohibited.

This exemption is because a "sophisticated investor" or an "investor able to bear the financial risk" is undefined. How does an entrepreneur measure sophistication? Is a CPA sophisticated in finance and investments? Generally speaking we might consider a CPA much more sophisticated than most people, but what if the investment was in a biotech company? How about a nanotechnology company? Do they automatically have sophistication in those areas? The issue of who can bear the economic risk is equally

Raising Capital problematic. Is an investor able to bear the risk if the investment represents only 20% of their assets? lo%? 2%? These subjective determinations limit the usefulness of this exemption because if an investment underperforms, the investor may claim that he or she was "unsophisticated" or unable to bear the economic risk. If he or she prevailed in their argument, the funds raised would constitute an unregistered offering for which there was no exemption. The investor could then demand return of invested capital.

REGULATION D Regulation D is the most common way to raise money as a private placement. It has several general provisions that apply whether the offering is made under Rule 504, 505, or 506. Selection of the Rule will depend on the amount of money to be raised and who the securities are being sold to. Generally, securities sold pursuant to Regulation D: a)

May not be advertised or sold through any general solicitation, or through a seminar or meeting whose attendees have been invited through any general solicitation or advertising.''

b)

Must provide specified and detailed information to non-accredited investors.]

c)

The seller must file a Form D with the Securities and Exchange Commission no later than 15 days after the first sale of securities and update that form after subsequent sales.12

d)

Except for special provisions in Sec. 230.504(b) (1) securities may not be resold without registration. The issuer has a duty to take reasonable care that securities will not be resold. Reasonable care might include:13 (i) an inquiry to determine whether the purchaser is purchasing for themselves or for another person, (ii) written disclosure to each purchaser that securities may not be resold without registration, and (iii) placement of a legend on the share certificate or other evidence of ownership that securities may not be resold without registration.

e)

A company must not be subject to the reporting requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934. (If a

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company is already regulated under some other provision of securities law, the SEC does not want it to be able to use Regulation D to circumvent other reporting requirements.) f)

The company must certify that it is not a development stage company with no specific plan or with a plan to merge or acquire another company. It should have at least a summary business plan for investor review.

g)

The company raising funds must certify they are not an investment company or a company organized to acquire another company. The rational is that neither of these goals provides enough information for an investor to make an informed decision on the merits. 14

In addition to the other requirements of Regulation D, the entrepreneur should provide enough information to comply with state and federal anti-fraud statutes. Such information should be sufficient to provide the investor with a reasonable basis for making a decision about investing, no material information may be omitted and no false or misleading statements can be included in this information. The entrepreneur issuer must also be able to answer investor's questions. Within Regulation D, there are three alternatives Rule 504, Rule 505 and Rule 506. Compliance with any one rule will provide a federal exemption from registration. Each rule has its strengths and weaknesses for a particular situation.

Rule 504: Limited Offerings of Securities Not to Exceed $1 Million Regulation D, Rule 504 can be used to raise up to $1 million. To qualify for a Regulation 504 exemption, a company must1*: a)

Certify the aggregate amount all securities sold pursuant to this section does not exceed $1 million in any 12 month period,'6 and

b)

Make sure the offering is sold exclusively in states that require registration of securities and disclosure of information to investors. Offerings must comply with all applicable state securities laws, or must be sold in states where it is exempt from registration or a combination of the two. The company must also provide state mandated disclosure documents to each investor.

224

c)

Raising Capital Only advertise in states that allow advertising. If the company is in a state that allows advertising, it can only sell to accredited investors." Accredited investors are defined below. Securities may be sold to non-accredited investors if there is no advertising.

Rule 505: Limited Offerings of Securities Not to Exceed $5 Million Regulation D, Rule 505 can be used to raise up to $5 million. In addition to general Regulation D requirements, to qualify for a Rule 505 exemption the company must not: a)

Sell more than $5 million of securities in any 12 month period.'8

b)

Sell to more than 35 "non-accredited purchasers" of securities. There is no limit to the number of accredited investors who may invest.Ig

This rule allows a company to raise significantly more money in any twelve months than a Rule 504 Offering. The tradeoff is that only a limited number of non-accredited investors can invest. Rule 504 imposes an affirmative duty on the issuer to provide each . non-accredited investor with disclosure documents that are substantially similar to those that would be required if the offering was registered. Strategically, this means that an entrepreneur would be wise to limit investors to those who are accredited. If non-accredited investors must receive the same level of disclosure documents as in a registration, many of the benefits of the federal exemption are lost. Financial statements must be audited by a Certified Public Accountant. If a firm other than a limited partnership cannot obtain audited financial statements without undue delay or expense, they may make an offering under this rule with only an audited balance sheet, dated within 120 days of the beginning of the offering. If a limited partnership cannot obtain audited financial statements without undue expense or delay, it can supply a federal income tax return.20 The prudent issuer will not rely on the "undue delay or expense" exceptions provided under this regulation. Relying on an exception to provide less information takes a company one step closer to the charge that it failed to disclose some material aspect of the firm's financial condition, thus opening it up to anti-fraud claims. If a company has no revenue at the time of the offering, it should provide an income statement that shows expenses only.

22 5

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While it may be unflattering, it is capable of being audited. Every company will have a balance sheet, even though it may show very little.

Rule 506: Exemption for Offers and Sales Without Regard to Dollar Amount Regulation D, Rule 506 was designed as a "safe harbor" to make sure that issuers fall within the provisions of the Section 4(2) exemption. There is no limit on the amount of money that can be raised under Rule 506 provided that:

investor^,^'

a)

There are no more than 35 non-accredited

b)

Non-accredited investors, either alone, or with their purchaser representatives are sophisticated enough to evaluate the risks and merits of the prospective i n ~ e s t m e n t . ~ ~

c)

Non-accredited investors must receive substantially the same information that they would get if the offering were registered and all accredited investors must get the same information that the nonaccredited investors receive.

d)

Financial statement requirements are the same as for a Rule 505 offering, which means that audited financial statements should be provided unless an exception for undue expense or delay applies.23

Rule 506 seems to provide the greatest flexibility and unless there is a compelling reason to use some other rule, entrepreneurs should probably use this one for private placements. The drawback to this rule comes when non-accredited investors are allowed to invest. Non-accredited investors must be sophisticated or must have sophisticated advisors. Again we get into slippery definitions as to who is sophisticated, increasing the risk that an investor will claim they are unsophisticated if an investment doesn't turn out as they expected. We also see that non-accredited investors must get disclosure material substantially similar to that required in a registration, which increases the time and cost to put together an offering. Both of these drawbacks can be overcome if an entrepreneur limits his or her offering to accredited investors.

Raising Capital Section 4(6) Exemption The Securities Act of 1933, Section 4(6) provides and exemption from registration for accredited investors. The limit of offering under this exemption is $5 million. One of the advantages to using this exemption is that there are no fixed disclosure requirements. On the other hand, to avoid the risk of a fraud claim, sufficient information should be supplied to allow an investor to make a rational evaluation of the security. This implies no material facts or circumstances should be omitted and all information must be true and not misleading. No advertising or public solicitation is permitted under this exemption.24 One example of a prohibited public solicitation would be inviting the public to a meeting where a security offering was to be discussed or inviting people to a meeting wherein the issuers knew there was a likelihood that those attending would find out about the offering. Internet communications through for example, chat rooms and blogs (web logs) would probably be considered a prohibited public solicitation.

Accredited Investor The term "accredited investor" is mentioned throughout Regulation D. An accredited investor is person who (i) is believed to have sufficient assets to withstand the loss of his or her investment, (ii) is sophisticated enough, either personally, or through his or her professional advisors to evaluate the merit and risk of an investment, and (iii) has sufficient bargaining power to demand and get all the information he or she need to fairly assess the merits of an investment. Accredited investors are those that fall into one or more of the following categories:25 1)

A bank, insurance company, registered investment company, Small Business Investment Company (SBIC) licensed by the SBA or an employment retirement plan as defined by ERISA.

2)

Any private business development company as defined by the Investment Advisers Act of 1940.

3)

Any IRS 501(c) (3) organization with more than $5 million of assets, and not formed for the purpose of purchasing the issuer's securities.

Securities Regulation 4)

Any director, officer, or general partner of the issuer.

5)

Any natural person who, with their spouse, has a net worth of $1 million or more.

6)

Any natural person who had income of $200,000 for two years and expects to have income over $200,000 in the current year, or who, with their spouse, had income of $300,000 for the last two years and is expected to have income of $300,000 in the coming year.

7)

Any trust with total assets of more than $5 million, and not formed for the purpose of purchasing the issuers securities.

8)

Any entity in which all the owners are accredited investors.

Regulations indicate that an issuer must make a good faith effort to determine whether a person is an accredited investor. Some interpret this as merely asking the investor whether they are accredited. Such a casual inquiry seems imprudent on its face. A better, though perhaps not perfect approach, would be to ask the investor to sign an affidavit that they fall into one or more specific categories. An affidavit is a sworn statement admissible in court.

Summary of Private Placement Options Each of the six private placement exemptions provided under federal securities laws has its advantages and disadvantages as shown in Figure 11-4 Analysis of Private Placement Options. In part, the decision as to the best option will be based on (i) the nature of the investors, (ii) the amount of funds to be raised, (iii) the state where the securities are to be offered, (iv) the availability of audited financial statements, and (v) the clarity of the governing statutes or regulations for each option. A final factor to consider is how each of these options relates to state securities law.

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Figure 11-4 Analysis of Private Placement Options Rule or

I

M;;in

Audited Financials

No

Section 4(2)

Unlimited

No No Yes

Rule 505

Yes

Section 4(6)

1 $5

Investors

Principal Drawbacks

Single state

The company and its investors must reside in a single state. Sophisticated Sophisticated investor is not defined. Varies by State law controls. state. Max 35 non- Non-accredited accredited investors must investors. receive disclosure Unlimited equal to that in a accredited registration. investors Max35 non- Non-accredited accredited investors must be investors. "sophisticated" Unlimited and receive accredited disclosure equal to that in a investors. registration. No non-accredited Accredited investors. investors.

DOCUMENTATION FOR A PRIVATE PLACEMENT Generally, the entrepreneur should prepare at least five items of documentation for a Regulation D offering: (i) disclosure information on the company which generally includes financial statements, (ii) a stock purchase agreement, (iii) and investor affidavit for each accredited investor, (iv) in the case of a Regulation D or Section 4(6) offering, a Form D for the SEC, and (v) a SCOR Form which is acceptable qualifying documentation in most states. The SCOR Form is also called the form U-7.

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Information on the Company Information, substantially equivalent to that provided in a Form S-1 registration statement must be provided to all non-accredited investors. While there are some carve outs requiring less information for offerings under $2 million, the better course of action is to adhere to the more rigorous standard. Information provided to non-accredited investors should be provided to accredited investors as well. The S-1, which is the primary registration form for large companies, will be discussed in detail in the chapter on Initial Public Offerings. The information in the S-1 is in a narrative form. However, to simplify disclosure for small offerings, a fill in the blank, questionnaire called a SCOR Registration is accepted by the SEC and many states for Rule 504 and Section 3(a) (11) offerings. This form is available from the North American Securities Administrators Association (NASAA) and is sometimes referred to as form U-7. 26 They can be contacted through their website: www.nasaa.org.

A Stock Purchase Agreement A stock purchase agreement sets forth the terms and conditions under which the investment will be made, including the privileges and duties of the parties. An investment agreement is another name for a stock purchase agreement. A model stock purchase agreement prepared by ACE Net, a division of the Small Business Administration is available in the CD-rom accompanying this book. This stock purchase agreement should be modified based on the needs parties as reflected in their negotiations about their respective rights and privileges. See Chapter 9, Structuring the Deal.

An Investor Accreditation Affidavit While this is not a formal requirement, the ability to obtain a private placement exemption turns on knowing who is and who isn't an accredited investor. Rather than relying on a simple clause in the Stock Purchase Agreement to confirm an investor is accredited, the more prudent course of action would be to obtain a separate affidavit from each potential investor, and obtain it early in the negotiation with investors.

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Form D The purposes of Form D are to provide the SEC, the states that have adopted it, and future investors about the nature of the offering, the company, the individuals who may benefit from funds raised, and the use of proceeds. If the issuer is relying on a Regulation D or Section 4(6) exemption, a Form D must be filed with the SEC within 15 days after the first sale of securities. A Form D must be amended and updated within 15 days of each subsequent sale until the financing round is over. Form D information is available to anyone through the SEC Public Reference ~ o o m At . ~present, ~ there is no fee for filing a Form D. Specific information sought on Form D includes: The nature of the exemption the issuer intends to rely on, for example that provided by Regulation D or Section 4(6). Identification information on the corporation, its promoters, officers, and owners holding more than a ten percent interest in the company. Information about the offering including whether the issuer intends to issue to non-accredited investors, the minimum investment accepted and the states in which the offer is being made. The type of security being sold: debt, equity, common, preferred, partnership interest or other, along with the total amount of each type of security offered and sold as of the Form D filing. The amount of any securities sold within the last 12 months must also be detailed by the type of offering: Rule 504, Rule 505, or Regulation A. A statement of the expenses incurred in making the offering such as printing and engraving costs, legal, accounting, and engineering fees, and other expenses. The proposed use of proceeds. A Form D is included in the CD-rom that comes with this book.

Securities Regulation

STATE SECURITIES LAWS Generally a company must comply with the securities law of every state in which it sells securities, in addition complying with Federal securities law. State securities laws are called "Blue Sky" laws because promoters used to be notorious for telling investors there was nothing but blue sky. Distinguish between states where a company does business and states in which it sells securities. A company may have offices in all fifty states, but only sell securities in its home state. In that case, it only has to comply with Federal and home state securities law.

Federal Pre-emption: Where State Laws Have Been Superceded Under the Commerce Clause of the Constitution, Congress has broad powers to regulate interstate commerce. While it doesn't exercise its power under all circumstances, it has used its power to grant some relief from state securities laws through the National Securities Markets Improvement Act of 1996 (NSMIA). 28 In the context of this law, "Covered Securities" are securities, for which Federal Law pre-empts state law. Pre-emption means that the Federal government has asserted exclusive jurisdiction. Covered securities fall into one of the following categories: Nationally traded ~ecurities,~~ Securities issued by a registered investment company or that has filed a registration statement under the Investment Company Act of 1940. Securities offered or sold to qualified purchasers, as defined by Commission rule.30 Securities sold in a transaction that is exempt from registration under Securities Act Sections 4(1) or 4(3), and the issuer files reports with the Commission pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. Securities sold in a transaction exempt from registration under Commission rules or regulations issued under Securities Act Section

Raising Capital 4(2) and that meet the requirements of Rule 506 under Regulation D.~' (vi)

Securities sold in a transaction exempt from registration under Securities Act section 4(4Q2

Covered securities also include a few other exemptions for specialized circumstances that are not relevant to most entrepreneurs or profit making businesses.

Preservation of States Rights with Covered Securities Even though the National Securities Markets Improvement Act of 1996 pre-empts the authority of states to regulate some securities, it does preserve certain state rights. For example, state anti-fraud statutes still apply. So a securities issuer cannot use Federal pre-emption to avoid state prosecution for issuing securities that commit a fraud on the public. In some circumstances, failure to disclose things like conflicts of interest, self-dealing, debt, ownership interests, and the value of assets can constitute fraud. False and misleading statements can constitute fraud as well as failure to disclose information. States may require: (i) copies of documents filed with the SEC, (ii) information about the securities sold in their state for purposes of assessing a fee, and (iii) consent to service of process, which means a company can be required to submit to the courts of that state.33

Securities Not Covered By Federal Pre-Emption Securities not covered by Federal pre-emption include: (i)

Securities traded on the Nasdaq Small Cap system or quoted on the NASD OTC Bulletin Board system.

(ii)

Securities listed on exchanges other than the NYSE, AMEX or Nasdaq National Market System (NMS).

(iii)

Debt securities of non-listed issuers, including asset backed and mortgage backed securities.

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(iv)

Private placements issued under Section 4(2) of the Securities Act that do not meet the requirements of Regulation D Rule 506.

(v)

Private placements issued under Regulation D Rules 504 and 505.

(vi)

Securities issued under Regulation A.

The reason the securities listed above are not covered by Federal preemption is that companies issuing them tend to be smaller, less mature and have fewer assets than companies to which preemption applies. For example, companies traded on the New York Stock Exchange (NYSE), American Stock Exchange (AMEX) and Nasdaq National Market System (NMS) must meet size and performance criteria. See Chapter 12, Initial Public Offerings for an overview of these criteria.34 Companies that fall outside the criteria for Federal preemption will have to comply with state securities law in addition to federal securities law.

OVERVIEW OF STATE REGULATION Federal securities laws operate on the principal that given all the facts, investors will make rational investment decisions. This is the disclosure approach to securities regulation. Some states require only disclosure and notification of that securities are being sold. However, about forty states require some level of merit review before securities can be sold.35States do not evaluate whether a company is likely to make or lose money or whether the investment is good or bad. Merit review is concerned with the fundamental fairness of the investment and considers issues like:

9

Cheap Stock - That is stock sold to issuers at a steep discount from that charged other investors.

9

Loans to Officers and Affiliates - A requirement that all such loans be repaid prior to issuing stock.

9

Insider Transactions - All transactions with insiders must be conducted at fair market value with approval by a majority of independent directors.

9

Debt Securities and Cash Flow - Cash flow must be sufficient to meet all fixed charges, such as interest and payment of bills as they

Raising Capital become due. When bonds are sold to investors, some states require a bond sinking fund. Impoundment of Proceeds - Some projects need a minimum amount of funds to go forward so companies raise money on a minimum 1 maximum basis. If the minimum isn't raised, the investor must return funds to the investors and terminate the deal. Some states subject such the proceeds to impoundment until the minimum is raised. Preferred Stock - Historical cash flow must be adequate to cover fixed charges associated with preferred stock, and preferred stock redemption features will be evaluated for fairness. Promoter's Equity - Promoters equity should be more than ten percent of the amount offered to investors Promotional Shares - If promotional shares were issued for less than 85 percent of the proposed public offering price, some states require that such shares be put in escrow pending the success of the company or that the offering price be reduced. Selling Expenses and Selling Security Holders - Selling expenses are limited to a certain percentage of the offering amount; pre-offering shareholders who are selling shares during the offering must pay a pro-rata portion of the selling expenses. Unequal Voting Rights - Prohibited, unless accompanied by preferential distribution or liquidation rights. Capitalization Requirements - Prohibiting the issuance of anything but common stock for "unseasoned" issuers. Limits on Per Share Offering Price - The offering price must bear some rational relationship to book value, earnings or price earnings ratios where there is no established market for the offering. Other price restrictions may apply, for example the shares must have a minimum sale price of $2 per share, or the price earnings ratio cannot exceed 25. There may be other limits on share price as well, for example, the price of shares in an offering cannot be "stepped up" as sale of shares proceeds.

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235

While these are some of the main merit review criteria used by states. Not every state uses the same criteria or applies it in exactly the same way.36

Attempts to Simplify State Registration About forty one states have adopted the Uniform Securities Act of 1956, a model securities law for the states. This law provides for three forms of registration: (i)

Registration by Notification - This is usually limited to mature issuers with a sound earnings history.

(ii)

Registration by Coordination - Where there is registration with the Securities and Exchange Commission, the state registration is coordinated with the Commission's review.

(iii)

Registration by Qualification - For states where merit review is required, qualification means meeting the fairness tests discussed above.

Another attempt at simplification was made by the North American Securities Administrators Association (NASAA) which adopted a model exemption entitled the Uniform Limited Offering Exemption (ULOE) which was designed to provide an exemption at the state level for offerings made under Regulation D, Rules 505 and 506. About 30 states have adopted some ~ states post their regulations on the web. form of U L O E . ~Most

State Securities Law Strategy The foregoing is a brief overview of the complexity that individual state securities laws can add to the process of raising capital. A company should first determine whether it qualifies under Federal Pre-emption. A profitable, substantial sized company should be able to qualify for preemption by getting listed on the NYSE, AMEX or the NASDAQ National Market System. A smaller firm can probably fit itself into the requirements for a Regulation D, Rule 506 offering. A second level strategy is to strictly limit the securities offering to "friendly" states. Those that only require disclosure and notification. If multiple state registrations are needed then a company should consider

236

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coordinated review. States have organized by region to coordinate the securities review process so that a company will only have to deal with a single point of contact that will speak for the other states in the region and consolidate their concerns in a single comment letter. A more detailed description of the coordinated review process is provided in chapter 13 Small Public Offerings. Another problem with state review is the time it takes. Most states don't reject applications outright; instead they provide a comment letter detailing what they perceive as weaknesses in the application. A company can elect to cure the weaknesses or abandon the application.

SELECTING A LAWYER If an entrepreneur has the SEC instructions, the Model Stock Purchase Agreement and the SEC Forms, why does he or she need a lawyer? Think of a lawyer as an architect. People hire architects to make sure they comply with building codes. Architects also provide design alternatives that a homeowner might not have thought of, save money, and produce more elegant designs. But the more an architect's client knows about design, the more likely he or she will get the house they want. Using a lawyer is similar. Lawyers can keep the entrepreneur in compliance with the law, provide alternatives and produce an elegant design. The more the entrepreneur knows about the process, the more control they will have over it, and the more likely he or she will get the desired outcome. One of the best ways to select a lawyer is to find one who specializes in securities law. Ask them point blank: "How many Regulation D offerings have you completed? How many times have you registered securities in state xyz? If the answer is less than ten times, keep looking. It is much less expensive to hire an experienced lawyer at a high hourly rate who already knows the law, has forms on hand, and knows the state regulators personally, than it is to hire someone at a lower hourly rate who is learning as they go.

SUMMARY Raising capital is a highly regulated activity in the United States. Penalties for failure to comply with securities laws can be severe. If a company fails to register securities with the federal government or to qualify for an exemption, the investor has a right to force the issuer to refund his or

Securities Regulation

237

her money if the investment does not work out as expected. This can be fatal for a company. Federal law defines practically every form of financial interest as a security. From this expansive definition, it has carved out certain types of securities that are exempt from regulation for example, commercial paper and securities sold in third party transactions in the stock market. Federal law then distinguishes between two classes of regulated securities: private placements and public offerings. Public offerings are discussed in Chapter 13. This chapter discussed a number of ways an offering could qualify as a private placement. Private placements are generally sold to a limited number of investors, contacted one on one and not via advertising or other public means. Investors are classified as either accredited, which means they usually have a certain level of wealth and sophistication, or non-accredited, which means they do not. Regulatory and disclosure requirements for non-accredited investors are generally much higher than for accredited investors. Regulatory requirements also vary by the amount of capital a company needs to raise in any twelve month period. For example, a questionnaire called a SCOR Form provides enough information to satisfy the requirements for a Regulation D, Rule 504 offering or a Section 3(a) (1 1) offering. In addition to federal securities laws, issuers must also comply with state securities laws. Whereas federal law focuses on the adequacy of information disclosure, many states have a merit review system in which they evaluate the fairness of a securities offering before they will permit it to go forward. This merit review addresses issues such as self-dealing, the price at which securities are offered to insiders and matters of corporate governance. To reduce the regulatory burden on issuers, federal law has carved out a number of situations in which it preempts state law. Where a company can qualify for federal preemption it does not have to submit to state merit review. Offerings that comply with Regulation D, Rule 506 and certain securities that trade on national markets qualify for federal preemption. The number of options available in federal securities law and problems coordinating state and federal law create a regulatory thicket that is best handled by a lawyer specializing in securities law. However, lawyers are most effective when they have well informed clients.

23 8

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DISCUSSION QUESTIONS What is a security? Give four examples of securities. What are two circumstances under which securities law impose liability on the issuers of a security? List three exemptions from federal securities law. List three forms of registration for publicly traded securities and describe when each is used. What is a private placement? How does it differ from a public offering? List five rules or regulations govern the sale of securities in a private placement. What is an accredited investor? List eight categories of accredited investors with brief descriptions of each. What are Blue Sky laws? What is the relationship of Blue Sky laws to federal securities law? What is federal pre-emption? Describe five circumstances in which state securities laws are pre-empted by federal securities law. What is the difference between a regulatory scheme based on disclosure and one based on merit review? Who uses which scheme? What are twelve common merit review standards? What do they mean? What should a company's strategy be with regard to state securities laws?

Securities Regulation

ENDNOTES 1

David L. Ratner, Securities Regulation, 3TdEd., West Publishing Company, St. Paul, Minnesota, 1988, p21. Ratner, p.22. 3 "The Laws That Govern the Securities Industry," U.S. Securities and Exchange commission, www.sec.gov/about/laws.shtml12/2001. "The Laws That Govern the Securities Industry." G e r , p.87 Ibid.p.53 7 Ibid.p.30; these short term notes are commonly referred to as Commercial Paper. 8 "Small Company Offering Registration (SCOR)" Corporation Division, secretary of State, Olympia, Washington www.dfi.wa.gov/sd/scor.htm p.3 downloaded 9/13/2003; "Q & A: Small Business and the SEC," U.S. Securities and Exchange Commission, www.sec.~ov/info/smallbus/~asbsec.htm p.9 downloaded 9/13/2003 9 "Regulation D: Rules Governing the Limited Offer and Sale of Securities without Registration Under the Securities Act of 1933" Interpretive Release 33-6455, Securities and Exchange Commission, 03/06/2003; http://www.sec.gov/divisions/corpfin/forms/regd.htm lo SEC Regulation 230.502 ( c ) l 1 SEC Regulation 230.502 (b) l 2 SEC Regulation 230.503 l3 SEC Regulation 230.502 ( d ) l4 SEC Regulation 230.505 (a) l 5 SEC Regulation 230.504(a) l6 SEC Regulation 230.504 (b)(2) l7 SEC Regulation 230.504 (b) (1); -"Q & A: Small Business and the SEC," U.S. p. 11. Securities and Exchange Commission, www.sec.~ov/info/srnalIbus/~asbsec.htm downloaded 9/13/2003 l8 SEC Regulation 230.505 (b)(2)(i) l 9 SEC Regulation 230.505 (b)(2)(ii); 230.501 (e) Accredited investors do not count toward total 20 "Q & A: Small Business and the SEC" p. 13. " KC Regulation 230.506 (b)(2)(i) 22 SEC Regulation 230.506.(b)(2)(ii) 23 "Q & A: Small Business and the SEC" p. 13. 24 "Q & A: Small Business and the SEC" p. 13. 25 SEC Regulation 230.50 1(a) 26 North American Securities Administrators Association can be contacted at www.nasaa.org. 27 A company's Form D can be obtained from the SEC Public Reference Room at 202-942-8090 during working hours.

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Public Law 104-290,110 Stat. 34 16 (October 1 1, 1996). NSMIA amended Section 18 of the Securities Act of 1933. A discussion of NSMIA and the securities that are covered and not covered by this act is available in a report entitled "Report on the Uniformity of State Regulatory Requirements for Offerings of Securities That are Not 'Covered Securities'." Which can be found at www.sec.gov/news/studies/uniformy.htm. 29 Section 18(b)(l) of the Securities Act defines a nationally traded security as one which: (A) is listed on the New York or American Stock Exchange or is listed on the National Market System of the Nasdaq Stock Market or its successors, (B) is listed on a national exchange that the Commission determines is substantially similar to those in (A), or (C) is a security of a nationally traded company that is senior to a security described in (A) or (B). For example, a preferred stock is generally senior to a common stock, a bond is generally senior to a preferred stock, and senior bonds are, of course senior to subordinated debentures. 30 Securities Act Section 18(b) (3). As of the writing of the entitled "Report on the Uniformity of State Regulatory Requirements for Offerings of Securities That are Not 'Covered Securities' " issued October 11, 1997, the Commission had not issued rules on who was a qualified purchaser within the meaning of this statute. 31 "Report on the Uniformity of State Regulatory Requirements for Offerings of securities That Are Not "Covered Securities" Pursuant to Section 102(b) of the National Securities Markets Improvement Act of 1996," Securities and Exchange Commission, October 11, 1997. Paragraph 11, B, et.seq. 32 Securities Act section 18(b)(4)(B) 33 Securities Act Section 18(c )(2)(A) 34 "Report on the Uniformity of State Regulatory Requirements for Offerings of Securities That are Not 'Covered Securities'." Report section I1 B. Which can be found at www.sec.gov/news/studies/uniformy.htm. 35 Campbell, Blue Sky Laws and the Recent Federal Preemption Failure, 22 Iowa J. Corp. L. 175 (Winter 1977) fn 6 1. 36 "Report on the Uniformity of State Regulatory Requirements for Offerings of Securities That are Not 'Covered Securities'." Section I.B. 37 Ibid. Section I B. 28

Chapter 12

PUBLIC OFFERINGS

INTRODUCTION An initial public offering (IPO) is a strategic option for raising new capital. It can also raise capital to replace bank debt, provide an exit strategy for angel investors and venture capitalists, increase a company's value, and provide liquidity to a company's owner. Going public is not the right option for every company and is only right for companies at a certain stage in their growth. In this chapter we will discuss what it means to go public, the advantages and disadvantages, securities regulation, the mechanics of an initial public offering (IPO), the IPO road show, securities pricing, and how to tell whether a company is ready for a public offering. We will also discuss the importance of being listed on a stock exchange, listing requirements for the major exchanges, market makers, that is the actual broker dealers who trade in a company's stock in secondary markets, and the importance of getting analysts to cover a company. Finally, we will discuss delisting a company and why a company would go private and how that affects the owners and shareholders.

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THE DECISION TO GO PUBLIC Whether going public is a good or bad choice for a company depends on a number of factors including the objectives of the owners and investors. Some owners simply want to raise large blocks of capital in the most efficient way. Others want to increase the liquidity of their investment so they can cash out small blocks of stock, reaping the rewards of their effort. Venture capitalists, angel investors and other investors may want to exit their investment altogether. Another set of factors to be considered are the cost of going public, the cost of complying with securities regulations once the company goes public, and whether the company is ready to go public.

Advantages The major advantages to going public are: Access to larger capital markets - NYSE, AMEX, NASDAQ, and region exchanges such as the Philadelphia Stock Exchange. Greater liquidity - Smaller slices of the company can be bought and sold, with the result that there will be many more potential buyers and sellers. Stock price changes more continuously because there will be more buyers and sellers, which will lead to a more stable company value. Broker dealers can make a market in the stock. Restrictions on sale of stock are removed. Greater transparency - Public disclosure of operations through required reporting increases the value of individual shares. Public companies that trade on national exchanges are exempt from state regulation.

Public Offerings

Disadvantages There are several significant drawbacks to going public. Some of which are significant enough to cause companies to file for deregistration. Deregistration is the act of taking a public company private. Disadvantages to going public include: The registration process needed to go public can be daunting and costly. Owners and promoters can incur significant liability: a.

Fraud charges if disclosures are grossly inaccurate, misleading or incomplete,

b.

Liability for return investors' capital if there are material, though not fraudulent misstatements or misleading omissions in the public offering statement.

Annual, quarterly, and other reporting requirements are extensive. Sarbanes-Oxley imposes significant additional corporate governance costs as well as criminal liability if signed financial statements prove inaccurate. Owners incur a fiduciary duty toward shareholders Owner's strategic flexibility is limited and often subject to shareholder approval. The potential for loss of control increases If a company underperforms analysts might stop covering it, the value of its stock might plummet, it might be delisted from an exchange, and ultimately broker dealers may conclude there is not enough interest in a stock to continue making a market, in which case the benefits of being a public company will be dramatically reduced.

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How Realistic Is It To Go Public? Faced with these pros and cons, what have other companies done? And what are the characteristics that have made an IPO successful?

Economic Cycles In 2002, about $8.5 billion was raised in 71 initial public offerings, down from about $65.5 billion raised in 1999 in 490 initial public offerings. See Figure 12-1, Analysis of Initial Public offerings.' Figure 12-1 Analysis of Initial Public Offerings

Year

Number of IPO's

Total Amount Raised (Billions)

Average Amount Raised (Millions)

This table tells us a couple of things. First, in good times and in bad, companies go public. Second, the appetite for initial public offerings is cyclical, which means that companies that want to go public should start preparing in bad times so they are ready in good times. Third, the average amount of money raised is significant, never dropping below $44 and rising to almost $425 million in 2001. This means that unless a company has a need and use for a significant amount of capital, it should consider an alternative funding source.

Public Offerings Size of Company

There is no statutory minimum size to take a company public. However, a study of 188 non-financial companies that went public in 1998 found that long term success was related to pre-IPO size and revenue growth. In this study, success was defined as a total return of at least 10% per year for three years on shares bought at the offer price. Unsuccessful companies were those for which the total return was negative and mediocre companies were those with a total return of between 0% and 10%. Based on these criteria 69.7% of IPO's were unsuccessful in terms of total return; 26.5% were successful, and the rest were mediocre. While it could be argued that the downturn in the economy over the period 1998 to 2001 had some impact on these results, investors do not care. They expect substantial return in good times and bad. About 42.9% of the companies with pre-IPO revenue over $500 million were successful; 28.9% of the companies with pre-IPO revenue between $50 and $500 million were successful; and 24.0% of the companies with less than $50 million in pre-IPO revenue were successful. The relative success of larger companies may be due to the fact that they are less dependent on two or three key customers, higher revenue indicates greater market acceptance of products and services, and larger companies have the resources to fall back on in bad times or if they make a mistake. On the other hand, 57.1% of firms with revenue over $500 million were unsuccessful on a total return basis so size alone is not a guarantee of success.

INVESTMENT BANKS Companies that want to sell stock to the public generally engage an investment bank to manage the process. If it is the first time a company sells stock to the public, this process is called an Initial Public Offering (IPO). But, what is an investment bank, and what does it do?

Investment Bank Services Investment bankers are neither investors nor bankers. They: (i)

Provide strategic advice to companies, especially in the area of maximizing company value.

Raising Capital Appraise and value divisions, subsidiaries, or whole companies and offer fairness opinions about certain transactions. Find companies for a client to purchase, or find buyers or clients who want to sell a company. Find investors or lenders for private placements. Line up broker dealers to make a secondary market in the stock after the IPO. Manage the process of taking a company public, which involves help navigating securities laws, assembling the prospectus and getting the company meetings with institutional investors and others that might want to subscribe to large blocks of stock. Underwrite securities issues.

Underwriting Underwriting is a term that refers to the process of selling new securities. The amount of funds to be raised, the type of security issued and fees are all negotiated with the investment bank prior to the engagement. Typically, an investment banker will buy an entire new issue at a discount and resell it in the market place for full price. The difference between the amount paid to the issuing company and the price it sells securities to institutional investors is called the spread. This spread is one way the investment banker generates a fee. For example, suppose an investment banker agrees to purchase $10.0 million of securities for $9.5 million. The $500,000 spread becomes part of its fee. The issuing company is guaranteed to raise a specified amount since the investment bank will pay it the net proceeds whether or not the investment banker can resell its securities. This puts the underwriter at risk if it can't sell the securities it purchased. Investment bankers manage risk in several ways: (i)

Through the fees they charge.

(ii)

Through the offering price - A security that will not sell at $15 per share, may completely sell out at $10 per share.

Public Offerings

(iii)

247

Through a book of orders - A book of orders is an expression of interest in purchasing a block of securities at a certain price. A new issue is oversubscribed if the demand for shares is greater than the supply-

If an underwriter is stuck with securities it cannot sell it can keep them in inventory, or it can sell them at a discount to the offer price. Both alternatives are expensive. If the underwriter holds securities in inventory, it must finance them because it has paid the issuer the net proceeds of the offering. If it sells securities for less than the offer price, clients who bought at the offer price will suffer a loss which is not good for an investment bank's reputation.2 This risk provides investment bankers with a motivation to set the offering price below market rather than at market. There is some evidence of the propensity of investment bank to undervalue stocks at IPO and such undervaluation can be seen in the "pop" or first day increase in stock price over the offer price. If a company goes public at $10 per share, but closes the day at $14, the issuer may ask why the investment banker didn't bring the stock to market at $12 or $13 per share. If a million shares are being offered, the issuer might conclude the underwriter left $2 to $3 million of his or her money on the table. An alternative to a typical underwriting agreement is a "best efforts" contract. In this type of agreement, an investment bank only agrees to do the best it can. The risk of not selling all the securities is borne by the company which allows it to take on clients with uncertain prospects.3 On the other hand, if a company needs a specified amount of capital to launch a new product, retire maturing debt, or to acquire another company, a shortfall could have dire consequences.

PRICING SECURITIES An investment banker usually recommends the price at which a security should be offered a day or two before it goes public. Price setting is part art, but there is enough science that a company can make an informed judgment as to whether the price recommended by the underwriter is reasonable. This will allow the entrepreneur to discuss the price from a position of strength, rather than simply acquiescing to the investment banker's recommendation.

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Supply and Demand In part, a stock's offering price is set by supply and demand. When the market in general is going up, and the IPO market is hot, the demand for new issues drives up the price. Conversely, when the market is down, and IPO's are out of favor, low demand means the offer price will have to be low to clear the market. Clearing the market is an economic term for adjusting price so that demand just equals supply. Sometimes a single, adverse event will collapse demand for new issues. For example, the week before one company was scheduled to go public, the Dow Jones Industrial Average dropped 500 points in one day. That sudden drop caused a number of institutional investors to shift into more conservative, established companies. The offering was postponed for two months by which time the Dow Jones Industrial Average had recovered and the IPO went smoothly.

Share Price as a Function of Revenue One way to estimate a company's value is to use the Revenue Multiplier method discussed in chapter 9, Structuring the Deal. This was the method most often used to value Internet companies in the late 1990's because few had earnings that could be used as the basis of valuation4 A company's share price is the total value of the company spread across all the shares that will be outstanding after the IPO. For example, suppose the Schmidlap Company, a distributor of industrial gases, was trying to set an offering price for 1 million shares of stock. One million shares of Schmidlap have already been issued to investors and employees. Schmidlap has revenue of $16 million. A survey of the industry indicates that industrial gas companies sell for 1.5 times revenue. How should Schmidlap be priced? First, compute the total value of the company using equation Eq. 12.1. Total Value = Company Revenue x Revenue Multiplier

Eq.12.1

Then substituting Schmidlap's revenue and the Industry Revenue Multiplier into the equation we find: Schmidlap Total Value

= $16 M x

1.5

Public Offerings

249

Since this value will have to be distributed over both current and newly issued shares, the offering price should be divided by the total number of shares that will be issued and outstanding after the IPO as shown in equation Eq.12.2. Target Price = Total Company Value (Current Outstanding Shares + Shares Offered) per Share

Eq. 12.2

For Schmidlap Company the offering price would be: Offering Price =

-

$24 M 1 million shares outstanding + 1 million shares offered $24 M 2 M shares

The revenue method would be used in one of three circumstances. A company may be a pre-profit start-up. If so, the prospects for the company and its intrinsic value might be far greater than its Pre-IPO earnings would indicate. A company may be on a growth trajectory, but has not moved very far beyond its break-even point. Finally, a company may be substantial, but a temporary reversal that has depressed its earnings.

Share Price as a Function of Earnings A more traditional way to price an offering is to use a multiple of Earnings Before Interest Taxes Depreciation and Amortization (EBITDA). EBITDA is an estimate of the cash generated from operations. Cash gives a company the power to develop new products, invest in sales and marketing, plant and equipment, attract the best people, cover debt service, and provide a return for investors. Depreciation and amortization are excluded because these are non-cash expenses. Taxes are excluded so that companies with different tax strategies can be compared. Interest is excluded so that companies with differing capital structures can be compared. Up until 2001, new IPO companies were valued at 4.0 to 5.0 times EBITDA. However, in 2001 that dropped to the range of 2.0 to 2.5 times EBITDA. The point is that the EBITDA multiplier, and consequently a

250

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company's value, can vary over the course of a business cycle. A company considering an IPO should compute an EBITDA multiplier for their industry rather than relying on multipliers for the market generally and multipliers should be computed within a few weeks of the IPO date. For more information on computing the EBITDA multiplier see chapter 9, Structuring the Deal. Total company value can be estimated using equation Eq. 12.3. Total Value

= EBITDA x

EBITDA Multiplier

Eq. 12.3

Example: Ajax Cement Company has an EBITDA of $1 1 million. After the offering, 1.5 million shares will be outstanding. Recent IPO's have had offering prices that value companies at about 4.2 times EBITDA. However, cement companies as an industry are only valued at about 3.8 times EBITDA. How should Ajax price its offering? Ajax Value

= EBITDA x

Cement Industry EBITDA Multiplier

Using equation Eq.12.2 above, and knowing the total number of shares that will be outstanding after the IPO, the target price per share can be estimated. Target Price = $4 1.8 M 1.5 M Shares per Share

In the prospectus, companies are expected to give the offering price as a range. This allows companies to make last minute adjustments to price depending on emergent market conditions while giving subscribers as much information as possible. Ajax might set the high end of the range to that of IPO's generally, or might set it some arbitrary percentage higher than the target price. Suppose Ajax set the high end using the general IPO multiplier of 4.2. Recasting equation Eq.12.3 to reflect a different EBITDA multiplier gives a high end value of: High Ajax Value

= EBIDTA x

Recent IPO EBITDA Multiplier

Public Offerings

Then using equation Eq. 12.2 to get target share price we have: Target Price = $46.6 M per Share 1.5 M Shares

The low end price can be computed in a similar way, either by looking at a more pessimistic benchmark multiplier or by using an arbitrary discount from the target amount, for example 10%. Low Ajax Value = $1 1 M x 3.8 x 90%

Using equation Eq.12.2 again we find the target share price is: Target Share = $37.6 M Price 1.5 M Shares

A wide target price range gives flexibility. However, if the range is too wide, the market will question whether the company and its investment bankers have a real grasp of the company's value. That will make subscribers nervous, unhappy, and drive them to the low end of the range. As a convention, the range of offering prices is usually quoted in whole dollars. So the range for Ajax the range would probably be set at $25 to $3 1.

MECHANICS OF AN INITIAL PUBLIC OFFERING Going public is a ballet that involves investment bankers, the SEC, auditors and other experts, and a lot of work by the company and its staff. The following is a roadmap of the mechanics of an Initial Public Offering.

Raising Capital Amount of Proceeds and Purpose Determine what proceeds will be used for and the amount needed. This is important to convince investment bankers and institutional investors to take a chance on a newly public firm. (ii)

Find an Investment Banker Find and negotiate terms with an investment banker. This often involves a "Bake Off' competition among investment bankers to find the one that can provide the most cost effective services.'

(iii)

Obtain Audited Financial Statements If financial statements have not been audited for the previous three years, find and engage a CPA firm willing to do a retrospective audit. For credibility, this should be a national CPA firm or at least a large regional firm. Complete the SEC Forms for Federal Registration Form S-1, contains prospectus information and provides detailed information about the company's business, management, ownership, assets, liabilities, customers, suppliers and more. This is very time consuming so build sufficient lead time should be built into the schedule. Set the Target Price Range The Underwriter and issuer set an initial offering price range.6 File the S-1 File the S-1 with the SEC which will review it for completeness. The SEC will not express an opinion as to either the accuracy of disclosure or the merit of the securities offered. At this stage, the prospectus is called a "Red Herring" because no stocks may be sold.

(vii)

Find a Market Maker The underwriter should find one or more broker dealers to make a market in the company's securities after trading begins.

(viii)

Conduct the Road Show Underwriters and issuers hold a two week series of "Road Show" meetings with institutional investors.'

Public Offerings

253

Build a Book of Potential Orders Underwriters "build a book" of potential orders by canvassing large institutional investors to get "indications of interest" in the offering during the road show. Knowing the quantity institutional investors are likely to demand at any price helps underwriters build a demand curve for the security. No securities can be sold at this point. SEC Evaluation Period The SEC has 20 days to advise the issuer of defects in its prospectus and recommend changes and additional disclosures. If the SEC says nothing, in 20 days the prospectus becomes "effective," which means securities can be sold. Publish Final Prospectus The final prospectus is published. The final prospectus is almost identical to the prospectus supplied to the SEC with the following exceptions: a) it contains updated financial information, b) underwriting fees, also called floatation costs are disclosed, and c) the net proceeds to the company are di~closed.~ Set Final Offer Price The day before trading begins the underwriters and issuer set the final offering price.9 In part, this will be a function of market conditions and how well recent IPO's have been received. Shares Sold to Institutional Investors The underwriter sells shares to institutional investors. If the underwriter cannot sell all the shares it bought from the issuer, the IPO is called a failed offering. A failed offering shakes confidence in both the underwriter and the issuer. Underwriter Remits Net Proceeds to the Issuer On the day the company goes public, the underwriter remits the offer amount less discount to the issuer by wire. For a "best efforts" contract, the underwriter remits the amount sold less its commission. Shares Begin Trading Institutional investors resell some or all of their shares in the secondary market often at a premium to the offering price.'0

254 (xvi)

Raising Capital Underwriters Exercise Options Underwriters usually negotiate for options that are exercisable at the offering price for a limited period of time, perhaps 30 to 90 days. If the stock price rises, the underwriter's additional compensation from options can be substantial."

(xvii) Market Maker of Last Resort The underwriter often becomes the market maker for stocks they take public.'2 If the underwriter can get several brokers to be the market makers, that indicates wide-spread interest in the company and its securities. If the underwriter is the only one willing to be a market maker, that is an indication that the offering is not being well received.

MARKET MAKERS Market makers are brokers who agree to buy at least one round lot, usually 100 shares, at a specified bid price and sell at least one round lot at a specified offer price. Market makers generate a profit from the difference between the bid and offer price. If the demand for a security is high, market makers raise the price at which they sell so they can raise their offer price and continue to purchase shares for resale. If a security's price drops, a market maker will drop his or her offer price to buy at a low enough price to resell at a reduced selling price and still make a profit. Market makers are important because, without a well defined market in which a particular security can be sold, investors will be reluctant to buy.I3 The NASDAQ National Market System requires at least three market makers before they will allow a security to be listed.14

IPO ROAD SHOW The road show derives its name from Broadway. It is a process in which the issuer's executives and investment bankers visit institutional investors. Like a new Broadway play, the road show starts in the small cities where the presentation is polished and answers to investor's questions are refined. Ultimately, the road show goes to New York, where hopefully, the buzz it has generated will increase institutional interest.15

Public Offerings

255

In theory, there is no need for a road show. Everything that is relevant about a company should be contained it its public filing. However, institutional investors want to look the issuer's executives in the eye and ask them the tough questions. At one level, the road show is pure theatre and executives often receive extensive coaching for their presentations. However, at another level, it is about communicating the company's story in a simple, straightforward manner.16 Lynn Diamond, of Innovative Information Techniques, a New York communications firm, coached one entrepreneur before his road show, cutting his 90 minute presentation down to 18 minutes. She also suggested using words any sixth grader could understand.I7 Investors want to see rapid growth and strong performance on key metrics. They look for revenue growing faster than sales and marketing costs. And they want to know whether the CEO can stand up to a withering fire of questions and show grace under fire.'' Not everyone can do it, and the credibility of the management team can make or break an IPO. Of course the other objective of the road show is to develop a book of orders that can be fulfilled when the stock goes 'public. If investors oversubscribe, the issuer and underwriter can move the offering price to the top of their range. However, if interest is weak, they may be forced to accept the lower range of the offer price. An IPO Road Show might hold 80 meetings in 20 cities over a fifteen day period. It is something of a marathon, and preparation prior to launch is extremely important because there is little time to back-fill and adjust.

INVESTMENT BANK FEES Fees vary depending on the services provided, transaction complexity and whether the investment bank has to deal with any "special circumstance^'^ that makes its job more difficult. Special circumstances may be anything from the difficulty raising money for a totally new industry, to taking a company public that has a long, but spotty earnings record. The important thing is for the company to approach an investment banker with some way to evaluate proposed fees. In theory, investment banking fees are justified by the fact that it would be more expensive for a company to line up investors on its own, than to use an investment bank which has a network of willing investors it can call on. 19

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Typical fees for IPO related services are presented in the Figure 12-2 Underwriting Fees for the Top Ten Investment Banks. 20 Figure 12-2 Underwriting Fees for the Top Ten Investment Banks

Lead Investment Banker

Market Share %

No. of Issues

Average Fee

Goldman Sachs Morgan Stanley Dean Whitter Merrill Lynch Credit Suisse First Boston Donaldson Lufkin & Jenrette Salomon Smith Barney Lehman Brothers Fleet Boston Deutsche Banc Bear Stearns Top Ten Totals Other Lead Investment Bankers Industry Totals

Underwriting fees must be disclosed on the face of the prospectus along with the net proceeds to the issuer in a form prescribed by regulation. Suppose Ajax Corporation has 800,000 shares issued to the owner and private investors prior to the IPO. At the IPO the company will issue an additional 700,000 shares at $28 each. Both existing and new shares will be registered. Ajax has negotiated an underwriting fee of 6.25%. The underwriter's fee is only applied to the newly issued shares and the fee disclosure required in the prospectus only reports on these new shares. Figure 12-3 Fee Disclosure, provides an example of the fee calculation and required format. The fee disclosure is also accompanied by certain caveats regarding the company's indemnification of the underwriters, expenses of the public offering not included in the underwriter's fee and the effect of options granted to underwriters.

Public Offerings Figure 12-3 Fee Disclosure

Initial Public Underwriting Proceeds To Offering Price Discount (1) Company (2') Per Share Total (3)

(1) (2) (3)

$28.00 $19,600,000

$1.75

$26.25

$1,225,000

$18,375,000

The company has agreed to indemnifj the Underwriters against certain liabilities, including liabilities under the Securities Act of 1933. See "Underwriting" in the prospectus. Before deducting estimated offering expenses of $450,000 payable by the company. The company has granted the Underwriters an option for 30 days to purchase up to an additional 100,000 shares at the initial public offering price per share, less the underwriting discount. The total offering price, discount and proceeds will be: $22,400,000, $1,400,000 and $2 1,000,000 respectively.

Think underwriting fees are high? So does the government. A study by two University of Florida professors found that for the period 1995 through 1997, fees were exactly 7% for 90% of the IPO's between $20 million and $80 million. The Justice Department filed an anti-trust lawsuit against a number of underwriters claiming that the uniformity of fees for small to midsized offerings just could not be a coincidence and provided a prima facie case of collusion. Fees cited in the Figure 12-2 are firm wide averages. Fees on very large offerings are as low as 4%.21

UNDERWRITER'S DUTY Investment banks have a fiduciary duty to the companies they take public. However, some have charged that investment banks have bent the rules for their own profit by setting IPO prices artificially low and allocating shares of undervalued stock to favored firms who sell in the aftermarket for big gains.22In November 1998 Theglobe.com skyrocketed 900 percent from its offering price on the first day, and may have been a precipitating factor in

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the dot com IPO frenzy that followed.23 Under pricing stocks with the intention of triggering a large first day increase is a violation of SEC Regulation M which forbids manipulation of stock prices.24

LOCKUPS: GETTING RICH SLOWLY When an entrepreneur's company goes public, he or she can become an instant millionaire, even billionaire - on paper at least. The reason he or she is not necessarily real millionaire or billionaire is that underwriters force their clients to agree not to sell his or her personal holdings for some specified period, usually 180 days.25 This is called the lock-up period. During this period a stock's price can drop dramatically. Investment bankers insist on lock-ups to:26 (i)

Avoid the appearance that entrepreneurs are going to take the money and run.

(ii)

Make sure entrepreneurs have a continued interest in the company's performance.

(iii)

Reduce the oversupply and downward price pressure that would result if large blocks of stock were dumped on the market.

(iv)

Avoid the appearance that insiders were selling because the company was in trouble.

At the end of the lock-up period, many of these same problems might arise. However, there are several strategies for addressing these problems. One way is to piggyback a second offering that comes soon after the IPO, but does not have a lock-up agreement attached to it. This second round funding is seen as a mechanism to prevent flooding the market with ~ecurities.~~ Another strategy is to stagger the lock-up period, allowing sale of a small percentage of personal holdings at a time. A third, but similar alternative is to ask the underwriter to waive the lock-up agreement. The underwriter might be willing to do this if the stock price will not suffer. After all, there is nothing statutory about the lock-up; it is merely a negotiated contract term between issuer and ~nderwriter.~~

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When the lock-up period expires, owners often sell a substantial number of shares which causes a stock's price to tumble. However, if the underlying company is fundamentally sound, sophisticated investors view the end of the lock-up as a buying opportunity, since the glut of stocks usually only depresses the market for a short period of time. The Wall Street Journal lists expected IPO lock-up expirations at the beginning of each week in its "Deals & Deal Makers" column.29

REQUIREMENTS TO BE LISTED ON MAJOR STOCK EXCHANGES There are three major exchanges in the United States, the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the National Association of Securities Dealers Automated Quotation (NASDAQ) National Market System. These markets set relatively high standards for listing in terms of company revenue, market capitalization, the number of shareholders and the number of shares outstanding. Companies listed on these exchanges must also comply with certain governance standards for example they must have independent directors, an audit committee, guard against conflicts of interest, and protect certain shareholder rights. These listing criteria provide a certain level of assurance that the firms traded on these exchanges are reputable. Listing on one of these three exchanges is one of the ways to qualify for federal pre-emption of state securities laws. In addition to these national exchanges, there are several smaller stock exchanges. These exchanges have less stringent listing criteria and therefore provide less assurance to investors. Examples of smaller exchanges include the Philadelphia Stock Exchange (PHLX), the Boston Stock Exchange (BSE), the Chicago Stock Exchange (CHX), the National Stock Exchange (NSX) formerly the Cincinnati Stock Exchange, the Pacific Stock Exchange (PCX) and the NASDAQ Small Cap Market. Figure 12-4 Selected Listing Criteria provides an overview of representative listing criteria. Figure 12-5 is an analysis of Selected Stock Exchange Fees.

Figure 12-4 Selected Listing Criteria 30

NYSE

AMEX

NASDAQ National

NASDAQ SmallCap

Number of Shares And Shareholders

Market Value Public Shares

Financial Tests

Other Criteria

Delisting criteria

2,000 holders of 100+ shares or 2,200 shareholders or 500 shareholders with monthly trading volume of 1M shares. 800 shareholders and 500,000 shares publicly traded or 400 shareholders and 1 million publicly traded shares. 400 shareholders, 1.1M publicly traded shares and $20M publicly held market capitalization. 1M publicly held shares and 300 shareholders.

(A) $500M in global market capitalization Or (B) $750M in global market capitalization. $75M market capitalization.

(A) and $100M revenue & $25M aggregate cash flows for 3 years. Or (B) and $75M revenue Assets $75M and revenue of $75M in each of the last fiscal year or two or three of the last years. Market cap of $75M or $75M assets and $75M revenue.

Going concern, national interest, governance standards for related party transactions, shareholder rights, and other items.

Price less than $1 for 30 days or failure to meet other criteria

Reputation of business and management; governance standards on conflicts of interest, independent auditors & directors, and shareholder rights. 4 market makers, 3 market makers under certain circumstances. Corporate governance standards similar to AMEX. 2 market makers and corporate governance similar to the NASDAQ National market. 3 year operating history; corporate governance detailed in NASDAQ rules 8 12 to 85 1.

Price less than $3 for a sustained period; failure to meet other listing criteria.

1M publicly held shares and 800 public shareholders

$75M market capitalization.

$50M market capitalization.

Equity of $5M and $750,000 net income.

$15M market capitalization and $3 per share prelist mice

Tangible net assets of $l2M.

Less than $1 price, $50M in market cap or $50M in revenue and assets. Less than $1 price, $2SM equity, $35M market cap. Less than $ l M market cap or $1 price & 250 shareholders.

Figure 12-5 Selected Stock Exchange Fees 31 (M is millions of shares) NY SE

AMEX

NASDAQ National

NASDAQ Small Cap

PHLX

Listing fees Application fee Per share fees

Min fee Max fee Annual fees Per share fees

$36,800

I lSt& 2ndM

I Up to 5M $35,000;

$14,750; 3rd& 41hM $7,400; sthup to 300M $3,500; over 300M $1,900 $1 50,000 $250,000

1

$930 per M

5io 10M $45,000; 10 to 15M $55,000; 15 M and over $65,000

I UP to 5M $15,000;

I

I

$35.000 $500.000

Up to 5M $25,000; 5 to 10M $35,000; 10 to l5M $45,000; over

Up to 10M $21,225; 10 to 25M $26,500; 25 to 50M $29,820; 50 to 75M $39,150; 75 to 1OOM $5 1,750; over lOOM $60,000. $2 1,225 $60,000

Up to 10M $50,000; over 10M $16,000.

$35,000 $65,000

5 to 10M $17,500;' 10 to 25M $20,000; 25 to 50M $22,500; over 50M $30,000.

Min fee Max fee

Up to 30M $100,000; 30 to 50M $125,000; over 50M $150,000

$15.000 $30.000

$15,000 $16,000

$7,500 u p to 100,000 shares $500; over 100,000 shares $1,250.

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GOING PRIVATE Going private is the opposite of going public and there appears to be a trend toward going private. Thompson Financial reported that 40 public companies went private in 2000 and 7 1 went private in 2001 .32 The two main reasons for going public are to raise capital and to provide liquidity to owners and investors. If a company's stock is thinly traded, that is if there are few shares being bought and sold on a daily basis, it becomes difficult and expensive for brokers to make a market in the stock. Analysts are reluctant to cover thinly trades stocks because of lack of interest. Institutional investors are reluctant to buy stock in a thinly traded company because they may not be able to exit quickly or only at "fire sale" prices. The price of thinly traded stocks drifts downward which makes it difficult to raise new capital and maintain owner liquidity. While the advantages of going public may vanish, the costs of being a public company remain. These include the cost of listing on exchanges, audit fees, SEC reports and officers and directors liability insurance. Officers of publicly traded companies must certify financial statements and can be held criminally liable for inaccurate statements. Sarbanes-Oxley is imposing additional internal control and reporting costs. One law firm estimated the cost of complying with Sarbanes-Oxley for a medium sized firm ranges from $1.3 to $2.4 million. Given these costs, the threshold at which being a publicly traded firm is economically viable rises substantially.33 Who is eligible to go private? Companies registered under the Securities Act of 1934 with less than 300 shareholders may go private by filing Schedule 13E-3 with the SEC. The company must disclose information about the need to go private and certify that going private will be fair to the remaining shareholders. It might be unfair to shareholders because minority investors have little control over management and will no longer be able to exit through sale of their shares in the public market.

SUMMARY When a company goes public, it sells securities to the public for the first time. The advantages of going public are the ability to raise a large amount of capital, increased liquidity for owners and investors, and increased company valuation because of that liquidity. Disadvantages include the initial expense of going public and ongoing costs for auditing, listing, reporting, and compliance with government regulations.

Public Offerings

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Traditionally, companies going public retain an investment banker to oversee all aspects of the IPO including registration, listing on a public exchange, drafting the prospectus, setting the offering price, and lining up institutional investors to purchase stock on the first day of trading. Underwriters charge a fee for this service which is usually around 7% of the amount offered plus options to purchase additional shares at the offering price. Lower fees can be negotiated when the offering is very large. The initial offering price for a share of stock is the company value divided by all the shares that will be outstanding after the issue. Two common methods of valuation are the Revenue Method, which values a company by looking at the ratio of market value to revenue of comparable companies, and the EBITDA model which values a company by looking at the ratio of market value to EBITDA of similar companies. The market value a company is the number of shares outstanding times its share price. The mechanics of going public are to: (i) determine how much capital is needed and for what purpose, (ii) find an investment banker to act as an underwriter and manage the process, (iii) obtain audited financial statements, (iv) complete the SEC forms for registration and qualifL in appropriate states, if necessary, (v) set the target price range, (vi) submit SEC and state forms for evaluation, (vii) find a market maker, (viii) conduct a road show, that is make presentations to institutional investors, (ix) build a book of potential orders, (x) publish the final prospectus when it becomes effective, (xi) set the final offering price, (xii) sell shares to institutional investors, (xiii) the underwriter remits proceeds to the issuer less the underwriter's discount, (xiv) institutional shareholders begin selling shares to the public, and (xv) routine trading in the secondary market begins. While underwriters have a duty of fairness to the issuer, some underwriters place their interest ahead of the issuer's interest. One way they do this is to under price the offer so that their institutional clients benefit from the first day run up in price. Under pricing also increases the value of underwriter's options. Underwriters have been criticized for allegedly price fixing fees and for allocating shares to preferred clients in exchange for future investment banking work. It is therefore important to shop around for an underwriter and ask questions. Some companies have concluded that the costs of being a public company outweigh the benefits. The Securities Act of 1934 provides that companies with less than 300 shareholders can go private. If they do, their securities can no longer be sold to the public until those securities are reregistered.

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DISCUSSION QUESTIONS What does "going public" mean? What are the advantages of going public? What are the disadvantages of going public? Of the hundreds of thousands of companies in the country, about how many go public each year? What has the size of the average public offering? Are there any statutory size criteria before a company can go public? Is there threshold pre-IPO revenue above which companies are more likely to succeed? What else might increase post IPO success? What is an investment banker? What types of services do investment bankers provide? In regards to an initial public offering, what does an underwriter do? How does an underwriter generate his or her fee? What are two methods and issuer can used to estimate the offering price of a stock? What are the mechanics of each method? How can a stock's price range be estimated? What are the main steps in taking a company public? What is an IPO road show? What is its objective? What are the mechanics of the road show? Where does it go? How many shows might an issuer expect and over what period of time? How much should an entrepreneur expect to pay in investment banking fees for and IPO? What might make fees higher or lower? What types of criteria are there for listing on public exchanges? Is there any significance to differences in criteria among exchanges? What are the costs of listing on an exchange? What is a lock-up agreement? Why do underwriters generally insist on a lock-up agreement? What is going private? Why do companies do it?

Public Offerings

ENDNOTES

'

Jay R. Ritter. "Some Factoids About the 2003 IPO Market," University of Florida. http://bear.cba.ufl.edu/ritter/work papers/Some%20Factoids%20about%20the%2020 04%201PO%20Market.pdf 8/14/2004. Herbert B. Mayo. Financial Institutions, Investments and Management, 6thEd., The Dryden Press, Harcourt Brace College Publishers, New York, 1998, p.142. Mayo. p. 142. 4 Miriam Hill. "Valuing IPO's An Inexact Science," Philadelphia Inquirer, May 2, 1999, F4. WSJ Research Staff. T h e IPO Machine," Wall Street Journal, April 19, 1999, C1. Ibid. C1. 7 WSJ Research Staff "The IPO Machine," Wall Street Journal, April 19, 1999, C1. 8 Mayo. pp.143-144. WSJ Research Staff "The IPO Machine," Wall Street Journal, April 19, 1999, C1. lo Ibid. C 1. Mayo. p. 144. l 2 Ibid. p. 144 l3 Mayo. pp.229-230. l4 "Listing Requirements and Fees, The NASDAQ Stock Market'' NASDAQ. Nov. 2003, p.2. l5 "The IPO Road Show: Companies Undergo Scrutiny Before They Go Public," ~ h x d e l ~ hInquirer, ia August 3 1, 1999, F 1. l6 Ibid. F4. l7 Ibid. F4. l8 Ibid. F4. l9 Mayo. p.141. 20 "Security Underwriters by all IPO's," Investment Dealers ' Digest, Vo1.17, ~ebruary28,2000, Securities Data Publishing. 21 Randall Smith. "IPO Firms Face Probe of 7% Fee -US Anti-trust Group Questions A Standard," Wall Street Journal, May 3, 1999. 22 Miriam Hill. "Initial Public Offerings or Just Giant Con Games?' Philadelphia Inquirer, May 15,2001, p.El. Also see: Susan Pullman and Randall Smith. "SEC's Inquiries Advance on Two Fronts," Wall Street Journal, November 28,2001, pp.ClC2. 23 Ibid. E9 24 Hill, E9 25 Suzanne McGee and Terzah Ewing. "'Piggyback' Deals: Keys to Unlock Insider's IPO Stakes," Wall Street Journal, February 17,2000, p.C1 & C21. 26 1bid. CI & C21. 27 Ibid. C1. 28 Ibid. C1 & C21. 291bid.C1 & C21.

"

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NYSE Regulations Section 102.00 Domestic Companies, hnp://www.nvse.com/Frameset.html?disvlavPage=/1clcm section.htmI?snumber=1 &ssnumber=102.00 downloaded 12/28/2004;American Stock Exchange Listing Standards for U.S. Companies, httv://www.amex.com/?hrefVe~uities/howToLseqHTL ListStandards.htm1 downloaded 12/28/2004; "Listing Requirements and Fees, The NASDAQ Stock Market," http://www.nasdaq.com/about/nasdaq listing req fees.pdf; "PHLX.COM: Equity Listing Requirements," http://www.phlx.com/exchange/listings.html. 3 1 IBID. 32 Meg Richards. "More Small Firms Make Switch Back to Private," Philadelphia Inquirer, June 14,2003, p.C1 33 Richards. p.C6. 30

Chapter 13

SMALL PUBLIC OFFERINGS

INTRODUCTION Traditional public offerings are complicated, expensive and more likely to succeed when revenue approaches $500 million. Few companies grow fast enough to attract venture capital. Banks cannot be relied on if a company is in an unusual or disfavored industry or if it has limited collateral and Angel investors invest small amounts. Federal and state regulations restrict sales of securities issued in private placements and without the ability to resell shares, investments become unattractive. Small public offerings overcome most of these problems for companies with the right profile. The ideal company for a small public offering has a history of profits, is growing, but not fast enough to attract venture capital, has a product that is easy to understand and brand recognition. The two main issues that differentiate small public offerings from a traditional IPO are: (i) simplified regulation and (ii) the means of distributing stock to the public.

REGULATION OF SMALL PUBLIC OFFERINGS Federal securities law provides three regulatory options for a small public offering: (i) Regulation A, Form 1-A; (ii) Form SB-1; and (iii) Form SB-2. Each must comply with state as well as federal law. Generally, the more money a company raises, the more complex the regulation.

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Regulation A Registration Regulation A is an SEC regulation allowing companies to raise up to $5 million in one year. Regulation A permits limited advertising, does not restrict who the securities may be sold to, or the number of investors, and allows stock to be resold in the secondary market. An important feature of Regulation A is a provision to "test the waters." "Testing the waters" is a unique feature of Regulation A in that it allows a company to determine whether there is any interest in an offering before making it effective. In essence, a company can advertise, within limits, and have people respond with an expression of interest in the stock in the form of a subscription or coupon. The details of this testing provision are set forth in Regulation A, for example:' An issuer may publish or deliver to prospective purchasers a written document or make scripted radio or television broadcasts to determine whether there is any interest in a contemplated securities offering. The text of the solicitation or script of the broadcast must be filed with the SEC (Attention: Office of Small Business Review) prior to its dissemination. Communications are subject to statutory anti-fraud provisions. No solicitation or commitment from any prospective investor is permitted until qualification of the offering statement. The written document or script of the broadcast shall state that (a) no money or other consideration is being solicited; (b) no sales will be made or commitment to purchase accepted until delivery of an offering circular; (c) an indication of interest made by a prospective investor involves no obligation or commitment of any kind; and (d) the identity of the chief executive officer and briefly describe the company and its products. Solicitations of interest pursuant to this provision may not be made after the filing of an offering statement.

Small Public Offerings

269

(vi)

Sales may not be made until 20 calendar days after the last publication or delivery of the document or radio or television broadcast.

(vii)

Any written document under this section may include a coupon, returnable to the issuer indicating interest in a potential offering, revealing the name, address and telephone number of the prospective investor.

Regulation A issuers must file a Form 1-A, which describes the company and the offering, and it must become effective prior to any actual sale of securities. A Form 1-A is available on the CD-rom that accompanies this book. As sales are made, an issuer must file a Form 2-A to report on sales and use of proceeds. A Regulation A offering will not qualify for federal preemption. A company will have to register and qualify in every state in which it offers securities. Regulation A requires two years of financial statements, but it does not require audited financiak2 Federal regulations set a minimum standard, but States will look more favorably on a company with audited financial statements than one with unaudited financial statements. While management is ultimately responsible for making sure financial statements are fair and complete, audited statements shift the burden of technical accounting details to outside accountants.

Forms SB-1 and SB-2 If a company qualifies as a Small Business Issuer, it can elect to use Form SB-1 or SB-2 instead of the traditional, and much more demanding form used for IPO's, the S-1. The SEC defines a Small Business Issuer as one that has no more than $25 million in revenue in the prior year and its outstanding, publicly held stock is worth no more than $25 million. For the first time issuer, this second criteria would seem to be moot. However, for company with some publicly trades stock that is returning to the public market for another capital infusion, this second criteria is important. A Form SB-I can be used to raise up to $10 million in any 12 months period. One advantage it has over an S-1 or an SB-2 is that it has a simple question and answer format. Unlike a Regulation A filing, it requires one year of audited financial statements. A Form SB-2 can be used to raise any amount of capital. The disclosure is somewhat more complicated because it requires a narrative style

270

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described in Regulation S-B. However, Regulation S-B is written in a simple, non-legalistic manner. A Form SB-2 requires two years of audited financial statements, as compared to three years for a Form S-1. Form SB-2 also requires a less extensive description of the company and its business than an S-1.3 Form SB-1, SB-2 and Regulation S-B are provided on the CD-rom accompanying this text. It would be difficult for companies using Form SB-1 and SB-2 to qualify for listing on a national exchange; therefore, they would not be entitled to federal pre-emption. Therefore, like other small business offerings, they must comply with state securities law for every state in which they are sold. State coordinated review procedures at the level of SB-1 and SB-2 equity filings are somewhat more complex and a different review protocol is used. A company can initiate a coordinated review by filing a CR-EQUITY form. More details on this form are available at the Coordinated Review Program website: www.coordinatedreview.org.

Comparison of Small Public Offerings The regulatory similarities and differences of small public offerings are summarized in Figure 13-1, Analysis of Small Public Offering.

Figure 13-1 Analysis of Small Public Offering

Maximum amount Federal Filing Characteristics

Advertising

Regulation A $5 million Form 1-A

Question and answer. Must be effective before funds raised Yes

Form SB-1

Form SB-2

$10 million Form SB-1 Question and answer. Must be effective before funds raised. Yes

unlimited Form SB-2 Narrative. Must be effective before funds raised. Yes

Small Public Offerings

STATE REGULATION Unless a public offering qualifies for federal pre-emption, it must comply with state securities laws in every state in which it is offered. As a practical matter, most small companies are only known locally or regionally and realistically they will only be able to sell stock where they are known. This usually means they will only sell stock in their home state and a handful of neighboring states. Not all states allow testing the waters. This complicates use of the internet because the internet is available everywhere. The Commerce Clearing House recommends specific disclaimers indicating that the Internet communication is limited to residents of specified state^.^ Most states accept the SCOR form for their disclosure and merit reviews. The SCOR Form, also called Form U-7, is a simple question and answer form developed by the North American Securities Administrators Association (NASAA). A copy of the form is on the CD-rom that accompanies this book. When an issuer wants to sell securities in more than one state, it can coordinate its state filings in one package and deal with one lead state as described in the Coordinated Review Program.

Coordinated Review Program The North American Securities Administrators Association (NASAA) has worked with states nationwide to develop criteria for reviewing and for coordinating review of securities offerings. Such reviews are done regionally, with one lead state appointed to coordinate input from other states so that a company only has to deal with one or at most two states and a single comment letter.5 Not all state regulations are the same. Some states are disclosure states, meaning that they only require adequate information disclosure; others are merit review states. Merit review does not assess whether a company is likely to make money. Merit review is designed to make sure an investment deal is not so one-sided that investors have no chance to share in profits. For example, regulators want to see that the company founders have put their own capital at risk in a venture. An informal rule of thumb gleaned from several state comment letters is that founders should have at least $1 invested for every $10 r a i ~ e d The . ~ NASAA has a list of state contacts on their website: www.nasaa.orrr/nasaa/abtnasaa/find reau1ator.a~~.

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NASAA Policy Guidelines State regulators use the North American Securities Administrators (NASAA) Policy Guidelines as a standard for merit reviews. Therefore, compliance with these guidelines will go a long way toward qualifying an offering. Examples of guidelines include7:

Risk Disclosure Guidelines These guidelines define risk factors, set standards for disclosure of risk. Use of Proceeds These guidelines set forth appropriate and impermissible uses of the proceeds and establish criteria for adequate disclosure. For example, a company cannot reserve more than 15% of proceeds for working capital, general corporate purposes, or any other vague or unspecified vague purpose. Impoundment of Proceeds Generally, offers to sell securities are subject to a provision that a minimum amount of capital must be raised. If that minimum isn't raised, the investors are entitled to receive their investment back with pro rata interest. This guideline sets forth procedures for the impoundment and return of investor's funds if minimums are not met. Options and Warrants These guidelines limit who can receive options and warrants, how many options and warrants can be granted, and under what circumstances options should be restricted or escrowed. Unsound Financial Condition These guidelines severely restrict, almost to the point of prohibition, issuance of securities in a financially unsound company. Indicia of unsound condition include (a) a going concern opinion from a public accountant, (b) an accumulated deficit or negative equity, (c) inability to pay obligations as they become due, or (d) a negative cash flow. Under certain circumstances a company with some or all of these indications can be registered if a company can show (a) an improvement in its financial condition as the result of the offering, (b) when profitability is expected to occur, (c) the bases for claiming the financial condition will improve as the result of the offering or that

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the company will become profitable, and (d) adequate disclosure of the unsound financial condition along with a warning that individuals who cannot risk losing their entire investment should not invest. There is also a provision that a company may be required to qualify investors as to income and net worth. (vi)

Underwriting and Selling Expenses This guideline is designed to assure that underwriting and selling expenses don't take too large fraction of invested capital.

(vii)

Loans to Officers and Other Material Affiliated Transactions These guidelines are designed to prevent officers and other insiders from taking unfair advantage of investors by stripping the company of assets through insider loans or self-dealing transactions. This guideline recommends sale of securities be disallowed unless there is strict scrutiny of every transaction by at least two independent, outside board members. Transactions must also arm-length in nature. That means is the terms of transactions must be no better than those that a stranger to the company could get. In addition, all such transactions must be disclosed.

(viii)

Promoter Equity This guideline is designed to assure that those raising capital for a company have some of their own capital at risk. The guideline says the minimum amount of owner capital should be 10% of the first $1,000,000 raised, plus 7% of the next $500,000 raised, plus 5% of the next $500,000 raised, plus 2.5% of the amount raised over $2,000,000. For example, if a company planned to raise $5,000,000 the entrepreneur should have $235,000 invested ($1,000,000 x 10% + $500,000 x 7% + $500,000 x 5% + $3,000,000 x 2.5 %.)

The NASAA has other guidelines that relate to specific industries or circumstances. All guidelines as well as other important information are available though their website www.nasaa.org. Click the Main Menu, then click Corporate Filings, then on the left side of the page under Proposals, and click Adopted, or link directly to a list of NASAA standards at: http://www.nasaa.ora/nasaa/scripts/fu display list.asp?ptid=132.

Raising Capital

MEANS OF STOCK DISTRIBUTION The traditional way of distributing new public offerings is for the issuer to sell an entire offering to an underwriter which sells large blocks of stock to institutional investors which then resell shares to the public. The offerings discussed in this chapter are too small to interest most underwriters and institutional investors. However, three models for distribution of small company stock have emerged the Dutch Auction, the Direct Public Offering with a professional advisor and the Direct Public offering without a professional advisor.

The Dutch Auction: An Experiment in IPO Democracy William Hambrecht, the founder of the San Francisco investment bank Hambrecht & Quist, stunned and angered the investment banking community by offering securities directly to the public through a Dutch Auction rather than distributing IPO shares to favored institutional clients. To do this, he formed a new investment bank called W.R. Hambrecht & Company. Hambrecht said the usual way of distributing stock from an IPO was seriously flawed. For one thing, shares were often dramatically under priced providing a windfall to an investment banker's favored institutional clients at the expense of the company going public. He wanted long term investors in client companies, but with dramatic first day rises in stock price, investors faced an irresistible temptation to sell their allocation and realize an immediate gain. Another problem, as he saw it, was that the general public was being robbed of an opportunity invest at IPO offering prices and could only purchase shares after institutional investors had realized most of the upside potential in a new stock. Finally, he believed that by pricing a stock closer to its actual market value, he could reduce the volatility that afflicted many newly public stocks. His solution to these problems was a Dutch Auction and a process he dubbed OpenIPO. With the issuer, he sets a range of share prices. Investors then have several weeks to submit bids and indicate the number of shares they want. The market thus sets the floor, or market clearing price. Those who bid over the market clearing price get all the shares they want and those who bid at the market clearing price get a percentage of the shares available. No bidder is allowed to purchase more than 10% of the offering, and the issuer reserves the right to limit any buyer's purchase to 1% of the offering. Hambrecht developed the concept based on a system conceived by the Nobel Prize winning economist William Vickery after watching how

Small Public Offerings

275

prices were set in the Amsterdam flower market. Another feature of his system is that he expects to charge 3% to 5% to take a company public whereas most investment banks charge smaller clients 6% to 7%.' Does it work? Since stock is being sold to retail investors, it works best for companies with brand names known and recognized by the public. Among Hambrecht's success stories are the Seattle sandwich chain Briazz with sales of $1 1.3 million which raised $16 million and the Emeryville, California based Peet's Coffee & Tea with sales of $67.8 million which raised $26.4 million in May 2001 when everyone though the IPO market was dead.g One of the difficulties with using a Dutch Auction is that companies using this method are ,unlikely to qualify for federal pre-emption, so care must be taken to qualify in states where shares are offered and make sure shares are not sold to residents of other states. Another problem is getting analysts to cover small issues. If there isn't enough reliable, digested information about a security, it is difficult to maintain a secondary market. Never the less, Dutch Auctions seem to be a permanent, if small, part of the IPO landscape. As of this writing, W. R. Hambrecht & Company is going strong. Their website: www.openipo.com/ind/index.htmlprovides additional information on Dutch Auctions. Other firms have copied Hambrecht's Dutch Auction approach. These firms may be found through a simple web search. Three criteria firms should be used to rank these firms are: (i)

Are they geographically close by? The more an underwriter knows about an entrepreneur's firm the better job it can do. Fees for Dutch Auctions are dramatically less than for traditional IPO's, so the time and expense an underwriter can spend getting to know an entrepreneur's company will be limited. Also, make sure the underwriter knows the securities law of the states in which the offer is made.

(ii)

How many companies has the underwriter taken public via a Dutch Auction, and how long has it been conducting Dutch Auctions? An entrepreneur does not want an underwriter that is learning through doing with his or her company.

(iii)

Does the underwriter have references that can be checked? If it is reluctant to give references beware. Information about clients and their securities is filed with the SEC and is in the public record. If a firm is reluctant to provide such public information, either its clients had a bad experience; the firm is not being candid, or both.

276

Raising Capital

Guidelines for Using a Direct Public Offering If a company wants to bypass underwriters and institutional investors, it can sell securities directly to the public. A direct public offering (DPO) is one in which the issuing company takes responsibility for selling securities. Not every company is a good candidate for a direct public offering (DPO). Drew Field Direct Public Offerings suggests nine criteria for deciding whether a company is likely to succeed with a DPO. It calls these criteria a "Screen Test." Among the criteria are'': (i)

Exciting The business should excite the investors making them want to share in the firm's success. For example, an electric car or solar cell company might appeal to environmentalists, a sporting goods manufacturer or retailer might appeal to athletes or campers, and so forth.

(ii)

Profitable There should be a history of profitable operations under current management. Shares in traditional IPO's are sold to institutional investors who often seem less interested in the performance of a company than in flipping their stock to the public after a share price run-up. However, with a DPO individuals are investing their own money for the long run and want to know that the company is sound.

(iii)

Honesty and Social Responsibility When people invest their own money in a DPO they often do it because they feel an identity with the company and its products. They want to believe management is honest and the company is socially responsible. Companies that do well by doing good are more likely to get investors than companies perceived as being corrupt, polluting or producing dangerous products.

(iv)

Understandable Concept An entrepreneur who can explain what a company does to his or her grandmother is likely to have an understandable concept. Two other tests are useful (a) explain what the company does in ten words or less, and (b) tell the company's story in one page including things like what the company does, what it is going to do with the capital it receives and the risks of investing in this particular company.

Small Public Offerings

277

Affinity Groups with Cash to Invest Customers and depositors make the ideal affinity groups for retailers and bankers respectively. They already have a relationship with the company, know what it does, and like it; otherwise, they would go elsewhere. Customers aren't the only kind of affinity group. Causes generate affinity groups. For example, believers in alternative medicine are an affinity group as are practitioners of home schooling. If a company has a product or service that appeals to those groups, they are natural investors in a DPO. Popular home town businesses have a built in affinity group, town residents. Many other groups are possible. Name Recognition A company should have enough name recognition that the members of the affinity group will at least read the public offering material and consider investing in the company. The value of a product's brand name will spill over to the perception of investment value. Customer database A pre-existing customer database containing names, addresses, phone numbers, email addresses and demographics go a long way toward assuring the success of a DPO. In addition, it may be possible to purchase a commercial database that targets customers or other affinity groups narrowly enough to achieve success. DPO Project Manager The company should appoint one person whose primary job is to make sure the DPO succeeds. This should not be the CEO or CFO, both of whom have other duties that will divert their attention from the DPO. The person appointed to run the DPO should report directly to the CEO on DPO matters. Audited Financial Statements While no audited financial statements are required under Regulation A, it is recommended that a company have or get two years of audited financial statements before attempting a DPO. Saving money by not getting audited financial statements will make it harder to get state regulators to approve the offering and much harder to get investors to invest. Many banks require audited financial statements for companies that borrow over $2 million anyway. So, audited financial statements for a company seeking to raise that much is a minimal burden.

Raising Capital If a company does not have audited financial statements, there are some public accounting firms that can use procedures to audit the prior two years statements. Whether this can be done is largely a function of the quality of record keeping, the strength of internal controls, and some other factors, such as, whether the company has a large inventory. If a firm cannot be found to do a retrospective audit, a company should plan to have the current year audited as well as the next year and use that time to build and identify an affinity group to market their shares to. If capital is needed sooner, the company should consider a private placement.

Direct Public Offerings with an Advisor If a company wants to make an internet offering, they usually retain a company that specializes in Direct Public Offerings (DPOs) to assist it. A number of such firms can be located on the web. Such firms are not underwriters because they do not purchase securities from a company and do not sell securities to institutional investors. DPO firms provide a number of services: (i) determine whether a DPO is right or a particular company and the company is right for a DPO; (ii) help the company obtain audited financial statements; (iii) assist management decide how much money should be raised, the percentage of the company to sell, and the target share price; (iv) determine the best regulatory scheme to use; (v) manage development of regulatory documents; (vi) design a marketing program to make sure the shares sell; marketing plans are usually narrowly tailored to customers, suppliers or some affinity group; and (vii) advise how to establish a post-offering, secondary market for the company's securities." The average investor is going to have scant interest in an offering if he or she cannot exit the investment in an orderly way. Direct public offerings do not need to use the internet, although it is becoming a key tool of firms that assist clients with a DPO. Use of the Internet was facilitated by SEC guidance on the use of electronic means to distribute prospectuses and other material to shareholders. Briefly, this guidance indicates that proactive means of distribution, such as email, can be made substantially equivalent to delivery of paper documents if guidelines such as to the structure of documents, format, font size, and use of bolding and highlights are followed. Passive means of distributing prospectuses and other information such as posting them on a website are not the same as delivery of documents.12

Small Public Offerings

Direct Public Offering without an Advisor A DPO without an advisor is one in which the issuing company takes on the total responsibility of managing the offering and selling its securities. DPO's are a counter cyclical funding source. Angel investors and venture capitalists are traditional sources of non-bank financing for small businesses. But when they pull back because of bad experience, a bad economy or other reasons, entrepreneurs in need of capital must find other, more creative sources of capital, one of which is the DPO. The advantages of this form of offering are: The amount of equity the company will have to give up to raise a stated amount of capital is usually less than it would if angel or venture capital were used because the expectations of individual investors in the market are 10% to 15% return, whereas the expectations of angels and venture capitalists are 20% to 40%. The company is not dependent on finding an underwriter who has enough confidence in the company or who can make enough money from the offering to accept them as a client. There are no underwriter's fees, which can range from 6% to 7% for small companies plus expenses. The risk that an underwriter will manage share price and allocation for its own benefit is eliminated. Regulatory and other offering expenses are greatly reduced as compared to a traditional IPO. DPO's require extensive publicity campaigns to sell stock, but such campaigns create an opportunity to educate customers about the company and its products. Customers who are shareholders tend to be more loyal and purchase more, and suppliers who are shareholders become more interested in the company and more helpful. The additional equity raised through a DPO reduces a company's risk profile from the point of view of banks and other creditors.

280

Raising Capital

(ix)

The small size of the offering needed to meet the entrepreneur's goals makes some companies unattractive as a traditional or even Dutch Auction client, but small offering size is not a problem in a DPO. The drawbacks to a DPO are that:

(0

The entrepreneur will have to invest a significant amount of time organizing the DPO and selling the stock.

(ii)

An entrepreneur could invest a substantial sum in a DPO and find there is no market for the stock; underwriters usually provide seasoned judgment as to whether there is such a market.

(iii)

As owners, the company's customers and suppliers and the entrepreneur's friends and family will have an inside look at company operations, since they will be entitled to financial statements at least annually and any documents filed with the SEC.

What kind of company might be a candidate for self-managed DPO? There must be a market for the company's stock. A consumer company with strong brand recognition is more likely to succeed than an industrial supplier with a hard to understand business model. Another question to ask is whether the company will be a good investment. If a company is losing money, or treading water and has no prospects for growth, turning customers into shareholders will only turn them into angry non-customers. So the decision as to whether a company is ready for a DPO includes factors far beyond the company's need to raise capital. If it has a board of directors or outside board of advisors, it should get a consensus as to whether a DPO is the appropriate mechanism for raising capital. Outside advisors might include the company's lawyer and accountant. Next, it should engage a lawyer familiar with securities regulation. Securities regulation is a specialized branch of law and general business attorneys rarely know all its nuances and are unlikely to have cultivated relationships with securities regulators. An accounting firm should be retained who can provide audited financial statements. Advise the firm that the company intends to use the audited financials in a securities offering. Many accounting firms provide compilations and reviews and do not provide audited financial statements or do not provide financial statements in connection with a securities offering. The cost of a DPO in terms of time and money depends on (i) the company's prospects, (ii) how well the company is known, (iii) the company's ability to identify potential shareholders and get them to buy, and (iv) how long will it take to get state approval for the registration. The San

28 1

Small Public Offerings

Francisco firm MicroAngels estimates the procedure costs about $38,000 and takes nine months: three months for the paperwork, three months to sell the stock, and three months to get listed on an OTC bulletin board or other exchange.I3While the experience of MicroAngels provides one data point, the entrepreneur should understand that a DPO for any particular company may take more or less time and cost more or less. And since things generally take longer than expected and are more expensive than expected, an entrepreneur contemplating a DPO should budget substantially more in time and expense.

Comparison of Stock Distribution Methods A Dutch Auction, Direct Public Offering and Initial Public Offering each have advantages and disadvantages based on the a number of factors like the size of the offering, speed and expense. Figure 13-2, Analysis of Methods of Going Public, highlights some of the main differences among them. Figure 13-2 Analysis of Methods of Going Public Dutch Auction Who sells the securities? Who are securities sold to? What is the typical size of an offering? What are typical costs?

Underwriter and associated brokers Directly to the public

$20 million would not be unusual On the order of $500,000 depending on size and underwriter

I I

Direct Public Offerinz

I The issuing company

Directly to the public, but mostly to customers and suppliers Under $5 million On the order of $40,000

Traditional IPO

Underwriters sell securities Institutional investors such as insurance companies and pension plans Over $200 million On the order of $14 million depending on size and the underwriter

Viability of the secondary market is always an issue when considering whether a small public offering is appropriate. If there are an insufficient number of shares in play, or if the shares don not turn over frequently, there will be little incentive for broker dealers to make a market in

282

Raising Capital

the stock. If there are no broker dealers to make a market, shares could become almost as illiquid as for a non-public company. One solution that some companies have taken is to become licensed broker dealers so that they can make a market in their own securities.

SUMMARY There are circumstances in which a healthy growing company cannot get bank financing; it is not growing fast enough to attract venture capital and it is too small for a traditional IPO. Small Business Public Offerings provide an alternative. Generally small businesses are defined by the SEC as companies with less than $25 million in revenue and less than $25 million in publicly traded securities. The principal advantages of a small public offering as compared to a private placement are (i) the offer can be advertised, (ii) it can be sold to anyone, not just to qualified investors or a limited number of non-qualified investors, and (iii) securities are not restricted and can be resold to anyone. The ability to resell securities gives them liquidity and improves their attractiveness in the marketplace. Small public offerings are regulated by both state and federal law. The federal government provides for three types of small offerings: (i) Regulation A which allows up to $5 million to be raised, (ii) Form SB-1 which allows up to $10 million to be raised and (iii) Form SB-2 which allows an unlimited amount to be raised. For multi-state offers, states have developed a Coordinated Review Program so that issuers only have to deal with one point of contact in each region of the country. Since most small businesses issue locally, a company will only have to deal with one state regulator. A standardized state form called the SCOR form, also called Form U-7 can be used with Regulation A offerings. For SB-1 and SB-2 filings states rely on the federal forms and some supplemental material. There is a special coordinated review program for these larger offerings called CR-Equity which uses North American Securities Administrators Association (NASAA) guidelines as a standard of review. Audited financial statements are not required for a Regulation A filing unless a company obtained them for some other purpose, and one and two years of audited financial statements are required for SB-1 and SB-2 offerings respectively. These set minimum standards and two years of audited financial statements is recommended regardless of the form of small public offering. QualifLing a security for sale is one thing and selling it is another. Generally, small public offerings are too small to interest traditional

Small Public Offerings

283

underwriters and institutional investors. There are, however, a few underwriters who will assist a company sell shares to the public through their network of broker dealers. Promoting shares on the Internet can be problematic because shares are rarely qualified in every state. Internet postings should explicitly limit the offer to states in which it has been qualified. Some underwriters use a Dutch Auction in which investors have the ability to bid up the price of shares before shares are actually traded. This method allows the market to set the price rather than relying on the underwriter to estimate the price at which the offering would sell out. An alternative to using an underwriter is for the company to sell securities itself. This is called a direct public offering or DPO. This works best for profitable companies with recognizable brands and well defined affinity groups who would be interested in investing for the long run. The regulations governing small public offerings are simplified as compared to the regulations governing IPOs. Nevertheless, a company considering a small public offering should consult with several professionals: (i) a lawyer familiar with securities regulation; (ii) an accountant at a firm that can provide audited financial statements in connection with a small public offering; (iii) a broker dealer to actually sell the securities, generally only a licensed broker dealer can buy and sell securities; and (iv) if a company doesn't use an underwriter, it may want to consult a company that specializes in management of small company offerings which can help it with document preparation and provide other guidance on selling securities.

284

Raising Capital

DISCUSSION QUESTIONS Where does a small public offering fit into the entire spectrum of capital sources? When might an entrepreneur consider a small public offering? What are the benefits of a small public offering as compared to a private placement? What are the three federal regulatory options for a small public offering? What is a SCOR Form? What is it used for? Who created it? Why? What is the coordinated review program? What are the implications of the coordinated review program for the entrepreneur? What is meant by "testing the waters?' allows testing the waters?

What federal regulation

How does the SEC define a small business issuer for purposes of an SB-1 or SB-2 registration. How much money can be raised through a Regulation A offering? How much can be raised through an SB-1 offering? How much can be raised through an SB-2 offering? Are audited financial statements required for a Regulation D, Rule 504 offering? Are audited financial statements required for a Regulation A offering? Are audited financial statements required for an SB-1 offering? If so, what? Are audited financial statements required for an SB-2 offering? If so, what? Can securities issued in a small public offerings be distributed the same way as those in a traditional IPO? Why or why not? What are some of the regulatory issues involved with a public offering over the Internet? How might an entrepreneur address such issues?

Small Public Offerings

285

12.

What is a Dutch Auction? What are the mechanics of a Dutch Auction? What are the benefits of a Dutch Auction to an entrepreneur?

13.

What are the issues surrounding a Direct Public Offering (DPO) by an issuer? What are the mechanics of a DPO? What types of companies are most likely to succeed with a DPO?

14.

What are the advantages of a DPO? What are the disadvantages of a DPO?

15.

What are NASAA Policy Guidelines? Why are they important? What are eight guidelines that most companies must follow and give a brief description of each?

286

Raising Capital

ENDNOTES -

' 5230.254 Solicitation of Interest Document for Use Prior to an Offering Statement. Regulation A refers to the requirements in Form 1-A, which in part F/S indicates that if audited financial statements are obtained for other purposes, they should be attached to the Form 1-A filing. 3 Securities and Exchange Commission, "Q&A: Small Business and the SEC," w~w.sec.gov/info/sma~lbus/qabsec.htm downloaded 1 1/15/2003. "Regulation D, Rule 504lSCOR Filing," Business Owner's ToolkitTM,Commerce clearing House www.toolkit.cch.com/text/P12~615O.asp 5 "Coordinated Review Program," North American Securities Administrators ~ G c i a t i o n(NASAA), www.coordinatedreview.org downloaded 11115.2003 6 Tom Stewart-Gordon. "Some Points for Professional Consideration," SCOR Report, Stewart-Gordon Associates, Dallas, Texas, July 17,2000; www.scorreport.com/professionals/professionals.htm 7 -, "NASAA Guidelines," North American Securities Administrators Association, Washington, D.C. w. Downloaded 11/15/2003. 8 . Lisa Bransten, Nick Wingfield. "New Company Aims to Shift IPO Playing Field," Wall Street Journal, 2/8/99, p.C1; Miriam Hill. "New Firm Aims to Give Individual Investors Clear Shot at IPO," Philadelphia Inquirer, 3/2/99, p.F5; Matt Marshall. "Open-IPO Plan Proves Controversial for Originator," Philadelphia Inquirer, 7/27/2000, p.F3. Jon Rhine. "Briazz's Dutch Auction IPO Defies Dry Market," Puget Sound Business Journal, 51151200 1 www.seattle.bizjournal.com/seattle/stories/200 1/95/14/daily7.htmldownloaded 9/24/2003. 10 -, "Screen Test for a Direct Public Offering," Drew Field Direct Public Offerings, www.dfdpo.com/screen.htm.downloaded 11/14/2003 11 , "About DPOs," Drew Field Direct Public Offerings, www.dfdpo.com/aboutd~os.htm,downloaded 11/14/2003. l 2 1933 Act Release No. 7233, 1Fed.Sec.L.Rep. (CCH) 1T3200 (Oct.6, 1995), and 1933 Act Release No.7288, 1 Fed.Sec.L.Rep.(CCH) 73201 (May 9 1996). Also see Lola Miranda Hale, partner McBride Baker and Coles, Chicago "SEC Guidance on Use of Electronic Media," Law Host Online Journal, www.lawhost.com/lawiournal/98summer/halech2.html. downloaded 11/14/2003 l 3 Lizette Wolson. "With Money Tight, Don't Forget the Direct Public Offering," San Francisco Business Times, reprinted in the Sacramento Business Journal, June 16, 2003, http://sacramento.bizioumals.com/sacramento/stories/2003/06/16/smallb8.html downloaded 9/29/2003

Chapter 14

SMALL BUSINESS INVESTMENT COMPANIES

INTRODUCTION As a source of funds, Small Business Investment Companies (SBIC's) are one of the best kept secrets in capital markets. The list of companies that have used this little known funding source reads like a who's who of the corporate world. They include: Federal Express, Sun Microsystems, Apple Computer, America On-line, Peoplesoft, Amgen, Staples, and Restoration ~ardware.' SBIC's are a creation of Congress and the Small Business Administration. Their mission is to provide capital to small and emerging companies that may not be able to get capital economically through other source^.^ The funding structure of Small Business Investment Companies allows them to raise capital relatively cheaply which gives them a unique risk reward profile. They are more risk tolerant than banks because they are less regulated, and because their funding sources demand less of a return than venture capital limited partners, they don't have to be as aggressive in seeking high payoff ventures. They also have a Congressional mandate to focus on small business which limits their field of operations and focuses them on start-ups and emerging businesses. In this chapter we will discuss how SBIC's operate; their source of funds and how that affects their risk 1 reward characteristics; the size and types of investments they usually make; the nature of companies that qualify for SBIC funding; and types of investments that are prohibited. We will also

288

Raising Capital

discuss how to find an SBIC; evaluate whether a particular SBIC is right for a company and the types of information an SBIC will need to make a favorable decision on a funding request.

CHARACTERISTICS OF SBIC INVESTMENTS SBIC's fill an important funding gap. Individual Angel investors typically invest $25,000 to $250,000 and groups of angels invest $250,000 to $1,000,000. On the other hand, the average venture capital investment is over $6 million. SBIC's help fill this gap by making average initial investments in the range of $750,000 to $2,750,000. One issue to consider when selecting a funding source is its willingness and ability to provide follow-on financing should the company grow. Figure 14-1 is an analysis SBIC Funding by ~ o u n d .In~ 2000, SBIC's invested about 70% of funds. in first round financing, and about 30% of their funds in follow-on financing for firms already in their portfolio. Figure 14-1 SBIC Funding by Round

Round Of Financing

(millions)

%$

Number of companies

Average investment (millions)

Initial Financing

$3,859.7

70.6%

. 2,25 1O

$1.7

Follow-On Financing

$1,606.6

29.4%

2,388.0

$0.7

Total Financing

$5,466.3

4,639.0

Equally important to an entrepreneur is the type of funding provided. Figure 14-2 Analysis of Funding ~~~e~ indicates that 73% of investments in 2001 were straight equity with another 20% of investments in the form of debt with equity features, like convertible bonds or bonds with warrants. Less than 7% of investments were pure debt.

Small Business Investment Companies Figure 14-2 Analysis of Funding Type Type of Financing

Total Amount

Percent

Straight Debt

$289,633,93 1

6.5%

903,422,529

20.3%

$3,262,218,583

73.2%

$4,455,275,043

100.0%

Debt with Equity Features Equity Only Totals

In the spectrum of funding sources, an SBIC is more like a venture capital firm than a commercial lender. Of the $280.5 billion in venture investments made over the period 1994 to 2000, about $23.7 billion or 8% was made by SBIC'S.~ Their relatively small contribution to the total pool of venture capital belies their importance because of the $14.4 billion invested in "SeedIStart-up Financing," about $9.3 billion or about 64.6% was from

SBICV The distribution of investments by industry segment is interesting because the differences between the preferences of traditional venture capitalists and SBIC's inform decisions as to who is more likely to fund a particular type of firm. Figure 14.3 is a comparison of Industry Preferences for Traditional Venture Capital and SBIC Firms over the period 1994 through 2000.~ Since each industry has its own characteristics in terms of risk, capital requirements, time to exit and likely payoff, it is important for a firm seeking capital to match a funding source to their industry. For example, a company whose product is a new manufacturing technology is about 13 times more likely to find an SBIC willing to invest than they are to find a venture capital firm to invest because venture firms invest only about 2% of funds in manufacturing and industrial sectors as compared to SBIC's which invest almost a quarter of their capital in those sectors. On the other hand, if a firm has a life sciences product it is more than twice as likely to get funding from a venture capital firm than it is through an SBIC (12% versus 5%).

290

Raising Capital Figure 14-3 Industry Preferences for Traditional Venture Capital and SBIC Firms (Billions of dollars)

Industry

----Venture Capital--Dollars Percent

----------SBIC---------Dollars

Percent

$218.7

79%

$7.0

30%

Life Sciences

$34.1

12%

$1.1

5%

Consumer Related

$8.8

3%

$5.8

24%

Business & Financial Services

$8.8

3%

$1.9

8%

Industrial & Manufacturing

$6.7

2%

$6.3

26%

Other

$3.4

1%

$1.6

7%

Communications & Computers

100%

100%

The size of a firm's capital requirement is another factor that informs whether a traditional venture capital firm or an SBIC is more likely to be a good match. Figure 14-4 Investment Size by SBIC Type provides an analysis of average SBIC investment as well as investment by the type of SBIC. The four major types of SBIC are: (i) Participating Security, in which the government take an equity interest in an SBIC and relieves it of the obligation of making semi-annual bond interest payments; (ii) Debenture SBIC's, which raise funds by issuing government guaranteed bonds; (iii) Bank SBICYs, which are formed and operated as bank subsidiaries; and (iv) Specialized SBIC's, which primarily serve women and minority owned businesses.'

Small Business Investment Companies Figure 14-4 Investments by SBIC Type Investments

Percent Total Invested Invested

Participating Security SBIC's

1,879

$1,443,486,83 1 32.4%

$768,221

Debenture SBIC's

1,256

$694,087,131 15.6%

$552,617

832

$2,272,926,251 5 1.O%

$2,73 1,883

SBIC Type

Bank SBIC's

Specialized SBIC's 3 10 Totals

4,277

$44,774,829

1.O%

Average Investment

$144,435

$4,455,275,042 100.0% $1,041,682

Here we have a paradox. SBIC's were originally intended to serve companies that did not qualie for either traditional bank loans or SBA guaranteed loans. However, banks now provide 51% of SBIC capital. But, even this data provides insight as to how to choose an SBIC. Bank investments average around $2.7 million whereas the average investment for a Participating Security or Debenture SBIC is well below a million. If a company's capital needs are modest, that is under $1 million, it might want to avoid bank SBIC's. The stage of a firm's development is another criterion that can be used to determine whether a traditional venture capital firm or an SBIC is more appropriate.9 The stage of development of a typical start-up firm can be roughly related to how long it has been in business. Figure 14-5 is an Analysis of the Age of Businesses Financed by an SBIC." Over half of SBIC funds go to companies in business less than three years and about 80% are for companies in business less than six years. Finally, there are SBIC eligibility requirements that limit weather an SBIC is an appropriate choice for a given company.

Raising Capital Figure 14-5 Age of Business Financed by an SBIC Time in Business

Amount Financed

Percent

Under 3 Years 3 to 6 Years 6 to 10 Years Over 10 Years

$2,568,339,023 969,993,147 285,358,160 631,584,713

57.6% 21.8% 6.4% 14.2%

Totals

ELIGIBILITY FOR SBIC FUNDING Any program remotely connected to the federal government is going to have restrictions and SBIC's are no exception. There are two types of restrictions, those related to size and those related to business type. Businesses must be small businesses as defined by the SBA. As a general rule, they must have net worth of $18 million or less and have net after tax income of $6 million or less for two years, exclusive of any tax loss carry-forward. At least 20% of SBIC invested capital must go to smaller companies. A smaller company is defined as one with a net worth of $6 million or less and net income for the preceding two years of $2 million or less, exclusive of any tax loss carry-forward. This size test is applied in the aggregate to a company and its affiliates. An SBIC can continue to finance a portfolio company that no longer qualifies as small up to the time it goes public or is sold. SBIC's cannot invest in finance and investment companies, leasing companies, companies that purchase farmland, most real estate companies, passive businesses, companies with no continuously active operations or companies with foreign operations. SBA regulations also prohibit investments in illegal or morally questionable enterprises. 11 The foregoing eligibility criteria might well be called ineligibility criteria because they define the outer boundary of enterprises that an SBIC might fund. There is no guarantee that a firm that lies with the aforementioned boundaries will be funded. As with any other investor, an SBIC must be convinced that the company has a viable product or service, a well thought business plan, that competition is not too stiff, and that management is capable of leading the company to success.

Small Business Investment Companies

RESTRICTIONS ON SBIC OPERATIONS There are a number of restrictions on SBIC operations. Some are obvious, for example they cannot fund a company that does not qualify as small and cannot fund companies involved in prohibited fields. But there are other restrictions as well. For example, an SBIC cannot invest more than 20% of Regulatory Capital in one company or group of affiliated companies. Regulatory capital is capital leveraged or guaranteed through a government program as well as the privately invested SBIC capital that was necessary to qualifjr for that capital. An SBIC generally cannot control a company it invests in. However, there is a provision that an SBIC can take control of a start-up company for up to five years to protect an existing investment. Legislation to relax this prohibition has been passed but until the SBA promulgates rules regarding control of portfolio companies the current prohibition stands. There are also controls on the exit an SBIC can negotiate. For example, it cannot force a portfolio company to buy back the SBIC's interest within 5 years. This effectively limits an SBIC's right to negotiate Puts, which are sometimes used as a forced exit strategy if a company fails to make progress toward an IPO or buyout.12

HOW SBIC's RAISE CAPITAL AND ARE STRUCTURED For an entrepreneur to get what he or she wants from an SBIC, he or she should understand how SBIC's are formed, raise capital and are structured. SBIC's are licensed by the Federal government after completion of an application, filing a satisfactory business plan, and after the government evaluates the quality and experience of management. Those wanting to form an SBIC must also commit a substantial amount of private investment capital, at least $5 million for a traditional, debenture SBIC and at least $10 million for a participating security SBIC.

Traditional, Debenture SBIC With a debenture SBIC, the SBIC licensee can leverage its invested capital through the issue of government guaranteed bonds. An SBIC may receive government guaranteed funds equal to $3 for every $1 of private

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Raising Capital

equity capital invested in the SBIC. They can leverage $4 of every $1 invested if more than 50% funds are available for "venture capital" purposes. In no event may the government commit more than $90 million to any one SBIC.'~ SBIC bonds are bonds sold by the SBA, with funds placed in a trust that SBIC's can draw against. Bonds are guaranteed against default of principle and interest by the federal government. Bond interest is at "market rates." However, the market rate for a government guaranteed bonds is less than for a non-guaranteed bond because it is risk free. Bonds have a five or ten year maturity and may be structured to include a balloon payment at the end. "Leveraged" funds from bonds are combined with an SBIC's private equity capital forming an investment pool. An SBIC must make semi-annual interest payments to the trust so that trust will have funds to pay bondholders. This creates cash flow problems for SBIC's that have a substantial amount of their funds invested in the form of equity. For example, if an SBIC raises $5 million in private equity, either from the SBIC owners or institutional investors, they can obtain additional funding of $15 million ($3 of bond funds for every $1 of SBIC invested capital for funding ordinary companies) to $20 million ($4 for every $1 of SBIC invested capital to fund new ventures.) Entrepreneurs should be able to exploit a debenture SBIC's need to continuously generate cash by requesting debt versus equity financing. An entrepreneur should prefer debt financing because he or she will not have to give up an ownership interest in return for funds. But why would an SBIC want to offer debt financing and forego a potentially larger payoff from an equity investment? The reason is that a debenture SBIC must generate a continuous stream of cash to meet its semi-annual interest payments. There are several implications for the entrepreneur in the structure of a debenture SBIC. Bonds guaranteed by the Federal Government are arguably zero risk bonds, very close in their risk profile to Treasury Notes. They will almost certainly sell for less than the prime rate. This means that SBIC's will be able to raise funds at very low cost. Further, unlike institutional investors, who will pressure Venture Capitalists for extraordinary returns, the SBA will very likely keep their hands off as long as bond interest is met, paper work is filed, and regulations complied with. An SBIC may, however, demand convertible bonds, which would let them participate in upside potential. The strategy there is to use payoff analysis to calculate the minimum amount of equity that would have to be given up in the conversion to meet the investor's target yield.

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* Take Away Lesson: Debenture SBIC's should be motivated to fund companies through debt to generate cash to cover SBJC bond interest pqyments.

Participating SBIC's The Participating SBIC program was designed to overcome the cash flow problems that SBIC's had in meeting semi-annual bond interest payments. With a participating SBIC, the government acts somewhat like an institutional investor, providing funds and sharing in the profits of equity investments. The minimum private capital required to form a participating SBIC is $10 million. An SBIC can get a commitment of up to five years for a block of funds that it can draw upon as needed. It can obtain $2 of SBA funds under this program for every $1 of invested capital. The maximum amount of leveraged funds for any SBIC or affiliated group of SBIC's is currently $108.8 million, which is adjusted annually for inflation. The SBA pools its interest in participating SBIC's and places those interests in a trust which sells bonds to raise capital. The bonds are guaranteed against default of principal and interest by the Federal government, are sold at market rates, and pay interest semi-annually. In exchange for undertaking the risk of an equity investment, the SBA gets a preferred return. The preferred return is the ten year Treasury Note yield plus a spread which is currently about 1.5%. In addition, the SBIC pays an annual fee of about 1% on outstanding leverage. Finally, the SBA gets a share of the SBIC's profits, based on a formula. Typically, this share is 10%; however, it may be a little more or a little less based on comparison to a benchmark treasury yield and the percentage of funds leveraged. The formula is too complex for this discussion, but, for example, with a Treasury yield of 6%, an SBIC could get two-thirds of its capital from the SBA while only giving up 9% of its profits, in addition to the SBA's preferred return. There is also a 2% take down fee when leverage is drawn down.I4 Suppose a participating SBIC has $10 million of private equity capital requests a commitment of $20 million in "leveraged" funds. Just to get and keep the commitment, the SBIC will have to pay a 1% per annum fee or $200,000. Suppose, after six months, the SBIC finds an investment and draws $1 million for use. At that time, it will pay a 2% draw down fee, or $20,000.

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The SBIC will have to fund both of these expenses from invested capital since none of its portfolio companies are producing income at this point. The SBA takes its share of profits at the end of the SBIC fund's life, after it exits its investments. Suppose $12 million of leverage funds have been used for three years, in addition to $10 million of private equity capital; the ten year Treasury Note has a yield of 6.0%; the SBA spread is 1.5%; and SBIC's gross profit is $6 million. Before any profits are distributed, the $12 million in leverage funds is paid back to the SBA trust. How do the gross profits get split between the SBIC and SBA? The first deduction from profits is the SBA preferred return of 7.5% (6.0% Treasury Note yield + 1.5% spread) times the leverage of $12 million for 3 years or $2,700,000 ($12 million x 7.5% x 3 years). This reduces the available profits from $6.0 million to $3.3 million. Now suppose the SBA's share of the profits is 9%, then an additional 9% of the $3.3 million or $297,000 is distributed to the SBA. The remaining $3,003,000 of profits is retained by the SBIC and its investors. The participating model has several implications for an entrepreneur. First, since participation relieves an SBIC of the obligation to make semiannual bond interest payments, it can be more flexible in making equity investments. Seed and Early Stage companies are unlikely to have cash flow to sustain repayment of principal and interest to an SBIC, so equity should be their preferred type of funding. Second, since the cost of equity capital is lower for an SBIC than for a traditional venture capital firm, the cost of SBIC capital to the entrepreneur should be lower. Third, SBIC's can afford to be patient capital because they only make large payouts when profits are taken as they exit an investment.

FINDING AN SBIC SBIC's are licensed by the Small Business Administration which maintains a directory of SBIC's on the web. Since most Angel Investors, Venture Capitalists, and SBIC's invest locally, the directory is organized by state. The directory, called "SBA Gopher Local Information" is located at: www.sba.gov/gopher/local-information/Small-Business-Investment-Companies/ This directory provides the name and address phone numbers and email addresses of SBIC's, as well as investment preferences like size of investment, form of investment, the funding stage, industry, geographic locations and the firm's focus. Unlike Angel Investors, who are hard to find, and Venture Capitalists, who are easy to find, but hard to connect with, except through

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personal referrals, SBIC's should be easy to find, using this directory, and easier to connect with if the entrepreneur knows their preferences and can pitch to those references in the first 15 seconds of his or her letter, email or phone call. Figure 14-6 is what a typical Gopher Directory Entry might look like. Figure 14-6 Gopher Directory Entry

SBIC Licensees Located in New Jersey Southern Alliance Mezzanine Investors, L.P. Robert Jones, Douglas Smith 196 Pompton Road, Carona, NJ 07049 Phone: (999)239-8900 Fax: (999)239-8909 Email: [email protected] INVESTMENT CRITERIA INVESTMENT SIZE RANGE Preferred Min: $1,000,000 Preferred Max: $3,000,000 TYPE OF CAPITAL PROVIDED Subordinated Debt wlwarrants Equity FUNDING STAGE PREFERENCE Later Stage Only Expansion Growth Capital LBO, MBO, Recaps Acquisitions INDUSTRY PREFERENCE Diversified Manufacturing Distribution Services GEOGRAPHIC PREFERENCES

Raising Capital New Jersey Pennsylvania New York New England Mid-Atlantic (with co-investors) DESCRIPTION OF FIRM'S FOCUS Funding for expansion, acquisition, buyout or recap of profitable later-stage companies

Lessons: The more you know about the people you want to 'bitch" to: I . the less time you will spend pitching to people who will never work with you, and 2. The better you will be able to focus in on "hot button" issues, while avoiding the things SBIC's don't want to hear.

G- Take Away

WHAT WILL AN SBIC NEED TO KNOW? An SBIC will screen a prospect the same way a venture capitalist would. Before an entrepreneur contacts an SBIC he or she should have compiled and organized most of the material the SBIC will need to make a first cut funding decision. On the one hand, individuals who run SBIC's are very busy and it might take a while to get an appointment. On the other hand, if the entrepreneur has an intriguing proposition, they may ask him or her to come in right away. If the entrepreneur does not have a package to present, his or her credibility will plummet and he or she may not get another appointment. Typically, they ask for information in the seven areas listed below. l5

Identification Information Identification information includes the official business name (as opposed to the trade name, or brand name), the location of all offices, branches and facilities, the form of organization; and if a corporation, state and date of incorporation.

Small Business Investment Companies

Product or Service Information Product or service information includes a description of the business and all products or services sold, a history of the company's development over the last five years, or since inception if it has been in business less than five years, and information about the revenue and profits derived from each product or service.

Facilities and Other Property Facilities and other property is a description of real and personal property that a company has at disposal and its adaptability to other uses. A description of the physical attributes of the production facility including any metric as to size and capacity is also required. An SBIC will want to know about any assets that can be sold, just in case the investment doesn't work out.

Marketing Marketing information should include detailed information about the company's customer base and potential customers. The percentage of revenue generated by the top five customer^,'^ marketing studies and or economic feasibility studies, and a description of the channels of distribution.

Competition A competitive analysis includes (i) a description of the competitive conditions in the industry, (ii) the company's position relative to its largest and smallest ~ o m ~ e t i t o r s and , ' ~ (iii) a full explanation and summary of pricing policies.

Management The management section should include brief resumes of the business's management team and owners, including their age, education, and business experience. In addition, banking, business and personal references

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for each member of management and for the principal owners should be included.

Financial Information Financial information should include (i) Balance Sheet and Income Statements for the last three years or since inception if the company is less than three years old, (ii) detailed projections of revenue and expenses and net earnings for the coming year, (iii) a statement of the amount of funding requested, and the time the funds will be needed, (iv) the reason for requesting funds and a description of proposed uses, as well as a description of the benefits expected from the financing, for example increased efficiency, reduced expenses, or even improvement in financial position. SBIC application guidelines did not indicate either audited or reviewed financials were required. However, both reviewed and audited financial statements provide credibility to a presentation, especially if a company has had on-going operations for a number of years.

SUMMARY Small Business Investment Companies (SBIC's) fill an important funding gap in the risk / reward 1 size spectrum. Traditional funding sources like banks are unwilling to deal with the risks of Seed or Early Stage companies, with companies that are growing too rapidly, that are in disfavored industries or have new and innovative products that they don't understand. Angel investors are less risk averse than banks, but individual angel investors typically only invest $25,000 to $250,000 while groups of angel investors rarely invest more than $1 million. At the other end of the spectrum are Venture Capital firms. These firms are willing to take prudent risks in return for substantial rewards; however, their average investment is about $6 million and growing. SBIC's fill the funding gap by investing on the order of $750,000 to $2,750,000 with an average investment across all types of SBIC's of about $1 million. Unlike Venture Capital firms, SBIC's are more likely to invest in Seed and Early Stage companies. More than half of SBIC funds are committed to companies in business less than three years, about eighty percent of funds are committed to companies in business less than six years.

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Most small businesses are eligible for SBIC funding provided they meet size and use tests. For a company to be considered small, they usually must have a net worth of less $18 million and have net income of less than $6 million. SBIC funds cannot be used for passive investments, speculation or for illegal or immoral purposes. There are two basic types of SBIC's, debenture and participating. Debenture SBIC's must have a minimum of $5 million in private capital. With this they can raise $3 of capital through sale of government guaranteed bonds for every $1 of private capital to a maximum of $90 million. Participating SBIC's must have a minimum of $10 million of private capital which they can use to obtain $2 of SBA funds for every $1 of private capital. Debenture SBIC's must make semi-annual interest payments on SBA funds. This limits their ability to make equity investments in Seed and Early Stage companies. Participating SBIC's don't pay interest on an on-going basis. Instead, they pay a preferred return to the SBA when it exits an investment plus a share of its profits. To fund participating SBIC's the SBA pools its interest in a number of SBIC's and sells bonds secured by the future earnings of the SBIC's. SBIC's use substantially the same criteria for evaluating investments as venture capital firms. So all the preparation needed for a venture capital firm would probably also be necessary to pitch an SBIC. The Small Business Administration maintains a directory of SBIC's on the web. This directory is organized by state and provides contact information as well as a profile of the preferences of each SBIC. The best chance of getting funding from an SBIC is to make a careful match between a company's profile on the one hand, and preferences of an SBIC on the other.

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DISCUSSION QUESTIONS Where do SBIC's fit in the overall spectrum of capital sources in terms of risk, reward, size of investment and stage of development? What is the average SBIC investment? What percentage of SBIC capital is for initial investments and how much for follow-on investment? How can a company's industry be used to determine whether it will be more successful pitching to an SBIC or a venture capital firm? Setting aside the issue of investment size, would a biotech company be more successful pitching to a venture capital fund or an SBIC? What is the basis of your answer? If a company was a manufacturing or industrial firm, would it be more successful pitching to an SBIC or a venture capital firm? What is the basis of your answer? How is a debenture SBIC organized? Where does it get funding? What are the implications for the entrepreneur? How is a participating SBIC organized? What fees and preferences does it pay to SBA? What are the implications for the entrepreneur? Do SBIC's invest primarily in mature companies or start-up / early stage companies? About how much of SBIC capital is invested in companies in business three years or less? What percentage of SBIC capital is invested in companies in business six years or less? What are the eligibility criteria for SBIC funding? How does one find an SBIC? How are SBIC listings organized? What types of information provided in an SBIC listing that can be used to help the entrepreneur identify an SBIC that is right for his or her company? List seven categories of information an SBIC will need to evaluate and investment? Briefly describe each.

Small Business Investment Companies

ENDNOTES 1

, "Small Business Investment Company Program Fiscal Year 2002 Special Report," U.S. Small Business Administration, Investment Division 409 Third Street, S.W. Washington, D.C. 204 16 June 15,2002, p.34. 2 , "Overview: Small Business Investment Companies (SBIC)", http://www.sba.gov/INV/overview.htmlarticle dated 2/96, downloaded 111512002 "All SBIC Program Licensees Financing To Small Businesses Reported for F KYears ~ 1991 to 2000," Table 2, SBA SBIC Financing Statistical Package, http://www.sba.gov/INV/stat/200 1.html "Today's SBIC: Newly Designed and Fulfilling the Needs of Small Business ~ z o n w i d e , "National Association of Small Business Investment Companies (NASBIC) website www.nasbic.org downloaded 10/16/03. Figure 14-2 data is for the year 200 1. '-, "Small Business Investment Company Program Fiscal Year 2002 Special Report," p. 11. 6 "Seedstart-up Financing" is defined by PriceWaterhouseCoopers(PWC) as investment in companies that have a product or concept under development, but is not fully operational. Such companies are usually in existence less than 18 months. See the PriceWaterhouseCoopers MoneyTree website www.~wcMonevTree.com; "Small Business Investment Company Program Fiscal Year 2002 Special Report," p. 15. 7 , "Small Business Investment Company Program Fiscal Year 2002 Special Report," p. 11. L ' T ~ d a ySBIC: ' ~ Newly Designed and Fulfilling the Needs of Small Business ~zionwide,"Figure 13-3 data is for the year 2001. PriceWaterhouseCoopers' MoneyTree website www.pwcMoneyTree.com has defined four stages in a company's lifecycle 1) SeedIStart - a company has a concept or product in development, but it is probably not fully operational, usually in business less than 18 months, 2) Early Stage - the product may be commercially available, but the company may not be generating significant revenue, the company is usually in business less than 3 years, 3) Expansion Stage -the product or service is in production and revenue is growing rapidly, but the company may still not be profitable, usually in business more than three years, and 4) Later Stage - products and services are commercially available, the company may or may not have positive cash flow and profits; these may include corporate spin-offs. lo "Today's SBIC: Newly Designed and Fulfilling the Needs of Small Business ~ayonwide,"13-4 data is for the year 2001 l1 Bruce A. Kinn and Arnold M. Zaff. "VCs Tap New Funding Source The SBIC Equity Leverage Program and the Reasons for Its Growing Popularity," Venture Capital Journal, Wellesley Hills, July 1,200 1 p. 1 l2 Bruce A. Kinn and Arnold M. Zaff. p. 1 13 , "Overview: Small Business Investment Companies (SBIC)" l4 Bruce A. Kinn and Arnold M. Zaff. p. 1. 15 ,"How To Seek SBIC Financing"

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l6 SBIC Guidelines call for an analysis of revenue of the top five customers. It is always prudent to provide more than minimum information. An analysis of the top ten customers is usual for an IPO and if possible provide the top ten customers for both the current and prior year. l7 John Culbertson, Gamma Group Venture Funds recommends analyzing the top 20 competitors. From his speech to the graduate class on Raising Capital, Rutgers University - Camden, January, 2002.

Chapter 15

INTERNAL SOURCES OF CASH

INTRODUCTION Over time, companies tend to tie up more capital than necessary in assets such as accounts receivable, inventory and plant property and equipment. Excess assets must be funded through either debt or equity. Some estimate that by the time the typical entrepreneur is ready to exit via sale or IPO, his or her ownership has been diluted to 20% of the company, with the other 80% belonging to "the money," that is to the investors. The fewer excess assets a company has, the less equity an entrepreneur will have to give up so asset minimization should be an important capital preservation strategy. Another issue entrepreneurs have to think about is that growth requires capital, not just for research and development, and not just for plant and equipment, but growth requires capital for accounts receivable and inventory. A rapidly growing company can outrun its capital and be forced to accept funding on highly unfavorable terms. Such unexpected capital shortfalls place entrepreneurs in a weak bargaining position, with little time to consider alternatives. The demand for capital is not confined to start-up or early stage companies. Mature companies constantly need to re-evaluate their capital structure and assess whether capital is deployed productively. In fact, the longer a company has been in existence, the greater the likelihood that it has a treasure trove of cash buried amongst its assets waiting to be uncovered.

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Raising Capital

This chapter examines ways to raise capital from better management of accounts receivable, inventory, and plant and equipment. It also examines how to forecast the capital demands of a growing company. Raising capital from outside sources creates dependence and dependence limits options and weakens a company's bargaining position. On the other hand, finding cash internally, lessens dependence, and strengthens a company's bargaining position.

HOW MUCH CAPITAL IS APPROPRIATE? In analyzing any problem, it is often useful to proceed from the big picture to the components of that picture. Every dollar of assets has to be financed by some form of capital. So the first question should be whether the company has an appropriate amount of assets. For many companies, this question can be addressed with the Return on Assets ratio. The equation for Return on Assets (ROA) is given as Eq. 15.1. This ratio compares income from operations to the assets that produced that income. If the ratio is high, management is doing a good job of producing income from assets. If the ratio is low, it could indicate one of two things: (i) the company has excess nonrevenue producing assets or (ii) management isn't efficiently using the assets at its disposal.' ROA

=

Net Income +Interest x (1-Tax Rate) Average Assets

Eq.15.1

Where: Net Income Interest Tax Rate -

is income after taxes is interest expense is the company's effective tax rate which can be found by dividing Income Tax by Earnings Before Taxes Average Assets - are the assets at the end of the current year plus the assets at the end of the prior year divided by two.

Interest is added back to Net Income so that companies with different financing strategies can be compared. The reason we multiply Interest times (1- Tax Rate) is that taxes subsidize the cost of interest. How? If a company pays $100 and is in the 20% bracket it saves $20 in taxes. So the real cost of the $100 of interest is only $80. Suppose Adams Company has Net Income of $370,000; Interest was $40,000; it is in the 25% tax bracket; assets at the end of the most current

Internal Sources of Cash

307

year was $7 million and assets at the end of the prior year were $5 million. We can use equation 15.1 to compute ROA. ROA

=

$370,000 + $40,000 x (1 - 25%) ($7,000,000 + $5,000,000) / 2

We can use industry ROA data to estimate how much a company should have invested in assets. Suppose the leading companies in an industry, Bob's, Carol's, and Ted's, have return on assets of lo%, 8% and 6% respectively. The average industry ROA is 8% ((10% + 8% + 6%) / 3). Equation Eq.15.1 can be rewritten by multiplying both sides by average assets and dividing both sides by ROA to give equation Eq.15.2. In rewriting the equation, we made two other small adjustments. For ROA we substitute Target ROA which is the ROA we want the company to achieve. Instead of Average Assets, we substituted Target Average Assets. This is the average assets the company should have for the income it is generating. Target Average Assets = Net Income + Interest x (1 - Tax Rate) Target ROA

Eq. 15.2

Filling in the information for Adams Company and the Industry ROA of 8% gives an average asset target of:

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Raising Capital

If a company has average assets of $6,000,000 and an asset target of $5,000,000 then potentially, the company has $1,000,000 more assets than it is productively using. The next question is: How can non-productive assets be identified and converted to cash?

THE CASH CYCLE The cash cycle begins when cash is used to purchase raw materials continues through manufacturing, sales and collections and ends when accounts receivable are converted back to cash. For a service company, the cash cycle begins when labor dollars are expended to provide a service and ends when cash is collected. If the cash cycle can be compressed, cash will emerge in the form of reduced inventory and accounts receivable. The amount of capital tied up in assets is a function of time and quality as well as the quantity of assets. If a piece of inventory is damaged or obsolete, it will tie up capital because it can not be easy to converted to cash. The longer an item is in inventory the higher the probability it will become damaged or obsolete. An account receivable that is uncollectible ties up capital. The longer an account is uncollected the higher the likelihood that it will never be collected.

ACCOUNTS RECEIVABLE What is a company really doing when it sells on credit? In a very real sense, it is making a loan to its customer. That loan takes resources and must be funded. On the Statement of Cash Flows, increases in accounts receivable are classified as a use of cash. In other words, credit sales use of capital. What happens when a company collects an accounts receivable? That collection generates cash which reduces the need for capital. Since companies that sell on credit are constantly making sales and constantly collecting, the amount of incremental capital needed depends on whether it is selling more on credit than it is collecting, or whether it is collecting accounts receivable faster than it is extending credit in the form of new sales.

Internal Sources of Cash

Metrics for Measuring Billing and Collections One way to determine whether a company's billing and collections department is efficient is to analyze Accounts Receivable (AR) Turnover. The Accounts Receivable Turnover is the ratio of net credit sales to average accounts receivable. Think of Accounts Receivable Turnover as how many times per year a company collects the money owed to it. This ratio only considers credit sales not cash sales. However, as a practical matter, most companies either sell most of their merchandise or services for cash, or they sell most on credit. Retail outlets that accept credit cards as well as cash and checks can consider themselves as having all cash sales. Business to business sales are usually credit sales. The equation for Accounts Receivable Turnover, Eq.15.3 is given below.2 AR Turnover

Where: Net Credit Sales Average AR -

=

Credit Sales Average Accounts Receivable

Eq.

is credit sales less returns and allowances, and is the average of this year's and last year's accounts receivable balan~e.~

Example: A company has Net Credit Sales of $10 million. Accounts receivable at the end of the current year is $2.6 million and the balance at the end of the prior year was $2.4 million. AR Turnover

=

$10,000,000 ($2,600,000 + $2,400,000) 1 2

The question of whether this is good or bad depends on industry averages. Accounts receivable turnover by industry can be found in RMA studies available at most libraries. Benchmark ratios can also be computed using data on a company's competitors. Dimensionless units like AR Turnover are often difficult of for nonaccountants to understand. Fortunately, another ratio, Days Sales Outstanding (DSO) translates this arcane accounting ratio into something more

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understandable. DSO is the average number of days it takes customers to pay their bills. The formula for DSO is given as equation Eq. 15.4. DSO = 365 davdvr. AR Turnover Example: Suppose a company has an AR Turnover of 4.0. Substituting the Turnover into equation Eq. 15.4 gives: DSO = 365 daysly-. 4.0 = 91 days

AR Turnover and DSO provide two metrics that can be used to measure the efficiency of billing and collections. Whether an AR Turnover of 4.0 and a DSO of 91 is good or bad depends on industry norms. Trends can also be followed to determine whether the department is getting more efficient or less efficient. Improving efficiency is going to generate cash. Deteriorating efficiency is going to use cash at an accelerated rate.

Raising Cash from Accounts Receivable Management should be as proactive in managing accounts receivable as they are in managing any other aspect of the business. They wouldn't tell salespeople, operations or finance to "Just do the best you can." Goals are set for each of these departments, and goals are tied into specific strategic objectives. There is no reason to be less proactive in managing accounts receivable. Suppose the goal management sets is to squeeze a specified amount of cash out the capital invested in accounts receivable. How can the goal be analyzed, quantified and communicated? One way is to modifj equation Eq.15.3 by saying we want to reduce the historical average accounts receivable by some target amount, call it Amount Raised. The modified equation is given by equation Eq.15.5. AR Turnover

=

Net Credit Sales Average AR - Amount Raised

Eq.15.5

Internal Sources of Cash

311

Example: Suppose Credit Sales are $10,000,000, the historical average accounts receivable is $2,500,000 and the amount the company wants to raise is $400,000. Using this information into equation Eq. 15.5 gives: AR Turnover

=

$10,000,000 $2,500,000 - $400,000

Again, while this ratio might have meaning to a business owner or accountant, but it does not provide a workable goal to the average person in the billing department. However, translating this into DSO using equation 15.4 gives it meaning. DSO

=

365 davslvr. 4.76

= 77 days

Collecting accounts receivable in 77 days is a goal the average person can understand. By reducing average collection time from 91 to 77 days this company could raise $400,000. Another way to look at raising cash from accounts receivable is to start with a DSO goal and compute the amount of capital that could be raised by reaching that goal. Suppose the company finds that the average days outstanding in the industry is 40, and it sets a collection goal of 40 days. The first step is to use equation Eq.15.4 to find the AR Turnover necessary to reach a DSO of 40 days. To do this we will modify Eq.15.4 by introducing the term New AR Turns which is the New Accounts Receivable Turnover goal and Target DSO which is our goal stated in days, giving equation Eq. 15.5. Target DSO

=

365 davslvr. New AR Turns

Substituting a Target DSO of 40 days into equation Eq. 15.5 gives: 40 days

=

365 davslvr. New AR Turns

Eq.15.5

Raising Capital New AR Turns

=

365 davslyr. 40 days

This can be substituted into a somewhat modified version of equation Eq.15.4 in which New AR Turns is substituted for AR Turns and New Average AR is substituted for Average AR giving equation Eq. 15.6 New AR Turns

=

Net Credit Sales New Average AR

Eq. 15.6

Suppose Net Credit Sales is $10,000,000 and New AR Turns is 9.125. The New Average AR can be computed by substituting these values into equation Eq. 15.6 gives: 9.125

=

New Average AR

=

$10,000,000 New Average AR $10,000,000 9.125

If the old average accounts receivable was $2,500,000 and the new average accounts receivables will drop to $1,095,890, the reduction in accounts receivable of $l,4O4,1 10 ($2,500,000 - $1,095,890) will generate an equivalent amount of cash. Stated another way, this improvement in accounts receivable collections is equivalent to having a stranger invest $1.4 million and demand nothing in return.

Granting Credit Cash can be locked up in accounts receivable if credit is granted to customers who cannot or won't promptly pay their bills. This is especially problematic for a start-up anxious to build a sales track record. Not everyone who asks for credit deserves it. The credit department, if there is one, or sales people if there is no credit department, should have strict guidelines as to when a credit application is needed and criteria for evaluating that credit application.

Internal Sources of Cash

313

Customers who don't pay within a reasonable period of time should be denied further credit and customers who are more than 90 to 120 days late should be referred to collection agencies. Remember, the objective is not to make a sale, it is to get paid. Investors who see long overdue accounts receivable are more likely to impute problems to poor products and services than they are to blame customers for failing to pay.

INVENTORY Inventory is another asset that can lock up a lot of capital. Most companies have far more inventory than needed to support manufacturing and sales. When a company buys inventory, either in the form of raw material or finished goods, it uses cash which increases the need for capital. When a company sells inventory, it generates cash and reduces the need for capital. Most companies buy and sell inventory continuously. If a company is buying inventory faster than it is selling inventory, its need for capital will increase. If it is selling inventory faster than it is buying inventory, it is generating cash and reducing its need for capital. One way to determine whether a company has excess inventory is by evaluating its Inventory Turnover ratio. Inventory Turnover is the ratio of Cost of Goods Sold to Average Inventory. It indicates how many times a company sells its entire inventory over the course of a year. Inventory Turnover can be computed using equation Eq. 15.1o . ~ Inventory Turnover

Where: Cost of Goods Sold Average Inventory -

=

Cost of Goods Sold Average Inventory

Eq.15.10

is the cost of goods actually sold during a year and is computed by averaging the ending inventory from the current and prior years.

Suppose Adams Company has a Cost of Goods Sold of $6,000,000. The ending inventory of the current'year and prior years are $2,100,000 and $1,900,000 respectively. Using this information in equation 15.10 gives: Inventory Turnover

=

$6,000.000 ($2,100,000 + $l,9OO,OOO) / 2

Raising Capital

Whether this is good or bad depends on a comparison to other companies in the industry. The higher the inventory turnover, the better. However, Inventory Turnover is another ratio that it is difficult for nonaccountants to grasp and use. However, it can be translated into a more understandable measure called Days in Inventory (DII) which can be computed using equation 15.1 1. Days in Inventory

=

365 davslvr. Inventory Turnover

Eq.15.11

Assume Adams Company has an inventory turnover of 3.0. The average number of days a good is in inventory is given by substituting values into equation Eq. 15.11. Day In Inventory

=

365 davslvr. 3.O

=

122 days

This measure of the efficiency of inventory use is easier for most people to understand. It says, on average, 122 days elapse from the time a company acquires raw material until it sells its finished product.

Raising Cash from Inventory Taking a proactive approach to inventory management, it is possible to reverse engineer a specific goal and recover some of the capital tied up in inventory. This is done by increasing inventory turns. Equation Eq. 15.10 can be modified by subtracting the Amount Raised from the old average inventory to get the New Inventory Turnover giving equation Eq. 15.12. New Inventory Turnover

=

Cost of Goods Sold Average Inventory - Amount Raised

Eq.15.12

Internal Sources of Cash

315

Suppose Adams Company has a Cost of Goods Sold of $6,000,000 and an old average inventory of $2,000,000. Its goal is to raise $500,000. What will their New Inventory Turnover have to be to meet this goal? New Inventory Turnover

=

$6,000,000 $2,000,000 - $500,000

Using equation Eq. 15.11, the Days in Inventory can be computed using the New Inventory Turnover. Days In Inventory = 365 dayslyr. 4.0 =

9l days

If Adams Company can reduce their Days in Inventory from 122 days to about 91 days it can squeeze $500,000 out of inventory.

Techniques for Reducing Inventory Many techniques are available for reducing inventory, but one of the most productive is to think in terms of the 80-20 rule. As applied to inventory, the 80-20 rule says that 80% of the Cost of a Goods Sold is from 20% of the items in inventory. For companies with a computerized inventory system, inventory turnover and DII can be computed at the level of individual parts or items. Such items are sometimes called Stock Keeping Units or SKUs. The DII for any given part can be compared to a target number of days of inventory and excess inventory can be sold to generate cash. For example, suppose a company sells computer power supplies that cost it $20 each and it sells about ten per day. If the computer analysis indicates the company has a 100 day supply on hand the amount tied up in inventory is $20,000 (100 days supply x 101day x $20). Now suppose that only ten days of stock is necessary to service customers. The target inventory

3 16

Raising Capital

level for this part would be $2,000 (10 days supply x l01day x $20.) That means that $18,000 of excess inventory is available to be harvested. The amount of capital tied up in inventory can also be reduced by compressing the time material is in inventory. Material becomes raw material inventory when the company acquires title to it. Material becomes part of work in process as soon as labor is applied to convert it from one form to another. Goods are in finished goods inventory only when they are ready for sale. The time raw materials are in inventory can be reduced through efficient housekeeping, warehousing and location tracking. The time material is Work in Process can be reduced through better material handling and speeding up the manufacturing process. The time items are in finished goods inventory can be reduced by buying or making goods just before they are sold.

* Take Away Lesson: Cash and the capital it represents are not just raised in the CFOS oflce. Cash can be raised on the factovfloor or in the warehouse by divesting the company of sIow moving and excess inventory and by accelerating the flow of goods through the company and out to the customers.

PLANT, PROPERTY AND EQUIPMENT It takes capital to finance plant, property and equipment. Reducing the amount of those assets can generate cash and reduce capital demand. Rather than take a ratio approach to identifLing excess plant and equipment, a simpler method is to examine a company's fixed asset ledger. A fixed asset ledger is simply the list of the company's assets used as the basis for calculating depreciation and auditing accumulated depreciation. If the ledger is computerized, as it is in most companies, sort the ledger by asset value high to low. Examine the high value assets first and ask two questions: (i) Have we used this asset in the last 60 days? (ii) Is there a less costly alternative to owning this asset? As a general rule, assets that are not being used in day to day operations on an on-going basis should be sold to raise cash. The truck parked behind the building, the unused computer, the drill press that nobody uses any more should all be sold. There is no point in saving them just in case

Internal Sources of Cash

317

they are needed in the future. First, they will never be more valuable than they are now. As time passes their value will decline. Second, even unused assets are costly in terms of storage, insurance and property taxes. Real estate is an especially high payoff area because companies that have been around for some time often acquire and hold real estate that they no longer need. Pay special attention to undeveloped land which may not be on the fixed asset ledger because it is a non-depreciable. Other high payoff property to sell includes non-revenue producing assets such as airplanes, yachts and corporate owned cars.

ACCOUNTS PAYABLE When a company sells on credit, it is making a loan to its customer. But when a company buys on credit, its supplier is making a loan to it. If a company buys goods on credit faster than it pays its bills, accounts payable will grow and suppliers will increase their net loan to the company. Accounts payable represents an important, non-interest bearing source of funds for a company. Some management consultants recommend paying bills very slowly as a way of forcing suppliers to increase their loans to the company. As a general rule, this approach is fool hearty. In the long run, it is impossible to force someone to grant a loan. Stretching payment terms beyond the norms in the industry simply flag the company as a bad customer and a bad credit risk. Pay bills when they are due. If you are perceived as playing games with suppliers, investors are likely to believe it is in your nature to play games with them as well.

SUMMARY Most companies miss the opportunity to raise capital from internal sources. Every asset on the balance sheet must be financed by either debt or equity capital. The more outside capital a company needs, the greater its dependence on banks and investors. Reducing the amount of assets that must be financed is dollar for dollar the equivalent of new investment without diluting the owner's equity or incurring additional debt. Most companies that have been in operation for a number of years have capital tied up in excess assets. One ratio that can be used to determine whether a company has excess assets is Return on Assets. The lower the Return on Assets, the higher the likelihood that a company is carrying too many assets.

318

Raising Capital

Cash can be squeezed out of accounts receivable through better collection techniques and taking care to only grant credit to companies that promptly pay their bills. Cash can be squeezed out of inventory by analyzing inventory items by SKU, identifying excess inventory and selling it. Inventory can also be reduced by increasing the speed at which inventory flows through a facility. The faster inventory moves, the less of it is required to support a given level of sales. Fixed assets should be analyzed and any fixed assets not currently being used to generate revenue should be sold. High payoff items to look for include land, buildings, airplanes, automobiles and manufacturing equipment.

Internal Sources of Cash

DISCUSSION QUESTIONS What is the relationship between assets and capital? If the assets of a company increase, what is the implication for capital demand? What are the risks to the entrepreneur in having to generate outside capital through debt or equity offerings? Assume a company has been in operation for a number of years, how can it estimate the appropriate level of assets? What is the cash cycle? How can an understanding of the cash cycle reduce dependence on outside capital? What is the cash effect of selling on credit? What is the cash effect of collecting accounts receivable? Is there a way to measure the efficiency of collections? What is the best way to communicate collections performance and goals to collections staff! How would an entrepreneur or manager proactively set goals for raising cash from accounts receivable? What is the cash effect of accumulating inventory? What is the cash effect of selling inventory? Is there a way to measure the efficiency of inventory accumulation and use? What is the best measure for communicating this to manufacturing, warehouse and other factory floor personnel? What are the mechanics of computing the efficiency of inventory use and computing a measurement that most people can understand? How would an entrepreneur or manager proactively set goals for raising cash from inventory? Is there a process for identifying an eliminating slow moving inventory? If so, what is it? How would a company identify plant, property and equipment assets that can be converted to cash?

Raising Capital

ENDNOTES

'

David Vance. Financial Analysis and Decision Making, McGraw-Hill, New York 2002, pp.20-22. Ibid. pp.25-26 3 This assumes that accounts receivable have increased or decreased fairly smoothly over the year. This might not be the case if accounts receivable abruptly rose or declined due to an acquisition or writing off a major account. If there were an abrupt change in the accounts receivable during the year, the correct method would be to substitute a weighted average accounts receivable balance for the average. 4 Vance. pp.28-29.

Chapter 16

BONDS

INTRODUCTION Bonds are long term debt instruments. Generally, the creditworthiness of the company issuing a bond is all that stands between the investor and the loss of their investment. Bond rating agencies provide information on issuer creditworthiness and this information bears on how much interest an issuer will have to pay to attract investors. Unlike venture capitalists or equity investors who may have one or more seats on a company's board of directors or a bank which has extensive covenants and on-going reporting requirements that they use to manage risk, bondholders have very limited control once they make an investment. In addition, bonds generally have limited upside potential if a company prospers, but bondholders can lose everything if a company collapses and since bonds tie up invested capital for years or even decades it is easy to see why bonds have a unique risk / reward profile. This chapter discusses the general features of bonds and the motivation that a company has to sell bonds or an investor to buy them. This will include a discussion of bond ratings and other ways that buyers evaluate risk as well as how bonds can be made more attractive by adding features that reduce risk or increase the potential reward for investors. Junk bonds and how they differ from ordinary corporate bonds will be discussed as well as bond valuation, premiums and discounts, bond underwriting, the secondary market in bonds and legal considerations when using bonds.

322

Raising Capital

GENERAL CHARACTERISTICS OF BONDS Bonds are means for a company to raise capital without giving up equity. This feature alone makes them a highly attractive source of capital. But there are other benefits as well. Interest on bonds is tax deductible, which means that the tax code subsidizes the cost of interest.' Bonds are usually a means of permanent, that is, long term financing. Ten, twenty or thirty year bonds are not uncommon. Contrast this to banks which rarely extend term loans beyond five to seven years. Bonds are subject to less ongoing monitoring than bank loans. Whereas bank covenants monitored monthly can trigger acceleration of a loan, generally bond indenture agreements provide little pre-maturity relief as long as the debt is being properly serviced. Proper service means that interest and sinking fund payments are being made timely. A sinking fund is a fund into which a company makes regular payments so that when the bond matures there will be enough money set aside to repay bondholders. Not all bond indenture agreements require sinking funds. Bonds pay interest twice a year. The amount of the interest payment is equal half the coupon rate times the face value of the bond to reflect the fact that half the interest is paid every six months. Unlike bank interest rates which generally float up and down as the prime rate or LIBOR (London Interbank Offer Rate) change, bond interest rates remain fixed over the life of the bond. For companies with good credit, bonds generally have lower interest rates than bank loans. For companies with marginal credit, high yield bonds, also as junk bonds, may provide an alternative to banks afraid to lend but interest is likely to be higher than bank rates.

RISK MINIMAZATION When a person buys a corporate bond, he or she can only look to the corporation for payment. The higher the risk that investors perceive in any particular investment, the greater the reward he or she will demand to compensate for that risk. Here we run into the problem of asymmetric information. Bond issuers know more about their company and its creditworthiness than bond buyers. To be "safe" bond buyers assume a worst case risk scenario and set the required reward to match that estimated level of risk. The strategy from the issuers' perspective is to provide purchasers with a realistic assessment of the risk so that buyers do not indulge their natural tendency to overstate it. One way to provide accurate risk information is to have bonds rated by independent agencies.

Bonds

323

Bond rating agencies include Moody's Investor Service, Standard and Poors, Fitch Investors Service and others, all of which evaluate the credit worthiness of companies throughout a bond's life. Each agency has slightly different rating criteria. Figure 16.1 provides Bond Rating Definitions for Moody's Investor Service. The rating of individual company bonds can be found for Moody's and Fitch's at their respective websites: www.moodys.com and www.fitchratings.com.

Figure 16-1 Bond Rating Definitions for Moody's Investor service2

Aaa Bonds and preferred stock which are rated Aaa are judged to be of the best quality. They carry the smallest degree of investment risk and are generally referred to as "gilt edged." Interest payments are protected by a large or by an exceptionally stable margin and principal is secure. While the various protective elements are likely to change, such changes as can be visualized are most unlikely to impair the fundamentally strong position of such issues. Aa Bonds and preferred stock which are rated Aa are judged to be of high quality by all standards. Together with the Aaa group they comprise what are generally known as high-grade bonds. They are rated lower than the best bonds because margins of protection may not be as large as in Aaa securities or fluctuation of protective elements may be of greater amplitude or there may be other elements present which make the long-term risk appear somewhat larger than the Aaa securities. A Bonds and preferred stock which are rated A possess many favorable investment attributes and are to be considered as upper-mediumgrade obligations. Factors giving security to principal and interest are considered adequate, but elements may be present which suggest a susceptibility to impairment some time in the future. Baa Bonds and preferred stock which are rated Baa are considered as medium-grade obligations (i.e., they are neither highly protected nor poorly secured). Interest payments and principal security appear adequate for the present but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Such bonds lack outstanding investment characteristics and in fact have speculative characteristics as well.

324

Raising Capital

Ba Bonds and preferred stock which are rated Ba are judged to have speculative elements; their future cannot be considered as well-assured. Often the protection of interest and principal payments may be very moderate and thereby not well safeguarded during both good and bad times over the future. Uncertainty of position characterizes bonds in this class. B Bonds and preferred stock which are rated B generally lack characteristics of the desirable investment. Assurance of interest and principal payments or of maintenance of other terms of the contract over any long period of time may be small. Caa Bonds and preferred stock which are rated Caa are of poor standing. Such issues may be in default or there may be present elements of danger with respect to principal or interest. Ca Bonds and preferred stock which are rated Ca represent obligations which are speculative in a high degree. Such issues are often in default or have other marked shortcomings. C Bonds and preferred stock which are rated C are the lowest rated class of bonds, and issues so rated can be regarded as having extremely poor prospects of ever attaining any real investment standing.

Ratings are based on the strength of a company's balance sheet, the amount of cash it generates, its prospects for continued success, and the rating agency's judgment. Rating agencies often add suffixes such as +I-,or 1,2 or 3 to express gradations between the letter grades.

* Take Away Lesson: The stronger a company's balance sheet and cash Jaw, !he higher the rating. Since higher bond ratings imply less risk of default, companies with high bond ratings willpay Iess interest.

Bonds

BOND STRUCTURE Bonds are usually structured to pay semi-annual interest for a number of years, and return principal to the investor at the bond's maturity. From the investor's point of view, a bond's value, Vb, is the sum of two discounted cash flows: one is the interest payment stream, the other is the return of principal. It can be written as shown in equation Eq. 16.1: Vb Where: Pmt PVIFA -

= Pmt x

PVIFA (k, n)

+ FV x PVIF(k, n)

Eq. 16.1

is the semi-annual interest payment, is the Present Value Interest Factor for an Annuity (PVIFA) see Appendix D. is the period discount rate, is the number of semi-annual payments, is the Present Value Interest Factor (PVIF) see Appendix C, is the face value of the bond

knPVIF FV -

The semi-annual interest payment, given by equation Eq16.2 is simply the annual interest rate on the bond, this is sometimes called the coupon rate, divided by two, because each semi-annual payment is for interest for a half a year, times the face amount of the bond. Note that the interest rate on the bond is set by the issuing company. It usually printed on the face of the bond. The discount rate is the market's evaluation of the riskiness of the bond. The two are rarely the same. Pmt

= Amount x Interest Rate / 2

Eq. 16-2

Where: Amount is the face amount of the bond and Interest Rate - is the annual interest rate printed on the bond. Suppose a five year, $100,000 bond, has a coupon rate of 6% and bonds of companies with similar risk are discounted at 8% per year. If interest is paid twice per year, the period discount is 4% (8% / 2). If they are five year bonds, making payments twice per year there will be 10 payments (2 payments per year x 5 years) and such a bond will be discounted for 10 periods. First use equation Eq.16.2 to compute the interest payment. Pmt

= $100,000 x 6% /

2

Raising Capital

With the amount of the semi-annual interest payment, we can then compute the value of the bond using equation Eq. 16.1.

Values for the functions PVIFA and PV are provided as appendices D and C respectively. The formula for the underlying functions PVIFA, and PV are given by equations Eq. 16.3 and Eq. 16.4 respectively.

1;

ix&;

Eq. 16.3

Eq. 16.4

In this example, the values for PVIFA(4%, 10) and PV(4%, 10) are 8.1 109 and .67556 respectively.

Here we see a $100,000 bond is only worth $91,888.70. Why? The discount rate is the rate at which the value of a sum of money erodes because of the time value of money. The time value of money includes an adjustment for risk. If the discount rate is higher than the bond's coupon rate, the bond value is wearing away faster than interest can increase it. On the other hand, if the discount rate is lower than the bond's coupon rate that means the value of the bond is increasing faster than it is eroding and the value of the bond will be higher than its face value. A company's bond can sell for more than its face value, in which case the difference, expressed as a percent, is called a premium, or it can sell

Bonds

327

for less than face value, in which case the difference, expressed as a percent, is called a discount. This discount, which is a percent off the face value of a bond must not be confused with the discount rate, which is the rate at which the bond's value erodes over time.

Discount Rate The discount rate is the minimum yield the market demands to purchase a bond. This rate reflects company characteristics as well as information about expected economic conditions. Conceptually, the discount rate, k, can be expressed as a series of factors given in equation Eq. 16.5. k = Krf+DRP+LP+MRP Where: Krf DRP LP MRP -

Eq. 16.5

is the risk free rate of return. This is usually estimated by the interest rate on a one year Treasury Bill. is the default risk premium. The higher the risk of default, the higher this premium will be. is the liquidity premium. The easier it is to convert a bond to cash, that is, the easier it is to sell it, the lower the liquidity premium. is the maturity risk premium. This premium accounts for the risk that Krf will change over time. As a general rule, the longer the time to maturity, the greater the MRP.

Investors weight the decision to purchase a given bond against all other possible investments. They are looking for both maximum yield and maximum safety. Realistically, however, greater yield means they will have to accept more risk. Types of risk include the risk that a company will default on principal and interest payments, that bonds will become illiquid, that is the risk that there will be no ready market for a particular company's bonds and the risk that interest rates will rise dramatically, which means the bond will be more heavily discounted by the next buyer should the investor decide to exit his or her investment in bonds before it matures.

General Electric Bond Mini-Case It is interesting to see how factors such as maturity, yield, and risk interact under the best possible conditions, for a company with little risk of

328

Raising Capital

default, and then use that as a starting point for understanding bonds issued by less well known, less financially secure companies. In March 2002, General Electric issued $1 1 billion of bonds. At the time, G.E. had a triple A credit rating. Figure 16-2 is an Analysis of General Electric's $1 1 Billion Bond Figure 16-2 Analysis of General Electric's $1 1 Billion Bond Issue

Amount

Maturity

Rate

$4 billion

3 years

0.125 percent over the 3 month LIBOR rate.

$2 billion

5 year

5.375% coupon rate, priced to yield 0.8% over five year treasury notes.

$5 billion

30 year

6.75% coupon rate, priced to yield 1.09% over thirty year treasury bonds.

Analyzing these bonds, we find several things. First, maturities are staggered. There will never be a year when all $1 1 billion becomes due. Second, the bond yields are pegged to some common benchmark that investors can use to gauge the appropriateness of prices and interest rates. The LIBOR is the London Interbank Offer Rate. It is the British Banker's Association average rate for dollar denominated deposits based on quotations at 16 major banks. As of the day G.E. bonds were issued, the three month LIBOR rate was 2.000%, making the initial interest rate on the 3 year GE bonds about 2.125%.~ The five year bonds have a coupon rate of 5.275% and were priced to yield 0.8% over Treasuries. Five year Treasury yields were about 4.4% at the time of the bond issue, which means the target yield was about ~ . 2 %The .~ thirty year bonds have a coupon rate of 6.75% with a yield of 1.09% over thirty year treasury bonds. Whether this bond sold at a discount or a premium could be determined by using equation Eq.16.1 and using the thirty year treasury bond rate plus 1.09% as the discount rate, k. The discount rate for computing bond value is the same as the yield required by the market place for bonds of similar risk. Bond issuers won't price bonds to yield more than the minimum the market requires, otherwise they would be giving away value for no reason. An issuer can not price bonds below the minimum required yield or its bonds will not sell out.

Bonds

329

Since the target bond yield of 5.2% is somewhat less than the coupon rate of 5.275% we expect the market value of the bond, Vb, to be higher than the face value of the bond, meaning it should sell at a premium to the face value of the bond. The actual price of the bond could be computed using Eq. 16.1 and using the target bond yield of 5.2% as the discount rate. To make sense of this, think about an extreme example. Suppose an investor could buy a $1,000 face value bond with a coupon rate of 10%. He or she would get $100 per year in interest. Assume for a moment the bond has a very long life, say 50 or 100 years, so the terminal value of the bond is not a consideration, only the interest. If the investor had to pay $2,000 for the bond and it only paid $100 per year in interest, the yield would only be about 5% ($100 interest / $2,000 cost). If the investor could buy that same bond for $500, the yield would be 20% ($100 interest / $500 cost). If no other investment of similar risk is yields 5%, then it might be worth while to purchase the bond even at a cost of $2,000. On the other hand, if every other investment of similar risk yields 20%, there would be little point in purchasing the bond for more than $500. As the yield demanded by the market place rises above the coupon rate of the bond, the value of the bond dips below its face value. But when the yield of a bond dips below the coupon rate, the value of the bond rises above the face value. Think of this as a bond value - yield seesaw with the face value of the bond and the coupon rate as the fulcrum and market value and yield as the ends of the seesaw which move in opposite directions. The premium over face value is easier to visualize if we think of valuing a $100,000 bond. Using equation Eq. 16.2 we find the semi-annual interest payment. coupon rate / 2 paymentdyr.) x $100,000

Pmt

= (5.275%

Pmt

= $2,637.50

Then we can use equation Eq.16.1 to compute the bond value. This bond value is the price that the issuer must sell the bond for in order for it to yield 5.2% Vb

=

$2,637.50 x PVIFA(5.2% / 2, 5 yrs. x 2) + $100,000 x PV(5.2% / 2, 5 yrs. x 2)

330

Raising Capital

Notice that we used the coupon rate to compute the semi-annual interest payment, but we used the yield for the discount rate. Few, if any, tables provide entries for a discount rate of 2.6%. Therefore we have to rewrite equation Eq. 16.1 substituting Eq. 16.3 and Eq. 16.4 for the Present Value Interest Factor for an Annuity and Present Value respectively.

Vb = $2,637.50 x r38.462 - 29.7551

+ $100,000 x .7736

Vb = $22,967.35 + $77,360.00 Vb = $100,327.35 The bond premium can be computed using equation Eq. 16.6. Bond Premium =

Vb - Face Value of Bond Face Value of Bond

Bonds can sell at a discount as well. The discount can be computed using equation Eq. 16.7. Bond Discount =

Face Value of Bond - Vb Face Value of Bond

Eq. 16.7

Bonds

33 1

The thirty year issue is priced to yield 1.09 over Treasuries. As of the date of issue, 30 year Treasuries were yielding about 5.21% which means the discount rate for this issue is about 6.3%. Arguably, the 1.09% represents the default risk premium and liquidity premium for General Electric bonds because the risk free rate of return, Krf, and the maturity risk premium, MRP are already included in the 30 year Treasury yield. Using equation Eq. 16.1 we can find the offering price of thirty year General Electric bonds, and from that we can compute the bond premium.

G-

Take Away Lessotis: I . The higher the discount rate, the lower the bond value. 2. Bonds with default risk, bonds with lung t e r m to matz~rity, and bonds for which there is no ready market have higher discount rates. 3. Movement in the one year Treasury Bill rare can afect the discount rate.

FEDERAL REGULATION OF BOND SALES Several federal laws regulate bond sales. The two most important are the Securities Act of 1933 and the Trust Indenture Act of 1939.

Registration Bonds are securities and as such are subject to the Securities Act of 1933 which requires registration. However, some bonds are exempt from registration if they fall within the provisions of SEC Regulation 230.144A. This regulation says that bonds don't have to be registered provided that are:6 (i)

Debt securities

(ii)

Highly liquid, which means there is a ready market for them.

(ii)

Information about the issuer is provided, including financial statements for two years.

(iv)

Sold to a Qualified Investment Buyer. A Qualified Investment Buyer is one that owns or invests in, $100 million of certain securities, and meets certain other condition7.

332

Raising Capital

Another matter to consider is that a company need not be a public company, in the conventional sense of the word to issue bonds, or to issue publicly traded bonds. Levi Strauss, for example, is a privately held company, meaning that company's common stock is not publicly traded. However, its bonds are registered and publicly traded. So there is nothing that prohibits a privately held company from issuing publicly traded bonds. This distinction is important because it means a company can raise money in the public market place without giving up equity.'

Trust Indenture Act of 1939 as Amended Whether a bond must be registered with the SEC or not, it must still comply with the provisions of the Trust Indenture Act of 1939. This act is designed to provide administrative safeguards for bondholders. One of the most important safeguards is the appointment of an independent trustee to speak for the rights of the bondholder. However, this act does not apply to debt securities when the total aggregate amount outstanding at any one time is less than $10 mi~lion.~ Before bonds can be issued, they must be qualified. Qualification includes registration plus some additional requirements.10To be qualified, the issuer must provide information similar to a registration under Section 7 of the 1933 Securities Act, and must provide an analysis of the bond indenture. A bond indenture is simply the instrument or agreement between the issuer and investors. This analysis is required regardless of whether the indenture includes a pledge of assets." This analysis must include (i) a definition of what constitutes default, although the act itself defines default as any failure to pay principal or interest when due,12 (ii) authentication and delivery of securities and use of proceeds, (iii) procedures for the release of any property that is pledged as security for the bonds, (iv) how the terms of the indenture, including satisfaction of amounts due and owing will be met, and (v) the nature and timing of the information that the issuer will supply to the trustee. Any property used as a security and referenced in the indenture agreement must have a certificate of appraised value by an independent appraiser.I3 The company must also provide a prospectus conforming to the requirements for a public offering, unless exempted. The issuer must appoint one or more trustees qualified to competently represent the bondholders and at least one trustee must be an institution such as a bank, or some other competent corporate body. The trustee must be free of any conflict of interest. For example, the trustee may not be an employee or major shareholder of the bond issuer. l4

Bonds

333

The issuer must make periodic reports to the trustee, at least annually, but arguably each time a significant corporate event occurs that could impair the company's ability to timely pay principal and interest. Such reports include copies of any reports sent to the SEC, such as a Form 10-K, annual financial statement, 8-K, quarterly financial statement, or the like. The trustee must make a brief report to indenture security holders not less frequently than annually affirming the trustee's continued eligibility to serve, account for any funds advanced to the trustee or that the trustee advanced on behalf of the bondholders, and the status of any property that that the indenture agreement lists as security for the bondholders. That report must also be filed with the SEC." One of the most significant provisions of the Trust Indenture Act is that the interests of individual bondholders may not be impaired without the consent of each individual bondholder, except that the trustees may negotiate a postponement of interest payments of three years if bondholders owning 75% of bonds outstanding consent. This provision severely limits the ability of a company to change the deal with bondholders if the company later gets into financial trouble.16 Bonds not registered and qualified under the act, and not otherwise exempt, may not be sold or transported in interstate commerce and issuers may not use the mails or interstate communication to sell such bonds. To do so is an unlawful act subject to fines of $10,000 and incarceration of 5 years.17This type of provision is often interpreted as meaning $10,000 and five years per incident and if ten bonds are sold unlawfully, that might be counted as ten incidents. In addition, the law imposes civil liability for false or misleading statements and for material omissions. However, there is a good faith exception to the civil liability provisions that exempts an issuer who simply makes a mistake or runs into unforeseen circumstances. None of the provisions of the Trust Indenture Act of 1939 create an insuperable barrier to raising capital through bonds. However, it is important to understand that this additional level of regulation exists and that it will add cost both in qualifying a bond offering and in on-going costs for trustee fees and administration. On the other hand, the act seems to imply that there is an exemption if the total amount of bonds outstanding is less than $10 million.

RISK MANAGEMENT STRATEGIES Bonds are characterized by the features that change their risk-reward profile. By reducing risk, bond issuers reduce the interest the market will demand.

Raising Capital

Senior Bonds Senior bonds, also called senior debentures, are bonds secured only by the full faith and credit of the company issuing the bond. Senior bonds represent a benchmark against which other bonds can be measured.

Subordinated Debentures Subordinated debentures are a form of debt that is only secured by the full faith and credit of the company issuing the security. It is subordinated to other forms of debt, so that in liquidation, other debt holders are paid first. A bank loan covenant may stipulate that a company cannot issue additional bonds equal or superior to the bank's debt. In that case a company might consider issuing subordinated debentures. Of course, a subordination feature makes this the riskiest type of bond for the investor and it will therefore demand more interest.

Mortgage Bonds Mortgage bonds are collateralized by specific assets purchased with bond proceeds. The most common assets used to collateralize mortgage bonds are real estate and capital equipment. In liquidation, the assets collateralizing these bonds will be sold and the proceeds used to pay bondholders before proceeds are applied to debts of other creditors. This reduces the level of risk for the bondholders but it also reduces the assets that banks can count as collateral.

Convertible Bonds Convertible bonds have a feature that allows the bondholder to convert debt to common shares of stock at a specified rate for a specified period of time. The conversion ratio is the number of shares an investor will receive for every $1,000 face value of bonds. For example, if the conversion ratio is 50, each share of stock will "cost" the bondholder $20 if he or she exercises the conversion option. As share price rises above $20, the bondholder will participate in that appreciation. This increases the bondholder's reward for purchasing the bond and should lower the yield demanded by the market.

Bonds

335

Raising capital through issue of new stock is only attractive when stock is selling for a high multiple of earnings. Convertible bonds are considered a backdoor way to sell equity.'' A conversion premium is the additional cost to acquire stock via a conversion as compared to purchasing a stock in the market. A conversion premium can be stated in dollars as the excess of the conversion price over the market price. For example if the conversion price is $20 per share and the market price is $18, the conversion premium is $2 ($20 -$la). A conversion premium stated as a percentage is the conversion price divided by the market price minus one. For example, if the conversion price is $20 and the market price is $18 the conversion premium would be 11.l% (($20/$18) -1). The higher the conversion premium, the costlier it is to use the conversion feature to acquire stock.

Bond Puts A put gives the holder the right to sell a bond back to the issuer at a certain price on a specified date. Puts are attached to bonds to reduce their maturity risk premium. Investors like to know that if interest rates rise, they can cash in their bonds and invest in higher yielding instruments. For example, Cox Communications sold $545 million of 0.348% discounted convertible bonds due 2021, with February 23,2002 puts.'9 Why would anyone buy bonds with such low interest rate and why would the holder want to hold them beyond the put date? Initially, the bonds would have sold at a deep discount so that their yield matched the yield of similarly risky instruments. The convertibility feature allows bondholders to participate in any significant appreciation of Cox Communications stock. However,. as the put date approached, the conversion premium was about 88%. In other words the market price was so much lower than the conversion price there was little chance of making money on the conversion. That meant there was no incentive not to exercise the puts. But this created a problem for Cox because it meant refunding half a billion dollars in an uncertain, post Enron-Anderson market. To forestall a credit squeeze, Cox Communications offered a one-time payment of $17 per $1,000 of face value of bonds. This was sufficient to forestall investors from exercising their Comcast faced a similar credit squeeze on $1.2 billion of zero coupon, 2020 bonds. They faced a put in December, 2001 which could have meant a significant refunding in an uncertain market. To forestall their bondholders, Comcast added another put date a year later. That provided

336

Raising Capital

investors with enough comfort that only $70 million of the issue was sold back to the company.21

Take Away Lesson: Puts can improve a bond issue 's attractiveness. However: pits can also rwult in a credit squeeze gputs become due zindeiunfavorabIe econonzic conditions.

Combinations of Features Issuers are only limited by their creativity as to the features they offer on a bond. Recall the objective of features is to change the risk-reward profile inherent in a company's bond rating. Consider the offering proposed by General Motors Corporation which has $1.25 billion a Moody's rating of A and a Fitch rating of A-. They are offering a $1.25 billion Series A issue with a coupon of 4.5% to 5% and a conversion premium of 27.5% to 32.5%, non-callable for five years with puts in years 5, 10, 15, 20 and 25. An additional $2 billion in Series B notes are expected to pay 5.25% to 5.75% with a conversion premium of 17.5% to 22.5%, with puts in years 12, 17, 22, 27. In addition, the bond will be priced at $25 so that it was well within reach of the general General Motors has a lower rating than General Electric, and its 30 year bonds are offering a higher coupon rate. The bonds are convertible, so if the price of General Motors stock rises significantly, investors can participate in the upside potential. It has puts that provide investors with assurance they can get out if a better investment comes along. The puts are staggered so that they won't all become due in the same year. These securities will also be registered for sale to the public and priced at $25 per bond. That places them within reach of the general public and not just fund managers, which dramatically expand the potential market. At the time of the offer, individuals were getting about 2% on their savings accounts or 4% on CDs.

EARLY BOND REDEMPTION Despite the conventional wisdom in financial textbooks, companies don't always pay a premium when they call bonds. Thermo Electron Corporation, for example, called both their 4 114 and 4 518 convertible, subordinated debentures via a Notice of Redemption in the Wall Street

Bonds

337

Journal, February 19, 2002 which set forth the terms and conditions of the redemption.23 The key features of the redemption notice were: 1)

The redemption date,

2)

Accrued interest to the date of redemption,

3)

The conversion price per share along with the number of shares for each $1,000 of face value of bonds,

4)

The redemption procedure which included the location(s) where bonds may be presented for redemption, and

5)

A notice that interest would cease to accrue and conversion rights would terminate at the close of business on the redemption date.

* Take Away Lesson: Bond investors must be diligent in monitoring the status of their bonds.

SINKING FUND A sinking fund is a mechanism for assuring that a company has enough money set aside to redeem the principal portion of a bond when it becomes due at maturity. Whether a bond sinking fund is set up is a function of the terms of the indenture agreement. If the indenture agreement does not require a sinking fund, the issuer has no obligation to establish one. From an investors' point of view, a company only makes semi-annual interest payments to bondholders plus a final payment when the bond matures. However, with a sinking fund, a company also makes payments to a fund that are roughly equivalent to the mortgage payments that would have to be made if the face amount of the bonds were borrowed. Whether payments are made to the sinking fund monthly, quarterly, semi-annually or annually is determined by the terms of the indenture agreement. No matter how frequently sinking fund payments are made, investors are only paid semiannually. The amount of sinking fund payments can be computed using equation Eq. 16.8.

Raising Capital PV

=

Pmt x PVIFA(i, n)

Eq. 16.8

Where: PV - is the face value of the bond. Pmt - is the monthly payment that will have to be made to the sinking fund, is the interest that the fund balance will receive if it is invested in a 1risk free or virtually risk free investment is the number of payments that will have to be made over the life of nthe bond. What this equation is doing is equating the present value of value of all the payments that must be made into the fund to the amount of the face value of the bond. We know the face value of the bond, PV; the interest rate, i; and the number of payments, n; we can find PVIFA in Appendix D or compute it using equation Eq. 15.3. The only unknown is Pmt which we can solved for by dividing both sides of equation Eq. 15.8 by PVIFA(i, n) giving equation Eq. 16.9. Pmt

PV PVIFA(i, n)

=

Suppose a company issues a $1 million, ten year bond with a coupon rate of 9.5%. The bond indenture agreement calls for the company to set up a sinking fund with fund payments payable monthly. Certificates of deposit at a well capitalized bank are considered virtually risk free. These certificates pay 6% per year. Equation Eq.16.9 can be used to determine much will a company have to deposit into the sinking fund monthly. Pmt

= -

$1.ooo,ooo PVIFA ((6%/12mo/yr), (10 years x 12molyr.)) $1,000,000 PVIFA (0.5%, 120)

JUNK BONDS There are two types of junk bonds. One is the result of an investment grade bond being down graded because of a company's financial problems. These are called "fallen angels." The other type of junk bond is debt issued by a company with an insufficient financial condition to command an

Bonds

339

investment grade rating. Prior to the junk bond revolution started by Michael Milken, these second tier companies were constrained to use banks. Two insights by Milken were the spark for this new class of bonds. First, he focused on a company's potential, rather than its historical performance. Second, he recognized that all capital markets run on the riskreward principal. He reasoned that if he increased the reward enough on these bonds, someone would buy them. He was right. The "upstart" firms financed by junk bonds include: Chi Chi's, Denny's, Lorimar, Warner and ~ r i o n . ~ ~ The global bond market for year ended December, 2001 was $3,610 billion, of which $86 billion was junk bonds.25

Underwriter Fees for Junk Bonds Any company that is considering issuing bonds, whether they are considered junk bonds or investment grade bonds should understand the costs they will incur in underwriting fees. Figure 16.3 is an Analysis of Underwriting Fees for Junk ~ o n d s . ~ ~ Figure 16.3 Analysis of Underwriting Fees for Junk Bonds Bonds No. Average Issued Of Issue Avg. Millions Issues Millions Fee % Manager 1 Investment Dealer Salomon Smith Barney

5,105.9

24

212.7

1.653

Merrill Lynch

3,036.2

Lehman Brothers

2,543.7

Morgan Stanley Dean Whitter

3,055.0

Goldman Sachs

1,887.1

Chase Manhattan

2,137.5

14

152.7

0.931

Credit Suisse First Boston

1,452.5

7

207.5

1.315

Donaldson Lufkin Jenrette

983.2

5

196.6

1.668

J P Morgan

1,411.3

9

156.8

0.992

Bear Steams

683.8

2

341.9

2.018

22,296.2 1,748.6 24,044.8

109 2 111

216.6

1.518

Subtotal Other Underwriters Industry Totals

340

Raising Capital

Arguably investment grade bonds are easier to sell so underwriting fees should be lower. Note the average bond issue is around $200 million. Clearly junk bonds are not a vehicle for small entrepreneurial companies.

BOND SALES IN SECONDARY MARKETS Major investment banks have a bond trading desk with dealers that specialize in making a market for certain bonds.27 When a dealer makes a market in bonds of a particular issuer, it means they agree to purchase and sell bonds offered for sale in the secondary market. Dealers set their purchase price based on the supply of a particular bond and set their sale price on the demand for a particular bond. The difference between a dealer's purchase price and their selling price is called the spread which is the primary way bond dealers make money. When dealers hold bonds in inventory, they bear interest rate risk. As interest rates rise, the value of bonds falls. Of course dealers can make money on their bond inventory if they hold bonds when interest rates decline which increases the value of the bonds in inventory.

SUMMARY Bonds are an extremely flexible vehicle and can be tailored to meet the needs of most large companies. Through a combination of coupon rates and features, bonds can be made attractive to a wide audience. Companies that are large enough to issue bonds should prefer them to other sources of funds for a number of reasons: (i) financing with debt means the investment of the existing shareholders will not have to be diluted, (ii) interest is tax deductible, dividends are not, and (iii) bond financing is more stable than bank financing and less costly. Since investors invest along a risk-reward continuum, the issuers' strategy is to minimize perceived risk. Information asymmetry can be reduced through use of a bond rating agency. The perception of risk can also be reduced thorough inclusion of bond features such as puts, which allow investors to exit an investment before the bond matures and sinking funds, which assure bondholders that funds will be available to retire the bonds when they become due. From the investor's point of view, a bond's value is the sum of two cash flows, a semi-annual interest payment and the terminal payout when the bond matures. From the company's point of view, there are two cash

Bonds

341

outflows. One is the monthly payments made to the sinking fund to retire the bond principal when it matures. The other cash outflow is the semi-annual interest payment to bondholders. There was a time when only the largest companies were considered credit worthy enough to issue bonds. Middle market companies were effectively shut out of the bond market because of their relatively higher risk profile. Their two major sources of funds were common stock, which diluted equity, or bank loans, with all the costs, delays and uncertainty that implies. However, some bond underwriters discovered that if rewards were set high enough, there was a ready market for bonds of middle market companies as well as companies with less than perfect credit. These high yield, less than investment grade bonds were labeled junk bonds by traditional investors. However, they provided a significant source of funds for a large number of companies. Fees for underwriting junk bond sales are 1% to 2% of the face value of the bonds. The average junk bond issue rises about over $200 million which means bonds are not practical for smaller companies.

342

Raising Capital

DISCUSSION QUESTIONS What are the advantages of issuing bonds as compared to raising capital through other means? Where do bonds fit into the entire risk / reward / size / stage of development spectrum of capital sources? What are bond rating agencies? What is their role in capital markets? What does a bond look like to an investor in terms of cash flows? Is it possible for a bond to be worth more or less than its face value? What are the mechanics of computing bond value? What is a bond premium? What is a bond discount? What is a discount rate? What is the relationship between a discount rate and a bond's stated or coupon interest rate? What are two types of federal regulation that bond issuers must be aware of? Briefly describe what an issuer must do to comply with each. List five bond types, features or strategies that issuers use to change the risk / reward profile of bonds. What is early bond redemption? Why would companies want to do it? What types of information is generally provided in bond redemption notifications? What is a bond sinking fund? What is its purpose? How are they set up and what must a bond issuer do on an on-going basis? What document controls the operation and payments due to a sinking fund? Who generally makes a market in bonds? How do these market makers get paid? What are the two classes of junk bonds? What is the strategy in issuing junk bonds that is why would a company want to issue junk bonds? What is the risk reward profile of these bonds? About how much capital is raised with a typical junk bond issue? What are typical underwriting fees for managing a junk bond issue?

Bonds

ENDNOTES If a company that pays $100,000 interest and is in the 30% tax bracket, it will avoid $30,000 in taxes (30% x $100,000). So, the "real" economic cost of the interest is only $70,000 ($100,000 - $30,000). "Moody's Bond Rating Definitions," www.mmodys.com, "About," "Long Term Bond Ratings as of 3/28/2002" 3 Richard A. Bravo. "Credit Markets: G.E. Sells Largest U.S. Dollar Denominated Corporate Bond Issue for $1 1 Billion," Wall Street Journal, March 14,2002, p.Cl8. "Money Rates," Wall Street Journal, March 14,2002, p.Cl8. "Credit Markets: Treasury Yield Curve," Wall Street Journal, March 14,2002, p.Cl8. 6 Johnathan G. Katz, Secretary, Securities and Exchange Commission, 17 CFR 270, Final Rule 17 CFR 23O.l44A(a)(l)(iv) 8 Sally Beatty. "At Levi Strauss Trouble Comes From All Angles," Wall Street Journal, October 13,2003 p.B 1 Trust Indenture Act of 1939, As Amended, Sec.304(9). lo Trust Indenture Act sec.309 'I Trust Indenture Act Sec.303(7). l2 Trust Indenture Act Sec.3 11(2)@)(ii) l3 Trust Indenture Act sec.324(d) 14 Trust Indenture Act sec.305 lS Trust Indenture Act sec.3 13 l6 Trust Indenture Act sec.3 16 l7 Trust Indenture Act sec.325 18 Comments of David Goldman, head of Global Credit Strategy at Credit Suisse First Boston, cited by Christine Richard. "Credit Markets: Aggressive Debt Issuance to Boost Return on Equity May Be Ending, as Balance Sheets Draw Scrutiny," Wall Street Journal, February 22,2002, section C. l9 Tom Barkley. "Credit Markets: Prospect of Redemption Has Some Issurers Turning to Creative Ways of Avoiding Liquidity Squeezes," Wall Street Journal, February 21,2002, p.Cl7. 20 Barkley. p.Cl7. 21 Barkely. p.Cl7. 22 Tom Barkley. "Credit Markets: GM Finds Solid Demand for Convertible Issue with 30 Year Term, Totaling Nearly $4 billion," Wall Street Journal, March 1,2002, p.Cl3. 23 "Notice of Redemption: Thermo Electron Corporation," Wall Street Journal, ~ebruary19,2002, p.C6. 24 M. Wayne Marr, Jr. "Regulation, The Cato Review of Business & Government," reviewing Exploding The Myth of Junk Bonds, by Glen Yago, The Oxford University Press, 1999,249 pp. 25 Randall Smith. "Securities Underwriting Set Record for Year, Year End Review of Underwriting," The Wall Street Journal, January 2,2002, p.Rl9.

344 26

Raising Capital

L L S e ~ ~ rUnderwriters itie~ in Junk Bonds," Investment Dealer's Digest, Vol. 17, ~ebruary28,2000. "HOWBonds Trade," Trimark Corporation www.finpipe.com/tradebonds.htm, downloaded 1/20/2002

''

Chapter 17

COMMERCIAL PAPER

INTRODUCTION Commercial paper sits at the intersection of two questions: (i) Is virtue its own reward? And (ii) Wouldn't it be great if companies could bypass banks and raise working capital directly without SEC interference? For large, companies with strong balance sheets and cash flows, virtue is rewarded in the form of access to a specialized form of financing called commercial paper. One of the most important features of commercial paper is that neither state nor federal registration is required. Companies that want to issue it, simply can. Another important feature of commercial paper is that its cost is lower than practically any other form of financing. This chapter will define what qualifies as commercial paper; the statutory basis for its exemption from regulation; the mechanics of issuing commercial paper; problems and drawbacks with commercial paper; strategies for using commercial paper; the risk reward profile of commercial paper; and provide an analysis of commercial paper rates as compared other credit rates.

346

Raising Capital

SECURITIES REGULATION AND THE DEFINATION OF COMMERCIAL PAPER Under the Securities Act of 1933, section 3(a) (3) debt instruments are exempt from registration if they mature in less than 9 months and are used for working capital. Such instruments are not securities within the meaning of the Securities and Exchange Act of 1934, section 3(a) (10) and are therefore exempt from regulation under this act as well.' The whole concept of commercial paper is therefore built on exemptions to these two major pieces of federal securities legislation. Trade practice and custom has built on this foundation so that commercial paper is now customarily defined as: (i) short term, usually 7 to 180 days, but up 9 months, (ii) unsecured, (iii) debt in the form of promissory notes, (iv) issued by companies, (v) for working capital. Most commercial paper matures in 30 days or less and is issued in denominations of $100,000 or more.2

WHO CAN ISSUE COMMERCIAL PAPER? Anyone can issue commercial paper. The real question is: Who will buy it? Because commercial paper is unsecured debt, only the best companies, with the strongest balance sheets find a market for their paper. Currently about 1,700 companies in the United States issue commercial paper. As of 1990, 75 percent of commercial paper was issued by financial companies and 25 percent was issued by non-financial companies such as utilities, manufacturers, and industrial concern^.^ However, in the aftermath Enron 1 Anderson questions about corporate accounting practices have resulted in fewer buyers of non-financial commercial paper. As of March, 2002 total commercial paper outstanding was about $1.4 trillion with 87% issued by financial institutions and only 13% issued by non-financial

institution^.^ Generally companies must have a top credit rating to issue commercial paper. Commercial paper is rated by five organizations, although ratings are only quoted for companies with an Aa bond rating or equivalent. Figure 17-1 is an Analysis of Commercial Paper Rating ~ ~ e n c i e s . ~ Unrated and lower rated paper is occasionally sold, but highly rated paper has the best acceptance in the marketplace. The primary investors in commercial paper include: pension funds, money market mutual funds, government units, bank trust departments, foreign banks and investment companies6

Commercial Paper

347

Figure 17-1 Analysis of Commercial Paper Rating Agencies Agency

Companies Rated

Ratings (Best to Worst)

Standard and Poor's Inc.

1,700

A-1, A-3, A-3

Moody's Investor Service

1,400

P-1, P-1, P-3

McCarthy, Crisanti & Naffei, Inc.

650

MCM- 1 to MCM-6

Fitch Investor Services Corp.

240

F-1 to F-4

Duff and Phelps, Inc.

100

Duffl+, Duffl, Duffl-, etc.

COST OF COMMERCIAL Interest rates on commercial paper can be significantly lower than on bank loans. As of April 12,2002 the prime rate was 4.75%7 whereas the rate for 30 day commercial paper for an AA rated non-financial company was only 1.77%.' If a company can meet its working capital needs with commercial paper, rather than a prime rate line of credit, its savings can be enormous. Firms can sell commercial paper directly, or through dealers in large securities firms. The spread, or commission charged by dealers is about 118 of a percent or about $125 for every $100,000 of paper i s ~ u e d To . ~ induce dealers to make a market, companies need at least $50 million, and probably $75 million in commercial paper outstanding. Most firms that sell commercial paper directly are financial institutions.1° The net cost of using commercial paper is somewhat higher than the commercial paper rate because of transaction costs.

Managing Rates Commercial paper rates depend on three factors: (i) credit rating, (ii) maturity, and (iii) dealers. Corporations with less than an AA rating can get a bank guarantee for their paper with a direct pay letter of credit. This makes them eligible for the same rates as AA rated companies. A bank will charge a fee for such a letter of credit and that fee will increase the cost of using commercial paper. As a result, few domestic corporations seek such guarantees.11 As a general rule, the longer the maturity, the higher the rate.

348

Raising Capital

However, very short term commercial paper may have a slightly higher rate to offset transaction costs. Figure 17-2 is an Analysis of Rates Versus Maturity for Commercial Paper as of April 11,2002. l 2 Figure 17-2 Analysis of Rates versus Maturity for Commercial Paper AA AA A2/P2 Term Financial Non-Financial Non-Financial

1 day

1.77

1.77

2.06

7 day

1.77

1.73

2.15

15 day

1.75

1.76

2.03

30 day

1.77

1.76

2.16

60 day

1.78

1.78

2.25

90 day

1.84

1.87

2.34

While rates generally rise with rising maturity, total sales commissions decline. Why? If a non-financial company refinances every 15 days, it must refinance 24 times per year. That means annualized refinancing costs are 24 times 0.125% or about 3% per year. Figure 17-3 is an analysis of Effective Annual Interest Rates for Non-Financial Commercial Paper which includes sales commissions. The prime rate was 4.75% at the time of this analysis. Figure 17-3 Effective Annual Interest Rates for Non-Financial Commercial Paper AA NonRefinancings ~inancial'~ Per Year

Annualized Effective Transaction Interest Cost

1 day

1.77%

365

45.63%

47.4%

7 day

1.73%

52.1

6.51%

8.24%

15 day

1.76%

24.3

3 .04%

4.80%

30 day

1.76%

12.2

1.53%

3.29%

60 day

1.78%

6.1

0.76%

2.54%

90 day

1.87%

4.1

0.51%

2.38%

Commercial Paper

349

If a company has more than $200 million in commercial paper outstanding, it can split its commercial paper transactions among two dealers and see which provides the best rates. If the gap between them is less than 2 basis points (less than 2 hundredths of a percent), then both are performing fairly well. However if the difference is 2 or more basis points, the strategy would be to allocation more commercial paper transactions to the better performing dealer. Other money managers suggest evaluating dealers every three months.14 Daily commercial paper rates are available at the Federal Reserve website: www.federalreserve.gov/releases/cp/.

MANAGING SHORT TERM FINANCING RISK The short term maturity of commercial paper means that companies must constantly be in the market. That is not a problem if a company can maintain its reputation and the economy is strong. However, if a company's financial health falters, or the economy turns down, this funding source can dry up over night. All investors in commercial paper have to do is collect on notes due and simply not invest in new commercial paper. The ability of investors to abruptly withdraw capital adds a degree of risk to this funding source. Some companies have managed this risk by arranging for a back-up line of credit with banks. l5 In the case of Tyco International, investors raised questions about its accounting practices and the market for its commercial paper evaporated. So Tyco was forced to turn to a bank line of credit that will cost it $400 million more, after tax, than if it financed with commercial paper.16 Even General Electric has been criticized for too much dependence on commercial paper. As a result it sold $1 1 billion of bonds to replace commercial paper. On the other hand, G.E. may have seen a strategic advantage in replacing commercial paper when it did because bond yields were at a historic low, whereas commercial paper rates were expected to rise over the course of the business cycle.17

MANAGING A COMMERCIAL PAPER OPERATION Typically, a company's treasurer or commercial paper manager would forecast cash daily and by 9:30 A.M. he or she would phone in half his or her orders to one dealer and half to another dealer. By 1:00 P.M., the dealers would have orders to cover the company's paper. Most commercial paper is represented by book entries which are partly identified, by a CUSIP number which identifies a particular issuer's

350

Raising Capital

security. Funds are handled through the trust departments of large depository banks such as First Chicago NBD, a big issuing and paying bank. All transactions are then cleared through the Depository Trust Company (DTC), in New York and then funds are credited to accounts in depository banks the same day the trades are placed.'8

MATURITY STRATEGIES One important feature of managing commercial paper is selecting maturity dates. A first level strategy is to match maturities to cash demand and cash receipts. A next level strategy is to make sure that all commercial paper doesn't become due on the same day. This is important because external events: a bad news day, an unfavorable analyst report, or an economic upheaval may curb the market's appetite for a particular company's paper. A third level strategy is to avoid maturities on certain dates: Christmas, Thanksgiving, the Friday after Thanksgiving and days people are likely to take vacation to create a four day weekend. If offices are closed, there will be no one to purchase new commercial paper. Replacement of maturing commercial paper with new commercial paper is called rollover. Most companies that use commercial paper for working capital assume that their paper will be continuously rolled over.

SUMMARY Commercial paper is a cost effective way of financing working capital for companies with AA bond ratings or equivalent and working capital demands above $50 million. Some sense of the savings available can be had by comparing the effective annual interest rate for 60 day commercial paper, including annualized sales commissions to the prime rate for the same period. As of April, 2002 the effective commercial paper rate was 2.54% when the prime rate was 4.75%. Use of commercial paper requires active management, continuous forecasts of cash demand, planning maturity dates, and managing dealers. Risk management is also an integral part of any commercial paper operation. Buyers of commercial paper can withdraw form the market abruptly on bad news about the company or the economy. To guard against that risk, most companies secure a back up line of credit with banks.

Commercial Paper

DISCUSSION QUESTIONS What is commercial paper? What are the characteristics of commercial paper? How is it regulated? Where does commercial paper fit into the risk / reward / size / stage of development spectrum? What would motivate a company to issue commercial paper? What would motivate an investor to buy commercial paper? Who typically invests in commercial paper? What are typical maturities for commercial paper? What are typical interest rates for commercial paper? What are transaction costs for selling commercial paper and what strategies are available to manage the net cost of commercial paper? What is the risk in using commercial paper? How can that risk be managed? What are the mechanics of issuing commercial paper and receiving the funds? What is meant by a maturity strategy? What should an issuer be aware of when selecting maturities for commercial paper offerings?

Raising Capital

ENDNOTES Securities Act of 1933, Section 3 - Exempted Securities, paragraph a(3) www.sec.govldivisions/corpfin/33act/sect3.htm, April 14,2002. FedPoint 29: Commercial Paper, www.federalreserve.gov/releases/cp,March 8, 2002. FedPoint 29: Commercial Paper, March 8,2002. 4 "Federal Reserve Release - Commercial Paper - Commercial Paper Outstanding," www.federalreserve.govlreleaseslcp1table1.htm, April 11,2002 FedPoint 29: Commercial Paper, March 8,2002. FedPoint 29: Commercial Paper, March 8,2002. Federal Reserve Statistical Release: Selected Interest Rates (Daily) www.federalreserve.gov/Releases/hl5/updatelApril 13,2002. 8 Federal Reserve Release: Commercial Paper, Commercial Paper Rates and Outstandings, www.federalreserve.govlreleases1cpApril 12,2002. 9 FedPoint 29: Commercial Paper, March 8,2002. 10 Richard H. Gamble. "Shopping with the Pros in the Commercial Paper Market," Controller Magazine, June, 1997. Full text on the web at www.businessfinancemag.com as of 411012002. I' Gamble. l2 Federal Reserve Board Release: Commercial Paper: Commercial Paper Rates and Outstandings, Data as of April 12,2002, www.federalreserve.govelreleases1cpl l3 Federal Reserve Board Release: Commercial Paper: Commercial Paper Rates and Outstandings, Data as of April 12,2002, www.federalreserve.gove/releases/cp/ l4 Gamble. Quoting comments by K. Carter Harris, managing director of Merrill Lynch Money Markets and Greg Weigard, manager of treasury operations for Air Products and Chemicals. 15 Gamble. Citing comments by Greg Weingrad, Manager of Treasury Operations for Air Products and Chemicals, Inc. 16 Gregory Zuckerman. "Cash Drought: A Dwindling Supply of Short-Term Credit Plagues Corporations: Market in Commercial Paper Is Hurt by Enron Fears, Dealing Economic Blow," Wall Street Journal, March 28,2002, p.Al. l7 Richard A. Bravo. "Credit Markets - GE Capital Sells Largest U.S. Dollar Denominated Domestic Corporate Bond Issue for $1 1 Billion," Wall Street Journal, March 14,2002, p.Cl8. l 8 Gamble.

'

Chapter 18

OTHER FINANCING VEHICLES

INTRODUCTION Sometimes the choice of vehicle is driven by cost minimization, but other times choice of vehicle is limited because of factors such as the company's size, risk profile, profitability, and the time to exit a particular vehicle. Many of the vehicles discussed in this chapter are variants of funding sources discussed in earlier, combined in clever ways, to address particular circumstances. Other vehicles are new. The most appropriate time to use each of these vehicles will be discussed as well as their costs and drawbacks.

SYNDICATED LOANS A syndicated loan is a loan in which several banks pool funds to lend to a single customer. Usually, one bank, called an agent bank, finds a commercial customer, analyzes its creditworthiness, prepares the paperwork for the participating banks, services the loan that is it collects payments and disburses them to participating banks, and monitors the loan throughout its life. Agent banks take a share of the loan and receive fees for finding the customer, setting up, and servicing the loan. Not all banks are agent banks. As of 1999 there were only 223 agent banks as compared to 345 in 1995. As bank consolidation continues, it is likely the number of agent banks will decline further.

354

Raising Capital

The average size of a syndicated loan in 1998 was $167 million, up from $145 million in 1995.' There is no reason to believe the size of syndicated loans will fall and every reason to believe they will continue to rise, so only companies that need on the order of $200 million are good candidates for a syndicated loan. As of 2001 there were more than $2 trillion in syndicated loans committed and more than $769 billion ~ u t s t a n d i n ~ . ~ How does syndicated lending help a business? First, syndication spreads lending risk, which lowers a business's risk profile and that translates into somewhat easier credit and lower interests. Second, individual banks may not have the statutory capital to lend the full amount requested. Third, banks are uncomfortable lending a large amount of money to a single customer because it creates a regulatory concentration problem. Concentration problems arise when a customer is sufficiently large, that if it failed it would have a material impact on the bank. Syndicated loans are an attempt to recapture some of the business lost to junk bonds. Syndicated loans are longer than traditional bank loans, less subject to periodic restructuring, and have fewer covenant^.^

BRIDGE LOANS Bridge loans are short term loans, usually made to established companies to meet specific objectives. Maturities are often in the range of 90 to 180 days and range from $1 to $10 m i l l i ~ nFirms .~ that make bridge loans respond quickly and expect significantly higher returns than banks. The Internet company, iPass, filed an S-1 (a prerequisite for an P O ) in March, 2000. However, it was clear that it would not be able to raise the required capital under the market conditions at that time. It needed capital to cover operating expenses until the market recovered and its negotiating position improved. It contacted Sand Hill Capital, a company specializing in growth capital loans. Within two days, Sand Hill had a due diligence team at iPass, and it closed the loan in a month. Sand Hill represents that it can close some loans in as little as two weeks. This speed is unheard of for a bankm5 Firms that specialize in the bridge loan market project a company's value at the end of the bridge loan period and base their assessment of risk on that value. Unlike venture capitalists that are patient capital, firms that make bridge loans are impatient capital. Much of the bridge lender's due diligence is designed to verify that it can exit the loan on schedule. Bridge loans are the right vehicle for a very narrow range of circumstances such as those iPass encountered, but are not the best vehicle for most other circumstances.

Other Financing Vehicles

MEZZANINE FINANCING Mezzanine funds provide financing for leveraged buyouts, recapitalizations, and other private equity deals. Mezzanine funds also fill the gap left when banks periodically contract commercial lending or are not willing to provide sufficient funds for a firm to meet its capital needs. Mezzanine financing is junior debt, subordinated to senior bank debt. For very large companies this gap can be filled with bonds, or if the company's credit worthiness is less than perfect junk bonds. However, it is difficult for firms to access the public bond market for sums less than $100 to $150 million. Mezzanine funds fill this gap and provide funds in smaller amounts. The cost of mezzanine financing is high compared to bank debt. Mezzanine funding is relatively short term and should not be considered permanent financing. Mezzanine financing firms usually expect to exit within two or three years and possibly much sooner. Therefore, any plan to use this vehicle should be accompanied by a plan to replace mezzanine debt.6

SECURITIZATION Securitization is a way for a company to raise capital independent of its creditworthiness or future prospects. Securitization is an alternative to bank financing; is less restrictive in terms of covenants; and costs less than banks, because banks stand between a company on the one hand and savers with money to invest on the other. As a middleman, banks increase transaction costs which increase the cost of capital. A company considering raising money through securitization must first identify a pool of assets that can be separated from the company and sold. Examples of assets pooled for sale include mortgages, leases, credit card balances, auto loans, notes receivable, and accounts receivable. There is no theoretical limit to what be securitized except that securitized assets must produce some fairly predictable cash flow.7 Securities sold as interests in pooled assets are called Asset Backed Securities. As of June, 2002 the market for Asset Backed Securities was about $6.6 trillion of which 70% were for mortgaged backed securities, of the remaining 30% about $1 billion were for assets such as student loans, mobile homes, vehicle loans, and home equity loans. About $400 million were credit card backed securities.' The asset pool is sold to a Special Purpose Vehicle (SPV), also called a Special Purpose Entity (SPE). The SPV will then sell securities whose return will be based on the cash flow generated by the asset pool.

356

Raising Capital

The SPV will purchase the company's assets at a discount sufficient to cover servicing costs of both collecting and managing cash inflows, and of servicing and paying securities holders. The discount will also include a provision for uncollectible accounts and other cash flow uncertainties. The mechanics of establishing an SPV, issuing securities and finding investors is usually handled by an investment bank. Another indispensable partner in securitizing assets is a rating agency. As a general rule, a company can't expect institutional or private investors to understand the intricacies of a security based on a pool of assets and fairly evaluate the size and quality of future cash flows. A rating agency relieves investors of this substantial analytical burden. If these securities are to be sold to the public, they will have to be registered. It is critical that the SPV be a separate legal entity. If assets are not "sold" to a separate legal entity, and the company originating the asset falls into bankruptcy, unsecured creditors will have a claim on the pooled assets. However, if the SPV is a separate legal entity, and there is a "true sale" that is a sale for fair value (less a reasonable discount); bankruptcy courts will be unable to invade the asset pool for the benefit of the company's general creditors. This protection is very important to investors in the SPV who want no rival claims on its assets. The separate entity nature of an SPV is what allows investors to ignore the creditworthiness of the company that originated the assets and focus solely on the value of the assets themselves. This simplification reduces investor information asymmetry considerably. It enables companies with less than perfect prospects to raise substantial funds in the market and reduces the cost of funds to the company.9 The cost of funds to the company will be based on the cost of funds to the SPV. If the SPV issues bonds that yield is 4%, servicing costs are 0.5%, and the risk inherent in the underlying cash flow from assets is 0.75%, the SPV would purchase pooled assets at a discount of 5.25% (4% + 0.5% + 0.75%). The higher the bond rating, the lower yield the market will demand on SPV bonds; the lower the bond rating, the higher the bond yield will have to be. The cost of raising capital through A rated bonds is usually, but not always less than the prime rate. A company may not qualify for the prime rate, but its bonds may still qualify as A rated, in which case the spread between the cost of funds through securitizing assets and bank debt would increase. When comparing securitization to bank debt, another "cost" to consider is the cost of complying with bank covenants on an ongoing basis. Bank covenants are trip-wires that a company must maneuver around. Crossing a trip wire will result in technical default, fees, penalties and

Other Financing Vehicles

357

additional restrictions. Securities issued by an SPV have relatively few covenants. Several strategies may be used to increase bond rating. One is to issue both senior and junior bonds secured by the same pool of assets. Suppose $100 million of securities were being sold, $90 million of senior bonds and $10 million in junior bonds. The fact that senior bonds will get paid first means that to the senior bond holders, the pool looks like it has an extra cushion of $10 million against default. This will raise the credit rating of the senior bonds and lower the overall cost of funds for the SPV. Why wouldn't a company sell stock or bonds directly? Again we return to the concept that the prospects of the company itself may not be that good. By purchasing securities issued by the SPV the investor replaces uncertainty about company operations with relatively more certainty about the value of a specific pool of assets. Underlying the concept of securitization is the marketability of SPV securities. Few investors want to purchase securities unless there is a market in which they can resell their investment should they decide to exit. A viable market implies a large number of buyers and sellers, which implies a large number of securities to buy and sell. No one will make a market in a security where there are only two securities to buy and sell, or two hundred, or even two thousand. A large number of securities in reasonable denominations imply the asset pool which underlies the securitization must be very large. While no exact figures are available, one investment firm indicates the minimum pool of consumer assets for privately placed securities is in the range $35 to $40 million, whereas, a minimum of $100 million is required for a public issue. They also indicated the cost to set up a securitization transaction can be as little as $150,000 to $200,000 for a private placement or as much as $1 million for a public issue.''

PRIVATE INVESTMENT IN PUBLIC ENTITIES (PIPES) Where does a public company turn for capital when it has poor operating and stock performance? In such circumstances, bank financing has probably already been cut off. A secondary stock offering for such a company might be impractical because of poor operating performance, low stock price, or low trading volume. Further, suppose a company is so highly distressed that it has little chance of survival, no matter what it does. What is its financing alternative of last resort? The alternative of last resort might be a Private Investment in Public Equities (PIPE). With a PIPE a private investor provides capital to a public company in a private placement following the requirements of a Regulation

358

Raising Capital

D. After the placement, the securities involved are registered. Registration is the key to a PIPE because it converts what would be an illiquid investment of private capital into a liquid asset in the form of stock that can be sold to the public. The terms and conditions of a PIPE are negotiable, but there are five typical structures: Floating Rate Convertible Preferred Stock or Debt, (i) (ii) Convertible Resets (iii) Common Stock Resets (iv) Structured Equity Lines (v) Common Stock Floating Rate Convertible Preferred Stock and Debt is similar to ordinary convertible preferred stock and convertible debt. The difference is that the conversion rate is pegged to some fraction of the company's daily stock price. If the stock price declines, the conversion rate increases so the market value of the post conversion shares is always greater than the investment. This can provide an investor with an immediate gain and limited downside risk. Convertible Resets are similar to Floating Convertible Preferred Stock or Debt except that the conversion rate is adjusted periodically, for example every three to six months, based on the company's stock price at the beginning and ending of the prior period. Dividends and interest for all types of PIPES are usually paid in stock, rather than in cash. A Common Stock Reset allows an investor to purchase stock at a discount from the current market rate. If the market price of the stock declines, additional shares are issued to the investor to effectively reset their price below market. Such resets occur only once, usually 30 to 60 days after closing. Floating Rate Convertible, Convertible Resets, and Common Stock Resets are called "protected" PIPES because the adjustment feature limits downside risk. About 50% of the negotiated adjustment provisions in PIPE contracts only adjust downward. That means the upside potential if a company recovers is unlimited. The ability to adjust conversion rates does not make a PIPE a risk free investment. If the company's stock price drops below $3, trading volume is too thin, or the company is delisted, it may be impossible for a PIPE investor to exit.12 Structured Equity Lines and Common Stock investments have no price protection once the deal is struck. Whereas a Common Stock PIPE provides a single infusion of cash, the Structured Equity Line provides a facility by which the company can call upon the investor to purchase blocks of stock at negotiated intervals as cash is needed. These are called "unprotected" PIPES because the stock price doesn't adjust down as the market does. To give investors an incentive to invest, Structured Equity Lines

Other Financing Vehicles

359

and Common Stock are usually accompanied by warrants. This multiplies the payoff for the investor if the firm succeeds and the stock price rises.13 The mechanics of a PIPE is for a company to retain an investment banker or PIPE specialist to advise the company on the structure of the deal and to find an investor. Hedge funds made 9 of the 15 largest PIPE investments between 1995 and 2000. The investor examines the company's public filings and conducts other due diligence including interviews of the company's officers. The investor assesses the risk and negotiates terms that provide the required yield while minimizing perceived risk. The deal is closed, a public announcement is made and a Form 8-K is filed with the SEC providing a more detailed description of the terms of the PIPE. About 30 days after the deal is closed, the investor's securities are registered and about 90 days after that the registration becomes effective at which time the investor can begin exiting the investment. Sometimes the contract stipulates that the investor can only exit in stages over a number of months or years.14 The PIPE market placed about $12.7 billion in 2000 in 620 transactions. The average size of protected issues was about $9 million and unprotected were about $19 million. The companies that use PIPE financing typically have a Return on Assets of -21% to -37% pre-issue. The conversion or purchase discounts ranged from about 12% to 15%. About a third to a half of PIPES included warrants.15 A year after a PIPE transaction, 70% of issuers realized negative returns, on the other hand, about 12% of companies issuing unprotected PIPES and 7% of companies issuing protected PIPES realized a 100% return based on stock price appreciation and dividends. PIPE financing is expensive, but it may be the only option available for a seriously underperforming company. PIPE financing is only available to a listed, publicly traded company with a share price above $3.

BANKRUPTCY AND SUPER PRIORITY LOANS Filing bankruptcy doesn't necessarily cut a company off from capital, it just makes it more difficult to acquire. Two sections of the bankruptcy code are important Chapter 7 (Liquidation) and Chapter 11 (Reorganization). If a company files under Chapter 7, it declares its intention is to sell its assets and distribute the proceeds according to the priorities set forth in the bankruptcy code. The sale and distribution of assets is done under the supervision of a court appointed trustee. Once a company files under Chapter 7, it is virtually impossible to raise additional capital. On the other hand, when a company files for Chapter 11, there is a fair chance of getting an additional infusion of capital. To understand why, we need to take a brief look at the bankruptcy process.

360

Raising Capital

A bankruptcy usually begins when a company files a petition with the Bankruptcy Court. There are two main effects to filing. The first is an automatic stay on collection of any bills the company owes. A stay means that nobody can sue the bankrupt for non-payment, no one can cut off its gas or electricity for non-payment and no-one can evict it from its building. In short, no one can take any action to collect on a pre-petition debt or force it to pay a pre-petition debt. The second thing that filing a bankruptcy petition does is to create a bankruptcy estate. This estate is a legal entity that contains all the assets and liabilities of the company as well as its ownership interest. Once the estate is created, it comes under the control of the court and the court has broad power to control the estate. However, absent a showing of incompetence, malfeasance or double dealing, the court will not appoint a trustee. Rather it will leave the debtor (the company that filed for bankruptcy) in control of the estate. This is called a debtor in possession (DIP) bankruptcy. While the main idea behind Chapter 7 is an orderly liquidation of assets and a fair distribution of proceeds, the idea behind Chapter 11 is to hold creditors at bay for some period of time until the company can reorganize itself. Part of the reorganization is to develop a bankruptcy plan that describes how much each class of creditors will be paid. Creditors are separated into classes, some of which get priority over others. For example secured creditors, that is those who have perfected liens on assets, will get paid first from the sale of those assets. If there is still a deficiency, they will become an unsecured creditor to the extent of the deficiency. Then the unsecured creditors are paid. Finally, if there is anything left, the shareholders will be paid. In many cases, the bankruptcy plan will only pay unsecured creditors a percentage of what is owed to them. The bankruptcy code recognizes that sometimes additional money is needed to maintain the value of assets, for example to fix a leaky roof; or if the company is more valuable as a going concern, to supply working capital. No one would lend money to a company in bankruptcy if there was a possibility it would become an unsecured creditor. Therefore, the code provides that a post-petition lender can get a super priority over all other unsecured creditors if certain procedures are followed. Briefly, the loan must be for actual and necessary expenses in the ordinary course of business. The court must approve the loan after notice and a hearing at which time other unsecured creditors can contest the necessity of the loan. If the court approves, it will issue an order giving the lien a priority over all other unsecured creditors except, for example: court fees, attorney costs, and so forth. There are firms, commercial credit companies, private investment firms and SBICs that specialize in lending to companies in Chapter 11. Such lending isn't risk free. A company may not be able to reorganize and may

Other Financing Vehicles

361

dissipate the loan proceeds and other unencumbered assets, in which case there may not be enough left to pay off the loan. So even though a postpetition lender gets a super priority, it still needs to evaluate the details of a particular bankruptcy situation before deciding to lend.

GOVERNMENT GRANTS AND LOANS The Federal and most state governments have specialized grant and loan programs to assist start-up businesses. Many of these program focus on minority and women owned businesses, the development of specialized technology especially in defense or health related matters, or to develop industries of special interest to particular legislators, for example to develop a new use for chick-peas. While the Small Business Administration's loan programs and support of Small Business Investment Companies make important contributions to capital markets, only a scant mention of other government programs is made here because such programs (i) are difficult to find, (ii) go in and out of existence in response to budgetary and other pressures, (iii) are slow to act, and in business time is money, and (iv) are often politicized, not only by politicians, but within agencies by bureaucrats who have their own hidden agenda. Many entrepreneurs who have good ideas and marketable products have been delayed, derailed, or stopped waiting for a government grant or loan. For most people, government grants or loans should be the last thing they should consider, not the first or even the tenth.

SUMMARY There are many highly specialized vehicles that can be used to raise capital and more are being invented every day. A vehicle might be right for some companies and wrong for others depending on size, cost, the length of time funds are needed, whether a company is publicly traded, financially distressed, or in bankruptcy. Syndicated loans are arrangements wherein several banks lend to a single customer. Syndicated loans reduce the risk to individual banks and syndicates can make larger loans than an individual bank may feel comfortable with. In part, syndicated loans are an attempt to recover business lost to the junk bond market. Therefore, syndicated loans often have marginally lower interest rates than traditional bank loans, are for longer periods of time, and have fewer covenants.

362

Raising Capital

Bridge loans are short duration loans used to meet specific goals. While venture capital might be called patient capital, bridge loans might be called impatient capital and the payback period might be as little as 90 to 180 days. Mezzanine financing can be thought of as debt junior to bank debt. It is often used in leveraged buyouts, recapitalizations and other private equity deals. It also fills the gap when bank lending periodically contracts. Mezzanine financing is often used by companies whose capital needs are too small to justify use of junk bonds. Securitization is the process of bundling together a pool of separable, cash generating assets and selling them to a Special Purpose Vehicle (SPV) which then sells bonds, and uses the money raised to pay the originator of the assets their value less some discount. Bond buyers need only look at the quality of the assets owned by the SPV to make their credit evaluation. They need not look at the operating performance of the originating company. If the quality of assets is good, the SPV's bonds can get an A rating which translates into a low cost of capital. This low cost capital can then be passed back to the originator via a lower discount on the price of assets purchased by the SPV. Private Investment in Public Entities (PIPE) is a way for public companies in poor financial condition to raise capital. For some public companies, a PIPE is financing of the last resort. In a PIPE a private investor makes an investment that entitles the investor to purchase stock at below market prices. This privately issued stock is then registered and the investor can exit the investment through the stock market. Even companies in bankruptcy can raise capital under certain circumstances. If a company files under Chapter 11 (Reorganization) it can petition the court for a super priority lien for ordinary and necessary business expenses. A super priority will place a lender after secured creditors and certain administrative expenses like legal fees, but ahead of all other unsecured creditors and shareholders. There are a number of firms including: commercial credit companies, private investors and SBICs that specialize in post bankruptcy financing. The Small Business Administration's loan program and its support for Small Business Investment Companies (SBIC) are important and useful vehicles. However, there are many state and federal loan and grant programs for small business. Most of these are hard to find, hard to understand, slow to respond, and immersed in bureaucracy. As a general rule, an entrepreneur should not consider non-SBA programs as a first, second or even tenth source of funds. The other alternatives discussed in this book will almost certainly be more predictable and responsive if the company properly prepares.

Other Financing Vehicles

DISCUSSION QUESTIONS What is a syndicated loan? Where does a syndicated loan fit into the risk / reward / size / time to exit spectrum? How does a syndicated loan work? How can syndication benefit a business? What is a bridge loan? Where does a bridge loan fit into the risk / reward / size / time to exit spectrum? When do companies use bridge loans? What is mezzanine financing? Where does mezzanine financing fit into the risk / reward 1 size / time to exit spectrum? When should a company seek mezzanine financing? What is securitization? Where does securitization fit into the risk / reward / size / time to exit spectrum? When should a company consider securitization? How does securitization work?

What is a PIPE? Where does PIPE financing fit into the risk / reward / size / time to exit spectrum? When should a company consider PIPE financing? What are the mechanics of PIPE financing? What is a Super Priority loan? Where does a super priority loan fit into the risk / reward / size / time to exit spectrum? When should a company consider a super priority loan? How and why does a super priority loan work?

Raising Capital

ENDNOTES Jonathan Jones, William W. Lang, Peter Nigro. "Recent Trends in Bank Loan Syndications: Evidence for 1995 to 1999, Economic and Policy Analysis Working Paper #2000-10, December 2000, pp.6,9 2 Lynn W. Adkins. "Bank Regulators Data Show Continued Increase in Adversely Classified Syndicated Bank Loans of at Least $20 Million," The Bank Place, [email protected] www.bnkstrategies.corn/articles/ Syndicated%20Loans%200ct%205.pdfm downloaded 11/13/2003 Jones. p.2. William Del Biaggio, 111. "Debt Is Good," American Venture, July, 2001, p15 Ibid. p15. Henny Sender, "Mezzanine Fund Opens, Goldman Sachs Launches Biggest Fund of Its Kind, Raising $2.7 Billion," Wall Street Journal, September 9,2003, p.C5; Kopin Tan. "Profile of Mezzanine Financing Rises," Wall Street Journal, October 1,2003, p.B6C. 7 Vinod Kothari. Securitization: The Financial Instruments of the New Millennium, Published by: Academy of Financial Services, Calcutta - 700 039 India, 2003, p.4. Mark Furletti. "An Overview of Credit Card Asset-Backed Securities," Payment Card Center Discussion Paper, Federal Reserve Bank of Philadelphia, December 2002 gp. 1-2 Steven L. Schwartz. "Securitization Post-Enron," 25 Cardozo Law Review 2003 Symposium Issue on "Threats to Secured Lending and Asset Securitization" submission draft 10/23/03, pp.4-6 lo Stonehenge Financial Partners, LLC, website www.stonehen~efp.com/Securitization.htm, downloaded 11/12/2003. l 1 Susan Chaplinsky and David Haushalter. "Financing Under Extreme Uncertainty," University of Virginia, Darden Graduate School of Business Administration, chaplinsk~s@vir~inia.edu, 434-924-4810, unpublished paper draft September 2002. l 2 Chaplinsky. pp.7-11. l 3 Chaplinsky. pp.6-8 14 Chaplinsky. p.5,8 l5 Chaplinsky. p.3 and Table 7

Future Value Interest Factor WIF(i, n) Period Interest Rates

n

0.50%

1 2 3 4 5

1.005 1.01003 1.01508 1.02015

1.44 1.5376 1.69 1.8496 1.728 1.90662 2.197 2.51546 2.0736 2.36421 2.8561 3.42102 1.02525 1.03807 1.05101 1.06408 1.07728 1.10408 1.15927 1.21665 1.27628 1.33823 1.40255 1.46933 1.53862 1.61051 1.76234 2.01136 2.28776 2.48832 2.93163 3.71293 4.65259

6 7 8 9 10

1.03038 1.04585 1.06152 1.07738 1.09344 1.12616 1.03553 1.0537 1.07214 1.09085 1.10984 1.14869 1.04071 1.0616 1.08286 1.10449 1.12649 1.17166 1.04591 1.06956 1.09369 1.11829 1.14339 1.19509 1.05114 1.07758 1.10462 1.13227 1.16054 1.21899

1.19405 1.22987 1.26677 1.30477 1.34392

1.26532 1.3401 1.41852 1.50073 1.31593 1.4071 1.50363 1.60578 1.36857 1.47746 1.59385 1.71819 1.42331 1.55133 1.68948 1.83846 1.48024 1.62889 1.79085 1.96715

11 12 13 14 15

1.0564 1.06168 1.06699 1.07232 1.07768

1.08566 1.09381 1.10201 1.11028 1.1186

1.11567 1.12683 1.13809 1.14947 1.16097

1.14642 1.16075 1.17526 1.18995 1.20483

1.17795 1.19562 1.21355 1.23176 1.25023

1.24337 1.26824 1.29361 1.31948 1.34587

1.38423 1.42576 1.46853 1.51259 1.55797

1.53945 1.60103 1.66507 1.73168 1.80094

16 18 20 24 28

1.08307 1.09393 1.1049 1.12716 1.14987

1.12699 1.14396 1.16118 1.19641 1.23271

1.17258 1.19615 1.22019 1.26973 1.32129

1.21989 1.25058 1.28204 1.34735 1.41599

1.26899 1.30734 1.34686 1.4295 1.51722

1.37279 1.42825 1.48595 1.60844 1.74102

30 32 36 40 48

1.1614 1.17304 1.19668 1.22079 1.27049

1.25127 1.27011 1.30865 1.34835 1.43141

1.34785 1.37494 1.43077 1.48886 1.61223

1.45161 1.48813 1.56394 1.64362 1.81535

1.56308 1.61032 1.70914 1.81402 2.04348

1.81136 1.88454 2.03989 2.20804 2.58707

50 60 72 84 96 108 120 240 360

0.75%

1.00%

125%

1.50%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00% 12.00% 15.00% 18.00% 20.00% 24.00% 30.00% 36.00%

1.0075 1.01 1.0125 1.015 1.02 1.03 1.04 1.05 1.06 107 1.08 1.09 1.1 1.12 1.15 1.18 1.21 1.2544 1.3225 1.3924 1.01506 1.0201 1.02516 1.03023 1.0404 1.0609 1.0816 1.1025 1.1236 1.1449 1.1664 1.1881 1.02267 1.0303 1.03797 1.04568 1.06121 1.09273 1.12486 1.15763 1.19102 1.22504 1.25971 1.29503 1.331 1.40493 1.52088 1.64303 1.03034 1.0406 1.05095 1.06136 1.08243 1.12551 1.16986 1.21551 1.26248 1.3108 1.36049 1.41158 1.4641 1.57352 1.74961 1.93878

1.2

1.24

1.3

1.36

1.58687 1.71382 1.85093 1.999 2.15892

1.6771 1.82804 1.99256 2.17189 2.36736

1.77156 1.94872 2.14359 2.35795 2.59374

1.97382 2.21068 2.47596 2.77308 3.10585

2.31306 2.66002 3.05902 3.51788 4.04556

2.69955 3.18547 3.75886 4.43545 5.23384

1.71034 1.8983 2.10485 2.33164 1.79586 2.0122 2.25219 2.51817 1.88565 2.13293 2.40985 2.71962 1.97993 2.2609 2.57853 2.93719 2.07893 2.39656 2.75903 3.17217

2.58043 2.81266 3.0658 3.34173 3.64248

2.85312 3.13843 3.45227 3.7975 4.17725

3.47855 3.89598 4.36349 4.88711 5.47357

4.65239 5.35025 6.15279 7.07571 8.13706

6.17593 7.43008 10.6571 17.9216 29.4393 7.28759 8.9161 13.2148 23.2981 40.0375 8.59936 10.6993 16.3863 30.2875 54.451 10.1472 12.8392 20.3191 39.3738 74.0534 11.9737 15.407 25.1956 51.1859 100.713

1.60471 1.87298 2.18287 2.54035 2.95216 3.42594 1.70243 2.02582 2.40662 2.85434 3.37993 3.99602 1.80611 2.19112 2.6533 3.20714 3.86968 4.66096 2.03279 2.5633 3.2251 4.04893 5.07237 6.34118 2.28793 2.9987 3.92013 5.11169 6.64884 8.62711

3.97031 4.59497 4.71712 5.55992 5.60441 6.7275 7.91108 9.84973 11.1671 14.421

6.13039 7.68997 9.64629 15.1786 23.8839

9.35762 12.3755 16.3665 28.6252 50.0656

14.129 19.6733 27.393 53.109 102.967

18.4884 26.6233 38.3376 79.4968 164.845

31.2426 48.0386 73.8641 174.631 412.864

66.5417 112.455 190.05 542.801 1550.29

136.969 253.338 468.574 1603 5483.9

2.42726 2.57508 2.89828 3.26204 4.13225

3.2434 3.50806 4.10393 4.80102 6.57053

4.32194 4.76494 5.79182 7.03999 10.4013

5.74349 6.45339 8.14725 10.2857 16.3939

7.61226 8.71527 11.4239 14.9745 25.7289

10.0627 11.7371 15.9682 21.7245 40.2106

13.2677 15.7633 22.2512 31.4094 62.5852

17.4494 21.1138 30.9127 45.2593 97.0172

29.9599 37.5817 59.1356 93.051 230.391

66.2118 87.5651 153.152 267.864 819.401

143.371 199.629 387.037 750.378 2820.57

237.376 341.822 708.802 1469.77 6319.75

634.82 976.099 2307.71 5455.91 30495.9

2620 4427.79 12646.2 36118.9 294633

10143 18760.5 64180.1 219562 2569612

1.28323 1.34885 1.43204 1.52037 1.61414

1.45296 1.64463 1.86102 2.10524 2.69159 4.38391 1.56568 1.8167 2.10718 2.44322 3.28103 5.8916 1.71255 2.0471 2.44592 2.92116 4.16114 8.40002 1.8732 2.30672 2.83911 3.49259 5.27733 11.9764 2.04892 2.59927 3.29551 4.1758 6.69293 17.0755

7.10668 10.5196 16.8423 26.965 43.1718

11.4674 18.6792 33.5451 60.2422 108.186

18.4202 32.9877 66.3777 133.565 268.759

29.457 57.9464 130.506 293.926 661.977

46.9016 101.257 254.983 642.089 1616.89

74.3575 176.031 495.117 1392.6 3916.91

117.391 304.482 955.594 2999.06 9412.34

289.002 897.597 3497.02 13624.3 53079.9

1083.66 4384 23455.5 125493 671418

3927.36 20555.1 149797 1091663 7955596

9100.44 46890.4 497929 4752755 56347.5 402996 6864377 502400 5325512 4479450

1.7137 1.8194 3.3102 6.02258

2.24112 2.45136 6.00915 14.7306

69.1195 194.287 540.796 1490.9 110.663 348.912 1088.19 3357.79 12246.2 121740 1184153 1355196

4071.6 10253

2.92893 3.82528 4.99267 8.48826 24.3456 3.30039 4.44021 5.96932 10.7652 34.711 10.8926 19.7155 35.6328 115.889 1204.85 35.9496 87.541 212.704 1247.56 41821.6

Appendix A

11017 29540 30987 92709.1

2.98598 3.58318 4.29982 5.15978 6.19174

3.63522 4.50767 5.58951 6.93099 8.59443

4.82681 6.27485 8.15731 10.6045 13.7858

ft

>

6.32752 8.60543 11.7034 15.9166 21.6466

206798 3592252 805680 ON

Future Value Interest Factor for an Annuity FVIFA(i, n) n 1 2 3 4 5

0.50% 1 2.005 3.01502 4.0301 5.05025

Period Interest Rates 0.75% 1.00% 1.25% 1.50% 2.00% 3.00% 4.00% 5.00% 6.00% 9.00% 10.00% 12.00% 15.00% 7.00% 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 2.0075 2.01 2.0125 2.015 2.02 2.03 2.04 2.05 2.06 2.07 2.08 2.09 2.1 2.12 2.15 3.02256 3.0301 3.03766 3.04522 3.0604 3.0909 3.1216 3.1525 3.1836 3.2149 3.2464 3.2781 3.31 3.3744 3.4725 4.04523 4.0604 4.07563 4.0909 4.12161 4.18363 4.24646 4.31013 4.37462 4.43994 4.50611 4.57313 4.641 4.77933 4.99338 5.07556 5.10101 5.12657 5.15227 5.20404 5.30914 5.41632 5.52563 5.63709 5.75074 5.8666 5.98471 6.1051 6.35285 6.74238

18.00% 20.00% 24.00% 30.00% 36.00% 1 1 1 1 1 2.3 2.36 2.2 2.24 2.18 3.99 4.2096 3.64 3.7776 3.5724 5.368 5.68422 6.187 6.72506 5.21543 7.15421 7.4416 8.04844 9.0431 10.1461

6 7 8 9 10

6.0755 7.10588 8.14141 9.18212 10.228

6.11363 7.15948 8.21318 9.27478 10.3443

6.15202 7.21354 8.28567 9.36853 10.4622

6.19065 7.26804 8.35889 9.46337 10.5817

6.22955 7.32299 8.43284 9.55933 10.7027

6.30812 7.43428 8.58297 9.75463 10.9497

6.46841 7.66246 8.89234 10.1591 11.4639

6.63298 7.89829 9.21423 10.5828 12.0061

6.80191 8.14201 9.54911 11.0266 12.5779

6.97532 8.39384 9.89747 11.4913 13.1808

7.15329 8.65402 10.2598 11.978 13.8164

7.33593 8.9228 10.6366 12.4876 14.4866

7.52333 9.20043 11.0285 13.021 15.1929

7.71561 9.48717 11.4359 13.5795 15.9374

8.11519 10.089 12.2997 14.7757 17.5487

8.75374 11.0668 13.7268 16.7858 20.3037

9.44197 12.1415 15.327 19.0859 23.5213

9.92992 12.9159 16.4991 20.7989 25.9587

10.9801 14.6153 19.1229 24.7125 31.6434

12.756 17.5828 23.8577 32.015 42.6195

14.7987 21.1262 29.7316 41.435 57.3516

11 12 13 14 15

11.2792 12.3356 13.3972 14.4642 15.5365

11.4219 12.5076 13.6014 14.7034 15.8137

11.5668 12.6825 13.8093 14.9474 16.0969

11.7139 12.8604 14.0211 15.1964 16.3863

11.8633 13.0412 14.2368 15.4504 16.6821

12.1687 13.4121 14.6803 15.9739 17.2934

12.8078 14.192 15.6178 17.0863 18.5989

13.4864 15.0258 16.6268 18.2919 20.0236

14.2068 15.9171 17.713 19.5986 21.5786

14.9716 16.8699 18.8821 21.0151 23.276

15.7836 17.8885 20.1406 22.5505 25.129

16.6455 18.9771 21.4953 24.2149 27.1521

17.5603 20.1407 22.9534 26.0192 29.3609

18.5312 21.3843 24.5227 27.975 31.7725

20.6546 24.1331 28.0291 32.3926 37.2797

24.3493 29.0017 34.3519 40.5047 47.5804

28.7551 34.9311 42.2187 50.818 60.9653

32.1504 39.5805 48.4966 59.1959 72.0351

40.2379 50.895 64.1097 80.4961 100.815

56.4053 74.327 97.625 127.913 167.286

78.9982 108.437 148.475 202.926 276.979

16 18 20 24 28

16.6142 18.7858 20.9791 25.432 29.9745

16.9323 19.1947 21.4912 26.1885 31.0282

17.2579 19.6147 22.019 26.9735 32.1291

17.5912 20.0462 22.563 27.7881 33.2794

17.9324 20.4894 23.1237 28.6335 34.4815

18.6393 21.4123 24.2974 30.4219 37.0512

20.1569 23.4144 26.8704 34.4265 42.9309

21.8245 25.6454 29.7781 39.0826 49.9676

23.6575 28.1324 33.066 44.502 58.4026

25.6725 30.9057 36.7856 50.8156 68.5281

27.8881 33.999 40.9955 58.1767 80.6977

30.3243 37.4502 45.762 66.7648 95.3388

33.0034 41.3013 51.1601 76.7898 112.968

35.9497 45.5992 57.275 88.4973 134.21

42.7533 55.7497 72.0524 118.155 190.699

55.7175 75.8364 102.444 184.168 327.104

72.939 103.74 146.628 289.494 566.481

87.4421 128.117 186.688 392.484 819.223

126.011 195.994 303.601 723.461 1716.1

218.472 377.692 371.518 700.939 630.165 1298.82 1806 4450 5164.31 15230.3

30 32 36 40 48

32.28 34.6086 39.3361 44.1588 54.0978

33.5029 36.0148 41.1527 46.4465 57.5207

34.7849 37.4941 43.0769 48.8864 61.2226

36.1291 39.0504 45.1155 51.4896 65.2284

37.5387 40.6883 47.276 54.2679 69.5652

40.5681 44.227 51.9944 60.402 79.3535

47.5754 52.5028 63.2759 75.4013 104.408

56.0849 62.7015 77.5983 95.0255 139.263

66.4388 75.2988 95.8363 120.8 188.025

79.0582 90.8898 119.121 154.762 256.565

94.4608 110.218 148.913 199.635 353.27

113.283 134.214 187.102 259.057 490.132

136.308 164.037 236.125 337.882 684.28

164.494 201.138 299.127 442.593 960.172

241.333 434.745 790.948 1181.88 2640.92 304.848 577.1 1103.5 1704.11 4062.91 484.463 1014.35 2144.65 3539.01 9611.28 767.091 1779.09 4163.21 7343.86 22728.8 1911.59 5456 15664.3 31593.7 127062

50 60 72 84 96

56.6452 69.77 86.4089 104.074 122.829

60.3943 75.4241 95.007 116.427 139.856

64.4632 81.6697 104.71 130.672 159.927

68.8818 88.5745 115.674 147.129 183.641

73.6828 96.2147 128.077 166.173 211.72

84.5794 114.052 158.057 213.867 284.647

112.797 163.053 246.667 365.881 535.85

152.667 237.991 396.057 649.125 1054.3

209.348 353.584 650.903 1184.84 2143.73

290.336 533.128 1089.63 2209.42 4462.65

406.529 813.52 1850.09 4184.65 9442.52

573.77 1253.21 3174.78 8013.62 20198.6

815.084 1944.79 5490.19 15462.2 43510.1

1163.91 3034.82 9545.94 29980.6 94113.4

2400.02 7471.64 29133.5 113527 442324

108 120 240 360

142.74 163.879 462.041 1004.52

165.483 193.514 667.887 1830.74

192.893 230.039 989.255 3494.96

226.023 275.217 1497.24 6923.28

266.178 331.288 2308.85 14113.6

374.413 778.186 1702.99 3865.74 8996.6 21284.3 50882.6 488.258 1123.7 2741.56 6958.24 18119.8 47954.1 128150 5744.44 40128.4 306130 2434771 62328.1 1394021

122400 344289

295390 1723309 927081 6713994

Appendix B

7217.72 29220 156363 836612 4476110

8729.99 14756 42150.7 120393 982106

ON ON

28172.3 52109.8 178275 609890 7137809

21813.1 45497.2 195373 1659761 114190 281733 1679147 832203 2511995 6064789

td

Present Value Interest Factor PVIFfk, n) Period Interest Rates

0.50%

0.75%

1.00%

1.25%

1.50%

2.00%

3.00%

4.00%

5.00%

6.00%

8.00%

9.00%

10.00%

12.00%

15.00%

18.00%

20.00%

24.00%

30.00%

36.00%

0.99502 0.99007 0.98515 0.98025 0.97537

0.99256 0.98517 0.97783 0.97055 0.96333

0.9901 0.9803 0.97059 0.96098 0.95147

0.98765 0.97546 0.96342 0.95152 0.93978

0.98522 0.97066 0.95632 0.94218 0.92826

0.98039 0.96117 0.94232 0.92385 0.90573

0.97087 0.9426 0.91514 0.88849 0.86261

0.96154 0.92456 0.889 0.8548 0.82193

0.95238 0.90703 0.86384 0.8227 0.78353

0.9434 0.93458 0.89 0.87344 0.83962 0.8163 0.79209 0.7629 0.74726 0.71299

0.92593 0.85734 0.79383 0.73503 0.68058

0.91743 0.84168 0.77218 0.70843 0.64993

0.90909 0.82645 0.75131 0.68301 0.62092

0.89286 0.79719 0.71178 0.63552 0.56743

0.86957 0.75614 0.65752 0.57175 0.49718

0.84746 0.71818 0.60863 0.51579 0.43711

0.83333 0.69444 0.5787 0.48225 0.40188

0.80645 0.65036 0.52449 0.42297 0.34111

0.76923 0.59172 0.45517 0.35013 0.26933

0.73529 0.54066 0.39754 0.29231 0.21493

10

0.97O52 0.96569 0.96089 0.9561 0.95135

0.95616 0.94904 0.94198 0.93496 0.928

0.94205 0.93272 0.92348 0.91434 0.90529

0.92817 0.91672 0.9054 0.89422 0.88318

0.91454 0.90103 0.88771 0.87459 0.86167

0.88797 0.87056 0.85349 0.83676 0.82035

0.83748 0.81309 0.78941 0.76642 0.74409

0.79031 0.75992 0.73069 0.70259 0.67556

0.74622 0.71068 0.67684 0.64461 0.61391

0.70496 0.66506 0.62741 0.5919 0.55839

0.66634 0.62275 0.58201 0.54393 0.50835

0.63017 0.58349 0.54027 0.50025 0.46319

0.59627 0.54703 0.50187 0.46043 0.42241

0.56447 0.51316 0.46651 0.4241 0.38554

0.50663 0.45235 0.40388 0.36061 0.32197

0.43233 0.37594 0.3269 0.28426 0.24718

0.37043 0.31393 0.26604 0.22546 0.19106

0.3349 0.27908 0.23257 0.19381 0.16151

0.27509 0.22184 0.17891 0.14428 0.11635

0.20718 0.15937 0.12259 0.0943 0.07254

0.15804 0.11621 0.08545 0.06283 0.0462

11 12 13 14 15

0.94661 0.94191 0.93722 0.93256 0.92792

0.92109 0.91424 0.90743 0.90068 0.89397

0.89632 0.88745 0.87866 0.86996 0.86135

0.87228 0.86151 0.85087 0.84037 0.82999

0.84893 0.83639 0.82403 0.81185 0.79985

0.80426 0.78849 0.77303 0.75788 0.74301

0.72242 0.70138 0.68095 0.66112 0.64186

0.64958 0.6246 0.60057 0.57748 0.55526

0.58468 0.55684 0.53032 0.50507 0.48102

0.52679 0.49697 0.46884 0.4423 0.41727

0.47509 0.44401 0.41496 0.38782 0.36245

0.42888 0.39711 0.3677 0.34046 0.31524

0.38753 0.35553 0.32618 0.29925 0.27454

0.35049 0.31863 0.28966 0.26333 0.23939

0.28748 0.25668 0.22917 0.20462 0.1827

0.21494 0.18691 0.16253 0.14133 0.12289

0.16192 0.13722 0.11629 0.09855 0.08352

0.13459 0.11216 0.09346 0.07789 0.06491

0.09383 0.07567 0.06103 0.04921 0.03969

0.0558 0.04292 0.03302 0.0254 0.01954

0.03397 0.02498 0.01837 0.0135 0.00993

16 18 20 24 28

0.9233 0.91414 0.90506 0.88719 0.86966

0.88732 0.87416 0.86119 0.83583 0.81122

0.85282 0.83602 0.81954 0.78757 0.75684

0.81975 0.79963 0.78001 0.7422 0.70622

0.78803 0.76491 0.74247 0.69954 0.6591

0.72845 0.70016 0.67297 0.62172 0.57437

0.62317 0.58739 0.55368 0.49193 0.43708

0.53391 0.49363 0.45639 0.39012 0.33348

0.45811 0.41552 0.37689 0.31007 0.25509

0.39365 0.35034 0.3118 0.24698 0.19563

0.33873 0.29586 0.25842 0.19715 0.1504

0.29189 0.25025 0.21455 0.1577 0.11591

0.25187 0.21199 0.17843 0.1264 0.08955

0.21763 0.17986 0.14864 0.10153 0.06934

0.16312 0.13004 0.10367 0.06588 0.04187

0.10686 0.08081 0.0611 0.03493 0.01997

0.07078 0.05083 0.03651 0.01883 0.00971

0.05409 0.03756 0.02608 0.01258 0.00607

0.03201 0.02082 0.01354 0.00573 0.00242

0.01503 0.00889 0.00526 0.00184 0.00065

0.0073 0.00395 0.00213 0.00062 0.00018

30 32 36 40 48

0.86103 0.85248 0.83564 0.81914 0.7871

0.79919 0.78733 0.76415 0.74165 0.69861

0.74192 0.7273 0.69892 0.67165 0.62026

0.68889 0.67198 0.63941 0.60841 0.55086

0.63976 0.62099 0.58509 0.55126 0.48936

0.55207 0.53063 0.49022 0.45289 0.38654

0.41199 0.38834 0.34503 0.30656 0.242

0.30832 0.28506 0.24367 0.20829 0.15219

0.23138 0.20987 0.17266 0.14205 0.09614

0.17411 0.15496 0.12274 0.09722 0.061

0.13137 0.11474 0.08754 0.06678 0.03887

0.09938 0.0852 0.06262 0.04603 0.02487

0.07537 0.06344 0.04494 0.03184 0.01598

0.05731 0.04736 0.03235 0.02209 0.01031

0.03338 0.02661 0.01691 0.01075 0.00434

0.0151 0.01142 0.00653 0.00373 0.00122

0.00697 0.00501 0.00258 0.00133 0.00035

0.00421 0.00293 0.00141 0.00068 0.00016

0.00158 0.00038 0.00102 0.00023 0.00043 0.00018

50 60 72 84 96

0.77929 0.74137 0.6983 0.65773 0.61952

0.68825 0.6387 0.58392 0.53385 0.48806

0.60804 0.55045 0.4885 0.43352 0.38472

0.53734 0.47457 0.40884 0.35222 0.30344

0.475 0.4093 0.34233 0.28632 0.23947

0.37153 0.30478 0.24032 0.18949 0.14941

0.22811 0.16973 0.11905 0.0835 0.05856

0.14071 0.09506 0.05937 0.03709 0.02316

0.0872 0.05354 0.02981 0.0166 0.00924

0.05429 0.03031 0.01507 0.00749 0.00372

0.03395 0.01726 0.00766 0.0034 0.00151

0.02132 0.00988 0.00392 0.00156 0.00062

0.01345 0.00568 0.00202 0.00072 0.00026

0.00852 0.00346 0.00092 0.00025 0.00011 0.00328 0.00111 0.00023 0.00105 0.00029 0.00033 0.00011

108 0.58353 0.4462 0.34142 0.26142 120 0.54963 0.40794 0.30299 0.22521 240 0.3021 0.16641 0.09181 0.05072 360 0.16604 0.06789 0.02782 0.01142

0.20029 0.16752 0.02806 0.0047

0.11781 0.04108 0.01447 0.00515 0.00185 0.00067 0.00025 0.09289 0.02881 0.00904 0.00287 0.00092 0.0003 0.00863 0.00083 0.0008 Appendix C

7.00%

a O

• < \

Present Value Interest Factor for an Annuity PVIFA(k, n) Period Interest Rates

n 1 2 3 4 5

0.50% 0.99502 1.9851 2.97025 3.9505 4.92587

0.75% 0.99256 1.97772 2.95556 3.92611 4.88944

1.00% 0.9901 1.9704 2.94099 3.90197 4.85343

1.25% 0.98765 1.96312 2.92653 3.87806 4.81784

1.50% 0.98522 1.95588 2.9122 3.85438 4.78264

2.00% 0.98039 1.94156 2.88388 3.80773 4.71346

3.00% 0.97087 1.91347 2.82861 3.7171 4.57971

4.00% 0.96154 1.88609 2.77509 3.6299 4.45182

5.00% 0.95238 1.85941 2.72325 3.54595 4.32948

6.00% 0.9434 1.83339 2.67301 3.46511 4.21236

7.00% 0.93458 1.80802 2.62432 3.38721 4.1002

8.00% 0.92593 1.78326 2.5771 3.31213 3.99271

9.00% 0.91743 1.75911 2.53129 3.23972 3.88965

10.00% 0.90909 1.73554 2.48685 3.16987 3.79079

12.00% 0.89286 1.69005 2.40183 3.03735 3.60478

15.00% 0.86957 1.62571 2.28323 2.85498 3.35216

18.00% 0.84746 1.56564 2.17427 2.69006 3.12717

20.00% 0.83333 1.52778 2.10648 2.58873 2.99061

24.00% 0.80645 1.45682 1.9813 2.40428 2.74538

5.89638 6.86207 7.82296 8.77906 9.73041

5.8456 6.79464 7.73661 8.67158 9.59958

5.79548 6.72819 7.65168 8.56602 9.4713

5.74601 6.66273 7.56812 8.46234 9.34553

5.69719 6.59821 7.48593 8.36052 9.22218

5.60143 6.47199 7.32548 8.16224 8.98259

5.41719 6.23028 7.01969 7.78611 8.5302

5.24214 6.00205 6.73274 7.43533 8.1109

5.07569 5.78637 6.46321 7.10782 7.72173

4.91732 5.58238 6.20979 6.80169 7.36009

4.76654 5.38929 5.9713 6.51523 7.02358

4.62288 5.20637 5.74664 6.24689 6.71008

4.48592 5.03295 5.53482 5.99525 6.41766

4.35526 4.86842 5.33493 5.75902 6.14457

4.11141 4.56376 4.96764 5.32825 5.65022

3.78448 4.16042 4.48732 4.77158 5.01877

3.4976 3.81153 4.07757 4.30302 4.49409

3.32551 3.60459 3.83716 4.03097 4.19247

3.02047 2.64275 2.33878 3.24232 2.80211 2.45498 3.42122 2.9247 2.54043 3.019 2.60326 3.5655 3.68186 3.09154 2.64945

11 12 13 14 15

10.677 10.5207 10.3676 10.2178 10.0711 9.78685 9.25262 8.76048 8.30641 7.88687 7.49867 11.6189 11.4349 11.2551 11.0793 10.9075 10.5753 9.954 9.38507 8.86325 8.38384 7.94269 12.5562 12.3423 12.1337 11.9302 11.7315 11.3484 10.635 9.98565 9.39357 8.85268 8.35765 13.4887 13.243 13.0037 12.7706 12.5434 12.1062 11.2961 10.5631 9.89864 9.29498 8.74547 14.4166 14.137 13.8651 13.6005 13.3432 12.8493 11.9379 11.1184 10.3797 9.71225 9.10791

7.13896 7.53608 7.90378 8.24424 8.55948

6.80519 7.16073 7.4869 7.78615 8.06069

6.49506 6.81369 7.10336 7.36669 7.60608

5.9377 6.19437 6.42355 6.62817 6.81086

5.23371 5.42062 5.58315 5.72448 5.84737

4.65601 4.79322 4.90951 5.00806 5.09158

4.32706 4.43922 4.53268 4.61057 4.67547

3.77569 3.85136 3.91239 3.9616 4.00129

3.14734 2.68342 3.19026 2.7084 3.22328 2.72676 3.24867 2.74027 3.26821 2.7502

16 18 20 24 28

15.3399 17.1728 18.9874 22.5629 26.0677

15.0243 16.7792 18.508 21.8891 25.1707

14.7179 16.3983 18.0456 21.2434 24.3164

14.4203 16.0295 17.5993 20.6242 23.5025

14.1313 15.6726 17.1686 20.0304 22.7267

13.5777 14.992 16.3514 18.9139 21.2813

12.5611 13.7535 14.8775 16.9355 18.7641

11.6523 12.6593 13.5903 15.247 16.6631

10.8378 11.6896 12.4622 13.7986 14.8981

8.85137 9.37189 9.81815 10.5288 11.0511

8.31256 8.75563 9.12855 9.70661 10.1161

7.82371 8.20141 8.51356 8.98474 9.30657

6.97399 7.24967 7.46944 7.78432 7.98442

5.95423 6.12797 6.25933 6.43377 6.53351

5.16235 5.27316 5.35275 5.45095 5.5016

4.72956 4.81219 4.86958 4.9371 4.96967

4.0333 4.07993 4.11026 4.14281 4.15657

3.28324 3.30369 3.31579 3.32719 3.33118

30 32 36 40 48

27.7941 29.5033 32.871 36.1722 42.5803

26.7751 28.3557 31.4468 34.4469 40.1848

25.8077 27.2696 30.1075 32.8347 37.974

24.8889 26.2413 28.8473 31.3269 35.9315

24.0158 25.2671 27.6607 29.9158 34.0426

22.3965 23.4683 25.4888 27.3555 30.6731

19.6004 20.3888 21.8323 23.1148 25.2667

17.292 17.8736 18.9083 19.7928 21.1951

15.3725 13.7648 12.409 11.2578 10.2737 9.42691 15.8027 14.084 12.6466 11.435 10.4062 9.52638 16.5469 14.621 13.0352 11.7172 10.6118 9.67651 17.1591 15.0463 13.3317 11.9246 10.7574 9.77905 15.65 13.7305 12.1891 10.9336 9.89693 18.0772

8.05518 8.11159 8.19241 8.24378 8.29716

6.56598 6.59053 6.62314 6.64178 6.65853

5.51681 5.52773 5.5412 5.54815 5.55359

4.97894 4.1601 3.33206 2.7775 4.98537 4.1624 3.33258 2.77763 4.99295 4.16486 3.33307 2.77773 4.9966 4.1659 3.33324 2.77777 4.99921 4.16653 3.33332 2.77778

50 60 72 84 96

44.1428 51.7256 60.3395 68.453 76.0952

41.5664 48.1734 55.4768 62.154 68.2584

39.1961 44.955 51.1504 56.6485 61.5277

37.0129 42.0346 47.2925 51.8222 55.7246

34.9997 39.3803 43.8447 47.5786 50.7017

31.4236 34.7609 37.9841 40.5255 42.5294

25.7298 27.6756 29.3651 30.5501 31.3812

21.4822 22.6235 23.5156 24.0729 24.4209

18.2559 18.9293 19.4038 19.668 19.8151

8.3045 8.32405 8.33095 8.33272 8.33318

6.66051 6.66515 6.66638 6.66661 6.66666

5.55414 4.99945 4.16658 3.33333 2.77778 5.55529 4.99991 4.16666 3.33333 2.77778 5.55552 4.99999 4.16667 3.33333 2.77778 5 4.16667 3.33333 2.77778 5.55555 5 4.16667 3.33333 2.77778 5.55555

108 120 240 360

83.2934 90.0735 139.581 166.792

73.8394 78.9417 111.145 124.282

65.8578 69.7005 90.8194 97.2183

59.0865 61.9828 75.9423 79.0861

53.3137 55.4985 64.7957 66.3532

44.1095 31.9642 24.6383 19.8971 16.6358 45.3554 32.373 24.7741 19.9427 16.6514 49.5686 33.3057 24.998 19.9998 16.6667 49.9599 33.3325 25 20 16.6667

10.1059 10.8276 11.4699 12.5504 13.4062

15.7619 16.1614 16.4156 16.5419 16.6047

9.44665 10.0591 10.594 11.4693 12.1371

13.8007 14.0392 14.1763 14.2371 14.2641

12.2335 12.3766 12.451 12.4805 12.4923

10.9617 11.048 11.0887 11.1031 11.1083

9.91481 9.96716 9.98954 9.99667 9.99894

30.00% 0.76923 1.36095 1.81611 2.16624 2.43557

36.00% 0.73529 1.27595 1.67349 1.9658 2.18074

ON 00

2.7575 2.76681 2.77185 2.77604 2.77727

O

OS

14.2761 12.4969 11.1101 9.99966 8.33329 6.66666 5.55556 14.2815 12.4988 11.1108 9.99989 8.33332 6.66667 5.55556 12.5 11.1111 10 8.33333 6.66667 5.55556 14.2857 14.2857 12.5 11.1111 10 8.33333 6.66667 5.55556

Appendix D

5 5 5 5

4.16667 4.16667 4.16667 4.16667

3.33333 3.33333 3.33333 3.33333

2.77778 2.77778 2.77778 2.77778

a

Appendix E

369

CD TABLE OF CONTENTS

AGENCY Document Title

File Name

Format

Size

SMALL BUSINESS ADMINISTRATION 8(a) Business Development and Small and Disadvantaged Business (SBD) Certification 8(a) Business Plan ACE-Net Model Terms and Conditions for a Securities Offering Application for 504 Loan Program Application for a LowDoc Loan Application for Business Loan Application for Micro Loan (Used for loans under $50,000) Financial Statement of Debtor Lenders Application for Guaranty or Participation Loan Note Personal Financial Statement Regulation C Registration (Rules on the form and content of registration statements and prospectus.) Resolution of Board of Directors SBA Loan Document Checklist SBA Model Balance Sheet SBA Model Cash Flow Budget SBA Model Income Statement SBA Size Standards SBIC Capital Certificate (Used when forming an SBIC) Schedule of Collateral Size Standards by NAICS Code Small Business Administration Act Statement of Personal History

sbalOlO sbalOlOc ACE-Net Model Terms and Conditions sba1244 sba4-L sba4

PDF PDF

467KB 510KB

Word PDF PDF PDF

67KB 876KB 642KB 284KB

sba4-sht sba770

PDF PDF

150KB 83KB

sba4-i sbafl47v41 sba413

PDF PDF PDF

121KB 53KB 155KB

Regulation C sbal60 SBA Loan Checklist Model Balance Sheet Model Cash Budget Model Income Statement SBA Size Standards

HTML 408KB PDF 44KB Plaintext 3KB Excel 25KB Excel 26KB 20KB Excel HTML 306KB

sbal-4 sba4-a NAICS Size Standards Small Business Act Form 912

PDF PDF HTML HTML PDF

168KB 96KB 459KB 550KB 208KB

370

Appendix E Stockholder's Confirmation for SBICs

sba1405

PDF

155KB

PDF

102KB

Form 1-A Form 1-A

HTML PDF

175KB 198KB

Form S-1

PDF

94KB

FormD Q&A Small Business and the SEC

PDF

939KB

Form SB-1

PDF

Form SB-2 Regulation A Regulation D

PDF HTML PDF

123KB 43KB 283KB

PDF

242KB

PDF

404KB

HTML

390KB

PDF

391KB

Coordinated Review Request MidAtlantic Region (Forms for other regions are available on: www.nasaa.org CR SCOR Request SCOR For Instructions SCOR Instructions

PDF Word

62KB 410KB

CASE STUDIES

Word

353KB

INTERNAL REVENUE SERVICE Request for Transcript of Tax Return

f4506t

SECURITIES AND EXCHANGE COMMISSION Form 1-A Form 1-A Form S-1 Registration Statement Under the Securities Act of 1933 Notice of Sale of Securities Pursuant to Regulation D - Form D

HTML

56KB

Q&A Small Business and the SEC 115KB

Registration for a Small Business Issuer Registration for a Small Business Issuer

Regulation A Regulation D Regulation S-B (Instructions for Regulation S-B completing Form SB-2) Regulation S-K (Instructions for Regulation S-K completing Form S-1) Report on the Uniformity of State Regulatory Requirements for Offerings of Securities That Are Not "Covered Securities" (Explains Federal Pre-emption of state securities laws) NSMIA Report SEC Instructions on Financial Statements Regulation S-X

NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION

Case Studies

INDEX

10-K annual financial statement 504 Loan Program 7(A) Loan Guarantee 7(m) Micro loan Program Acceleration bank loan Accountants & auditors, investor approval Accounts payable, aged Accounts payable, conserving cash through Accounts receivable Accounts receivable turnover Accounts receivable, aged Accredited Investor Accredited investor affidavit ACE Net Affidavit, accredited investor Affinity group, direct public offering Age of business funded by SBIC American Stock Exchange Angel Clubs Angel expectations, return Angel expectations, return Angel Funds Angel Funds, like venture capital funds Angel investment criteria Angel investor advice Angel investor characteristics Angel investor profile Angel investor risk tolerance Angel investors Angel need for company data Angel preference leading edge technology Angel preference, entrepreneur Angel preference, industry Angel preferences Angel rate of return Angel, company characteristics Angel, governance mechanisms Angel, guidance for Angel, intellectual reward Angel, preference for people over ideas Angel, preference for skilled management Angels, where found Anti-dilution mechanism, puts AR turnover . Asset backed securities Asset based lenders Assets Audit

40 64 62 65 46 191 41 317 308-312 308-312 41 226-227 229 229 229 277 291 -292 259-261 130-133 119 122 130-133 131 114-122 123-124 111-112 113-114 112 111-133 118 117 115 121 -122 121-122 121 116-119 120 126-127 121 116 116 125-133 189 308-312 357-359 69-84 4 45

Audited financial statements for IPO Auditedfinancialstatements, direct offering Auditedfinancialstatements, requirement for Bake off, investment banker search Bank covenants Bank debt, replace via IPO Bank guarantee Bank, chartered by Bank, loan application Bank, myths about Bank, workout department Bankruptcy financing Bankruptcy, Chapter 11 Bankruptcy, Chapter 7 Banks Banks, federal Banks, redline industries Banks, reliability Benchmark companies Benchmarking Benchmarking Billing & collections, metrics for measuring Board of directors, seat on Board seat, Angel demand for Bond features, combination Bond puts Bond rating definitions Bond rating services Bond redemption, early Bond sales, secondary markets Bond sinking fund Bond structure Bond value, computing Bonds Bonds, convertible Bonds, convertible Bonds, general characteristics Bonds, junk Bonds, mortgage Bonds, regulation of Bonds, risk management Bonds, risk minimization Bonds, senior Bonds, trust indenture act Book of orders, public offering Borrowers, large Borrowers, small Borrowing capacity

252 277-278 269-270 252 45, 46 241 35, 36 33, 34 36, 45 47 46 361-363 1 361 33-50 33 48, 49 48, 49 166 40 166 308-310 190 120 336 335-336 323-324 323-324 336-337 340 337-338 325-327 325-327 321-340 177-178 334-335 322 338-340 334 331-333 333-336 322-324 334 332-333 253 36, 37 36 42, 44

372 Boston stock exchange Bridge loans BSE Business age, SBIC funding Business model Business model Business model, scaleable Business proposition, compelling Business schedule Buy back investment, right to Buyer, partial Calculation of growth rate Calculation, EBITDA multiplier Calculation, revenue multiplier Capital lease Capital requirements, NASAA standards Capital structure, complex Capital, amount needed Capital, amount needed Capital, appropriate amount Capital, credit cards Capital, customer as source Capital, definition Capital, estimating risk Capital, factors determining source of Capital, friends and family Capital, need for Capital, purpose Capital, reasons for raising Capital, sources of Capital, start-up sources Capital, vendors and suppliers Capital, venture Capitalization requirements Caplines Programs Cash cycle Cash flow and debt securities Cash flow breakeven Cash flow valuation Cash flow, steady state Cash, conserving, importance of Cash, raising from accounts receivable Cash, raising from inventoly Cash, raisingfromplant and property CD-rom, Index to Certified lenders Chapter 11, bankruptcy Chapter 7, bankruptcy Cheap stock Chicago Stock Exchange CHX Cincinnati Stock Exchange Collateral, SBA loans Collections, proof of market acceptance Commercial credit company Commercial paper Commercial paper maturity strategy Commercial paper operations Commercial paper rates, managing Commercial paper risk Commercial paper, cost of

Raising Capital 259 356 259 291-292 99-105 99-102 200-201 201 205 186-187 185 172 167 168 28 271 182-183 18 92-93 306-308 22-25 27-28 4 94 1 20 2 2,3 90-91 49 5 19 27 139-158 234 63-64 308 233 2 169-171 41 306-308 310-312 314-315 316-317 Appdx E 57 361-363 361 233 259 259 259 58-59 204 70 345-350 350 349-350 347-348 349 347-348

Commercial paper, not regulated Commercial paper, who can issue Common stock Company showcases Company size, effect on public offering Company valuation, similar Company value, pre-investment Company, life cycle Company, valuing Competitive advantage Compilation Complex capital structure Comptroller of the currency Concept, understandable, for direct offering Confidence building Conserving cash, importance of Contacting venture firms Control by venture capitalist Conversion premium Convertible bonds Convertible bonds Convertible preferred stock Convertible preferred, participating Coordinated review program Coordinated review program Cost in money, venture capital Cost of commercial paper Cost of goods sold, used in inventory tumover Costs of venture capital Covenants, bank Covenants, default on Credit Cards credit line Credit sales, used in AR turnover Credit scoring Credit, granting to customers credit, letter of Criteria for delisting Criteria, state merit review Criteria, venture capital Crowded market Customer database, direct public offering Customer, as capital source Customers with money Customers with pain Customers, flagship Data, Angel need for Data, entrepreneur expected to have Days sales outstanding Deal sheet Deal sheet Deal size, venture firm Deal structure, variables that affect Deal, characteristics of Deal, structuring Debt ratio Debt securities and cash flow Debt with equity kicker Decline, product life cycle Default, bank loan covenants Defense Loan and Technical Assistance

345-346 346 177 127-128 245 171 -174 171-173 8 165-176 119 44 182-183 33, 34 276 206-207 306-308 157-158 148-150 335 177-178 334-335 177 179 270 271 -273 146-147 347-348 313-314 145-150 45, 46 46 22-25 35 309 38,39 312-313 35, 36 260 233-235 144 203 277 27-28 202-203 202 205 118 118 309-310 164 210-211 142 164 119-121 163-192 9, 10 233 178 98 46 65

Index Delisting Development, stage of Development, stage of Diligence, due Dilution Dilution of entrepreneur's interest Dilution, maintenance of ownership Dilution, stock options Direct public offering with advisor Direct public offering without an advisor Direct public offering, who should consider Disclosure of risk for merit review Discontinue and write-off, exit Discount for private company Discount rate Discount rate to estimate preferred dividends Discount rate used to estimate bond interest Discount, underwriting Discount, underwriting Discounted cash flow Discounted cash flow, problems with Dividends, estimated required DPO advisor firms DPO advisor, services offered DPO who should consider DPO without an advisor DSO Due diligence Dun & Bradstreet studies Dutch auction criteria for selecting an advisor Dutch auction, small public offering Duty, undenvriteh Early adopters Eady stage, defined Earnings before interest taxes depreciate & amon EBITDA EBITDA model, varying gross margins EBITDA multiplier EBITDA multiplier calculation EBITDA multiplier method Economic cycles, effect on public offering Effective prospectus Elastic price Employee stock options, dilution Entrepreneur matching services Entreoreneur., abilitv, to execute Entrepreneur, angel knowledge of Entrepreneur, cash flow knowledge Entrepreneur, character of Entrepreneur, experience of Entrepreneur, knowledge Entrepreneur, management skills of Entrepreneur, personal credit check on Entrepreneur, personalfinancialstatement Entrepreneur, tax returns of Equation, accounting Equity required by investor Evaluation period, by SEC of prospectus Excess assets Exemptions from Federal securities law Exit clauses

373 180-181 260 Exit payoff 152-155 7 Exit preference, venture capital 183-187 8, 9 Exit provisions 152-155 122-123 Exit strategies, venture capital 119 188-189 Exit strategy, angel investor 184-185 305 Exit via forced sale 154-155 189 Exit via IPO likelihood 194 190 Exit via puts 184 278-281 Exit via share registration 186-187 279-281 Exit, designing flexibility 186-187 276-277 Exit, designing in 153 272 Exit, discontinue and write off 152 153 Exit, public offering 153 169 Exit, sale to buy-out specialist 153 327 Exit, sale to management 153 178 Exit, sale to private company 153 178 Exit, sale to private equity firm 153 256 Exit, sale to public company 7 253 Exit, time to 12 169-171 Exit, time to 9 174 Expansion stage, defined 174-175 178 Expected value, revenue 107 278-281 Experience of entrepreneur 107 278 Experience of management team 65 276-277 Export Working Capital Loan 34 279-281 Facilities, bank 81-83 309-310 Factoring, cost of 80-81 122-123 Factoring, mechanics of 79-80 39 Factoring, reasons for 79-84 275 Factors 150 274-275 Failure to meet objectives, venture capital 34 257 FDIC 34 97 Federal Deposit Insurance Corporation 231 -232 9 Federal pre-emption of state laws 232-234 166 Federal pre-emption, securities not covered 33 166 Federal Reserve 33 175-176 Federal, banks 257 167 Fee disclosure, underwriting 339-340 167 Fees, for underwriting junk bonds 255-257 166 Fees, investment bank 259, 261 244 Fees, stock exchange 253 Financial condition, unsound, merit review 272-273 44, 45 96-97 Financial data, quality of 139 190 Financial intermediary, venture capitalist 252 128-129 Financial statements, audited for IPO 40 116 Financial statements, public companies 39, 45 115 Financial underwriting 207-208 115-116 Financing rounds 125-133 114-116 Finding angels 142-144 107 Firm structure, venture capital 323 115 Fitch's bond rating service 205 115 Flagship customers 101 106 Focus groups 288 106 Follow-on financing, SBIC 184-185 106 Forced sale, exit by 267-269 4 Form 1-A 230 181 Form D 220 253 Form S-1, public offering form 220 306-308 Form SB-1, public offering form 220 217-228 Form SB-2, public offering form 220 183-187 Form-lA, regulation A public offering

Raising Capital

374 Forms SB-1 & SB-2 Forums for emerging growth companies Fragmented market Friends and family Full disclosure Funding, by industry Funding, type SBIC Future value interest factor Future value interest factor for an annuity FVIF FVIFA General Electric mini-case Going private Governance mechanisms Government grants or loans Granting credit to customers Growth potential Growth rate, calculation of Growth, product life cycle Guidance for angel investors Guidelines for direct public offering Hambrecht & Quist Hire, fire, investor right to decide Home equity loans Impoundment of proceeds Impoundment, proceeds for merit review Indications of interest in public offering Industry preference, angels Industry preferences, SBIC / Venture capital Industry ROA Inelastic price Inelastic price Information about the company Initial financing, SBIC Initial public offering Initial public offering, exit Insider transactions Institutional investors, criteria Institutional investors, purchase of shares Intellectual property, valuation Intellectual reward, angel Interest, bond, estimating required Internal sources of cash International Trade Loan Internet, use in small public offering Introduction, product life cycle Inventory Inventory turnover Inventory, techniques for reducing Investible deal Investment agreement, issues Investment agreement, legal fees Investment agreement, model Investment bank fees Investment banks Investment banks, list of top Investment banks, underwriting Investment by SBIC type Investment criteria, angels Investment criteria, venture capital Investment, stage of

269-270 125-127 117 20 216 290 289 Appdx A Appdx B Appdx A Appdx B 327-331 262 120 363 312-313 117 172 97 126-127 276-277 274-275 191 25-27 234 272 253 121 -122 290 306-308 96-97 97 118 288 241-262 152 233 18 253 176 121 178 305-317 65 278 97 313-316 313-314 315-316 119-120 187-192 165 165 255-257 245-247 256 246-247 291 114-122 144 179

Investment, threshold conditions Investments, staging of Investor control mechanisms Investor matching services Investor, accredited Investor, equity required Investor, landing the Investor, preferred equity required Investors, institutional, criteria IPO decision IPO exit likelihood IPO road show IPO road show IPO, mechanics of IRS form 4506, tax return copy request Junior liens Junior secured lenders Junk bonds Later stage funding Later stage, defined Lawyer, selecting Leading edge technology Leases Legal fees, investment agreement Letters of credit Levers of control, venture capitalist LIBOR Life cycle, company Line of credit Liquidity premium Listing requirements, stock exchanges Loan covenants, SBA Loan guarantees, SBA Loan mechanics, SBA Loan Programs, SBA Loan underwriting, SBA Loan, application Loan, super priority Loans to officers and affiliates Loans to officers and affiliates, merit review Loans, bridge Loans, mezzanine Loans, syndicated Loans, term Lock-up London Interbank Offer Rate Low Documentation loans LowDoc loans Management team Management, proven Management, quality of Management, work ethic of Market acceptance, proof of Market assessment Market dominance, no Market fragmented Market maker Market makers Market size and growth Market size estimates Market value

198 190-191 190-191 128-129 226-227 181 197-211 182-183 18 242-243 154-155 252 254-255 251-254 61 71-73 71-73 338-340 121 9 236 117 28-29 165 35,36 149 70 8 35 169 259-261 61 62 57-61 61-65 58 36, 45 361 -363 233 273 356 357 355-356 34, 35 258-259 70 63 63 107 198-200 10 116 204 94-96 117 117 252 254 205-206 118 166

Index Market, crowded or over funded 203 Market, focus on vs. technology 124 Marketing plan 105-106 Matching services 128-129 Maturity, product life cycle 97 Mechanics of an initial public offering 251 -254 Merit review criteria 233-235 Merit review guidelines, NASAA 272-273 Metrics for billing and collections 308-310 Mezzanine financing 357 Micro loan program 65 Modeling 174-176 Monetary Control Act of 1980 34 Money, customers with 202-203 Monopolistic Competition 96 Moody's investor service 323-324 Mortgage bonds 334 Multiplier method, revenue 168 NASAA 229 NASAA 271-271 NASAA policy guidelines, merit review 272-273 NASDAQ 259-261 Nasdaq 259-261 National Association of Securities Dealers 259-261 National Stock Exchange 259 National Venture Capital Association 164 Network, personal 125 New business schedule 205 New York Stock Exchange 259-261 North American Securities Administrators Assn 229 North American Securities Administrators Assn 271 -273 Note discounters 71-79 Notes, terms 20, 21 NSX 259 Offer price for securities at IPO 247-251 Offer price, final 253 Oligopoly 95 One hour drive, angel criteria 121 Operating lease 28 Operations, venture firms 142-144 Options, granted to underwriter 254 Options, merit review 272 Organization, angel funds 131 Over funded market 203 Ownership maintenance, dilution 189 Pacific Stock Exchange 259 Pain, customers with 202 Partial buyer 185 Participating convertible preferred 179 Participation in sale 184-185 Payables, conserving cash through 317 Payoff analysis 179-183 Payoff at exit 180-181 PCX 259 Pennsylvania Private Investor Group 131-133 Personal credit check 60 Personal credit check of entrepreneur 106 Personal financial statement 60 Per~onal financial statement of entrepreneur 106 Personal guarantees 59 Personal network 125

375 Personal tax returns, copies 61 Philadelphia stock exchange 259-261 PHLX 259-261 PIPE 359-361 Pipeline, sales 118 Pitch 197 Pitch format 208-210 Pitch, detailed 209-210 Pitch, short 208-209 Pitch, style 210 Pitching 197-211 Pitching, informal 197 Plant, property and equipment, cash fiom 316-317 Pooled assets 357-359 Potential growth 117 PPIG 131-133 Pre-emption, Federal 231-232 Pre-emptive rights 189 Preferences, angel 121 -122 Preferred lenders 57 Preferred stock 234 Preferred stock, convertible 177 Premium price 97 Premium, conversion 335 Premium, public company I69 Pre-production sales strategy 204-205 Pre-revenue, company valuation 169-171 Present value 325-326 Present value interest factor 325-326 Present value interest factor Appdx C Present value interest factor for an annuity Appdx D Preservation of states rights 232 Price control, monopoly power 95 Price elasticity 96-97 Price flexibility limited 97 Price flexibility, loss of 95 Pricing securities at IPO 247-251 Prime rate used to estimate bond interest 178 Prime rate used to estimate preferred dividends 178 Private company value 169 Private investment in public entities 359-361 Private Investor Networks 130-133 Private placement exemption, Regulation D 220 Private placement exemption, Sec.J(a)(l I) 220 Private placement exemption, Sec.4(2) 220 Private placement exemption, Sec.4(6) 220 Private placement options, summarized 227-228 Private placement, company information 229 Private placement, documentation for 228 Private placements 217-228 Private placements, regulations governing 220 253 Proceeds of sale, remittance by underwriter Proceeds, amount of and purpose 252 Proceeds, impoundment of 234 Proceeds, impoundment, merit review 272 Proceeds, use of, merit review disclosure 272 Product life cycle 98-99 Product life cycle, manipulation of 98 Product, focus on 124 Profit modeling 102-103 Prohibited purposes, SBA loan 57

376 Promissory Note Promoter equity, merit review Promoter's equity Promotional shares Proprietary technology Pro-rata buyout participation Prorata participation in sale Prospectus effective Prospectus, publish final Prospectus, SEC evaluation of Prospectus, share price range in Public company financial statements Public company premium Public offer decision Public offering, company size Public offering, economic cycles Public offering, mechanics of Public offerings Public offerings vs. private placements Publicly traded companies, registration forms

Purchase with recourse Purchase without recourse Purchases & sales, investor right to approve

Pure competition Pure monopoly Puts Puts as anti-dilution mechanism Puts, bond PVIF PVIFA Raising cash from accounts receivable Recourse, purchase with or without Red Herring Red-line Registration by coordination Registration by notification Registration by qualification Registration for IPO Registration forms, publicly traded company

Registration, bonds Regulation A Regulation D Regulation D Regulation D Regulation D Reliability, banks Repeat sales Retained earnings Return on assets Return, expected by angels Revenue multiplier calculation Revenue multiplier method Revenue, expected value Review Reward Reward Reward, intellectual, angel Risk Risk factors Risk Management Association studies Risk management strategies, bonds

Raising Capital 20,21 273 234 234 201-202 185 185 253 253 253 250-251 40 169 242-243 245 244 251-254 241-262 217-228 220 83 83

191-192 95 95 194 189

335-336 Appdx C Appdx D 310-312 83 252

48,49 235 235 235 252 220

331-333 267-269 218 220 222-228 230

48,49 100, 102 4

306-308 119 168

168 174-175 44,45 7 11 121 7

10, ll 39,40 333-336

Risk vs. reward, venture capital Risk, disclosure of for merit review Risk, minimization of in bonds Risk, reduction of Risk, reduction SBA guarantees RMA financial statement studies Road show Road show, IPO Rule 504 Rule 505 Rule 506 S-1, filing as part of IPO process Sale and lease back Sale of IPO shares to institutional investors

Sale to buy-out specialist, exit Sale to management, exit Sale to private company, exit Sale to public company, exit Sales Sales & purchase, investor right to approve

Sales pipeline Sales strategy, pre-production Sales, as confidence building measure Sarbanes Oxley Sarbanes Oxley SBA SBA certified lenders SBA documentation SBA Express SBA form 912 statement of personal history

SBA lenders finding SBA loan collateral SBA loan eligibility SBA loan mechanics SBA loan programs SBA loan prohibited purposes SBA loan underwriting SBA personal guarantees SBA preferred lenders SBA size criteria SBA website SBIC SBIC finding SBIC funding type SBIC funding, eligibility for SBIC funding, sources of SBIC investment, character of SBIC, information needed SBIC, types of Scalability Scaleable Schedule 13-E Schedule of new business SCOR Form Search for venture capital Seat on board of directors SEC evaluation period SEC website SEC, view on internet to sell stock Sec.3(a)lI Sec.3(a)ll

140 272 322-324 11 55 39,40 252 254-255 223-224 224-225 225-226 252 74-76 253 153 153 153 153

203-206 191-192 118

204-205 203 243 262

55,66 57

59-61 63

60,61 57

58-59 56

57-61 61-65 57 58 59 57

56,57 65

287-300 296-298 289

292-293 293-296 288-299 298-300 291 117 200-201 262 205

228-229 155-158 190 253 40 278 220

221

377

Index Sec.4(2) Sec.4(2) Sec.4(6) Secondary market for bonds Securities Securities laws, state Securities regulation Securities regulation, commercial paper Securities regulation, overview Securities, asset backed Securities, convertible preferred stock Securities, held by venture capitalists Securities, pricing Securitization Security defined Security law liability Security law rational Selecting venture capital firms Self-reliance Selling expenses Senior notes Sensitivity analysis Share price as a function of EBITDA Share price as a function of revenue Share price range in prospectus Share price, limits on Share registration, exit strategy Shares, trading in the secondary market Showcases, company and technology Sinking fund Size criteria, small business Size, transaction Size, transaction Small Business Administration Small Business Investment Company Small business issuer Small public offering, stock distribution Small public offerings Small public offerings, analysis of Social responsibility, factor in direct offering Sources of venture capital SPE Special purpose entity Special purpose vehicle Specialized 7(A) Programs SPV Stage of development Stage of development Stage of development, yield required Stage of investment Staged financing Staging investments Start-up, defined State registration, attempts to simplify State regulation State regulation State securities law strategy State securities laws Statement of personal history, SBA form 912 States rights under Federal pre-emption Statistical, credit scoring

220 221-222 220 340 177-179 231 215-236 345-346 219 357-359 177 147-148 247-251 357-359 216 216-217 216 156-157 17 234 334 104-105 249-251 248-249 250-251 234 184 253 127-128 337-338 56, 57 7 12 55, 66 287-300 269 274-282 267-282 270 276 142 357-359 357-359 357-359 62-65 357-359 7 8, 9 179 179 149 190-191 9 235 233-236 271 -273 235-236 231 60, 61 232 38, 39

Stock Stock distribution, small offering comparison Stock distribution, small public offering Stock exchange fees Stock exchange, listing Stock price as a function of EBITDA Stock price as a function of revenue Stock price at IPO Stock price range in prospectus Stock purchase agreement Stock purchase agreement, issues Stock purchase agreement, model Stock, common Strategy, investor right to approve Structure, venture firm Structuring the deal Subordinated debentures Super priority loan Supply and demand, effect on stock price Sustainable competitive advantage Syndicated loans Tangible net worth Target assets Target price per share Target price per share as a function of EBITDA Target price per share based on revenue Tax return copies Tax returns of entrepreneur Team building, angel Technology showcases Technology, focus on vs. market Technology, proprietary Term loans Term sheet Term sheet Threshold conditions for investment Time to close deal Time to exit Time to exit Tranche B lenders Transaction size Transaction, size Trust indenture act U-7 Underwriter, remit proceeds of sale Underwriter's duty Underwriter's options Underwriting & selling expense, merit review Underwriting criteria bank Underwriting fees, disclosure Underwriting fees, junk bonds Underwriting securities Underwriting, bank loan Underwriting, comparative data Underwriting, financial Unsound financial condition, merit review Use of proceeds Valuation Valuation, EBITDA multiplier method Valuation. intellectual vrovertv Valuation, modeling

22 281-282 274-282 259, 261 259-261 249-251 248-249 247-251 250-251 229 187-192 165 177 191 142-144 163-192 334 361 -363 248 119 355-356 42 306-308 252 250-251 248-249 61 106 123-124 128 124 201-202 34, 35 164 210-211 198 206-207 7 12 71-73 12 7 332-333 228-229 253 257 254 273 37, 38 256-257 339-340 246-247 37, 45 39, 40 39, 45 272 90-91 150-152 166 176 174-176

378 Valuation, similar companies Valuation, times when necessary Valuations, realistic Value EBITDA method Value revenue method Value, pre-investment Valuing the company Vendors and suppliers Venture Capital Venture Capital Association, National Venture capital levers of control Venture capital search Venture capital securities Venture capital staged financing Venture capital, cost in control Venture capital, cost in money Venture capital, costs of Venture capital, exit preference Venture capital, exit strategies Venture capital, failure to meet objectives Venture Capital, financial intermediary Venture capital, sources of Venture Capital, unique role Venture capital, who needs Venture capitalist risk Venture capitalist what they can bring Venture capitalist, selecting Venture exits via IPO Venture fairs Venture firm deal size Venture firm operations Venture firm structure Venture firm, contacting Venture, investment criteria Voting rights, unequal Waiver of Default Warrants, merit review Without recourse Work ethic of management Working capital Workout Department Yield, required at stage of development Yield, required on a bond

Raising Capital 171-174 150-152 120 167 168-169 171-173 165-176 27 139-158 164 149 155-158 147-148 149 148-150 146-147 145-150 152-155 152-155 150 139 142 139 141 140 156 156-157 154-155 127-128 142 142-144 142-144 157-158 144 234 46 272 83 116 41 46 179 327