ENTREPRENEURIAL FINANCE OUTLINE II FALL 1998 SMITH/SCOTT I. Sum of First Part of Course -orientation to different entrep styles & business 1. different patterns - Clay Walker (Emerald Planet), Jack Bloom (Auto America), Walt Minnick (Project Greenscape), Dave Phillips (CCC Info Systems), Ken Langone (Home Depot) 2. different types of entrep in different areas 3. don’t start sm business to keep sm 4. any busiuness can be a gazelle -opportunity recognition 1. mgt team - most important factor 2. mrkts & #s 3. risks 4. most will miss -business plans 1. place to start 2. move on if not good opportunity -financing sm co. 1. sources of money - gorillas, angels, VC 2. terms & conditions a. required rates of return most important b. dependent on valuations - VC method 3. continuing need for money II. Financing a. sm business loans from banks - Brian Evans (Chase Bank) -lending to sm co. 1. goal a. return amt loaned plus interest rate w/some protection b. retain customer as client - as deposit source 2. loan criteria a. co. generally 1. existing 2. already have other financing hopefully another sophisticated lender - bank wants only to be supplemtl capital source 3. operations of real co. - accounting, legal services b. mgt quality very important - experience, resources, role in co., enthusiasm, credit history, etc. c. protection for bank 1. co. a. steady growth of sales b. cash is king - good cash flow, more than sufficient to support debt c. profitability - net income d. assets - fixed assets, A/R, inventory - quality, less concentration the better e. equity in co. $ for $ 2. personal guarantee - assets not that useful b/c owner can overleverage himself leaving bank w/nothing even though personal guarantee given 3. US SBA - guarantee of paymt on some % of loan max of $750k, graduated fee 3. speaker’s dept a. clients - sm & middle mrkt co. (sales up to $5m & $10m) 1. increase chances of getting loan also include: a. establishing relationship w/bank - have account there, invite over to business b. have professional referral like from CPA
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b. loan 1. size - $500k to few million 2. system - working towards automated system to approve loans for $50k to $150k - save transaction costs c. rejection rate - 50% of 20-23k loan applications this yr b. credit analysis & financing terms in sm firms -Zeus Steel bank loan example - wants to increase bank credit line to $750k & borrow additional $200k for acquisition 1. analysis a. initially 1. determine what co. does a. buys secondary steel at discount & selling full price to those not well serviced 2. determine what is going on in case by looking at #s a. buying more inventory & financing A/R w/A/P & sales of PPE b. method 1 look at current assets to current liabilities 2. look at quality & turnover for A/R, A/P, inventory b. determine how much cash available to service debt 1. look at cash flow - EBITDA 2. potential sales changes a. industry changes - cyclical, etc. b. over concentration of clients whose needs may be cyclical 2. conclusion a. growing co. is going to have problems 1. story - owner is trying to grow via expanding customer base into more marginal buyers, buying substantial inventory & taking on substantial price risk a. more inventory - greater price risk (can go up he’s in good shape, can go down he’s in bad shape) 2. unilaterally made more risky for lender by tying up cash flow in illiquid assets a. credit risk - might go bankrupt & not able to pay, may not be able to retain security interest in assets b/c have to perfect, etc. b. mrkt risk - price fluctuation, demand cyclical 3. therefore necessary to change terms & conditions of loan b. not too boring to be interesting c. lending case - Iris Newman (Veritas Medical) -lessons learned from starting this co. 1. keep faith & try 2. don’t assume 3. keep focus 4. have contingency plan -co. in this case 1. 2 functions of co. a. application system for doctors 1. clients - systems like HMO, hospitals, independent doctors 2. format - pay upfront & deduct amt for each application printed b. verification system - required ever 2 yrs 1. not much into it b/c not as cost effective for them b/c lots of big players 2. funding a. self $250k b. state loan $50k - require 2/3 times back 3. profitability a. mrkt - 600k doctors, 200k other health care service providers nationwide 1. want to focus on East coast 2. need 5-6k doctors in system to be successful, currently max of 1,500 3. not many competitors in application side
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b. mrktg - by self & word of mouth 1. helped that won awards 4. on-going strategy a. focus on application side & just increasing sales b. consider taking on strategic partner (pharmaceutical) 5. problems a. things don’t always go as planned 1. mrkt timing b. things always take longer than anticipated 1. health care industry folks take a long time to decide 2. getting dr. info takes a long time c. difficult to work w/others as entrep 1. have to find right people to work for co. 2. dr. are computer illiterate d. lots of distractions -WIN - Philadelphia organization where females get together to discuss financing difficulties d. new approaches to lending - David Reesha (Sirrom Capital Corp.) -co. 1. business a. provide mezzanine financing (sub debt) usually less than $5m to private sm co. 1. sm co. - revenues $5-50m, less than 200 e-es a. co. growing 20-25% so able to pay off quickly so co. can go after more loans for more warrants mostly service co. (bad b/c no hard assets as collateral) 1. favorable industry b. co. mgt - tied equity in co. c. co. earnings - strong cash flow, collateral margin of 20-25%, more variable costs d. co. financing - w/out sr debt e. viable exit - refinance, sale, IPO 2. sub secured loans - $1-5m secured by tangible & intangible assets w/warrants 3. return - focus on equity upside a. 2-3% processing fee - to cover operating expenses b. 13-14% interest rate on loan c. aim for 20-25% IRR 1. return on equity covers losses of failed or not as successful equity investmts 2. 6% btwn costs of lending & amt making b. mrkt - lg & fragmted, underserved by traditional lenders c. current portfolio - $350m invested for ave loans of 2.5yrs, $2.5m w/$91m value of warrants 1. industry diversification - 7-8% max concentration (in media) 2. geo diversification - 10-12% max concentration (Atlanta) 2. structure a. business developmt co. - Investmt Co. Act 1940 - have to mrk assets to mrkt quarterly, reserve against each asset b. investmt co. - IRC - not taxed as long as distribute 90% of earnings to shareholders d. financing 1. raised $150m via SBA as SBIC corp w/some restrictions - $101m outstanding @ 7% 2. $25m public $ - then on NASDAQ, now on NYSE total mrkt cap now $200m 3. commercial paper at 8% 3. future strategy a. slower growth & higher quality assets looking more like bank 1. sacrifice greater gains b/c higher risk 2. causes a. issue b/c weak IPO mrkt 1. can’t realize gains on equity side
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2. can’t really go there for financing themselves b. hired to many people 3. reasons not in worse shape a. leverage controlled by statutes b. diversified c. strong operations - referral sources, good deal flow e. LBO’s & entrepreneurial finance - Smith (NYU), Joel Rudenstein (Transportation Displays Incorp.) -2 types of entrep 1. start up co. 2. financial -LBO - financial entrep 1. claim - can use leverage constructively to change lifestyle co. into gazelle a. theories 1. Miller & Modigliani - value of firm is earning potential that is not affected by capital structure except to extent of tax shield value (tax deductible interest paymts) 2. Altman - true value of firm is upward slope line & then downward curve toward end b/c risk of bankruptcy 3. optimal point of leverage - where the line begins to curve down b. increases value of equity going up mountain of debt & then coming back down 1. up - to selling shareholders 2. down - to LBO equity investors c. risks 1. paying too high a premium so insufficient room to change & profit 2. insufficient changes so not enough cash flow to pay off debt in reality only few defaults 2. practice of creating value via leverage a. buy co. under certain formula 1. buying control premium permits change underlying economic structure a. changeable factors - assets, liabilities, capital, cash flow, mgt 1. mgt can change - acquisitions, diversification of business, LBO, stock recapitalization, organizational structure 2. purchase money formula - minimal equity 5-10%, maximize sr bank debt 40%, sub debt 50% 3. debt a. generally - lender secured w/inventory, A/R, business cash flow, personal guarantee b. banks - want senior level & repaymt via asset sales 1. don’t really like LBOs b/c increases risk & lowers credit rating c. sub debt - mezzanine financing btwn ground (equity) & first floor (sr debt) 1. return - gets interest as normal debt but also has equity kicker 2. necessary info - how to value cash flow, how to establish security interest 3. sources - finance co., high risk insurance co., LBO funds, pension/mutual/junk bond funds value is artificially created via tax structure, b. mg co. for cash & not earnings to pay down sr debt first 1. sell of noncore assets & other assets that can be leased back 2. reduce costs - stretch out payables & condense receivables 3. increase sales c. return to normal capital structure 3. Kohlberg Rules - Bootstrapping a. ideal candidate for LBO is stand-alone co. b. optimal capital structure - 10% equity, 90% debt c. sell of unneeded assets d. cash flow should be noncyclical & predictable 1. avoid - high tech, biotech, commodities, airlines e. should have mgt cooperation
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1. they know industry 2. they can more accurately forecast pro formas 3. they know where hidden assets are f. incentivize mgt 1. tying compensation directly to performance/reaching targets 2. force equity investmt into co. g. pre-arrange exit - sell co. or reLBO -Transportation Display Incorp. 1. method of turning co. around - from failed LBO a. regain credibility - lenders, customers, e-es b. sold noncore assets c. increase cash flow - focus on selling, etc. 2. lessons learned a. underpromise & overdeliver b. 24hr communication rule c. reward higher performers d. compare w/competition e. cash is king f. attach to stars g. hire best advisors h. know that restructuring always takes longer than anticipated i. can make lots of $ owning sm part of big success j. bad news can be good news k. enjoy it III. Harvesting the Wealth a. IPO -IPO 1. preferred exit strategy a. most proceeds to issuer b. mrkt for it afterwards - valuation available, liquid c. common stock by corp best received by mkrt - to do IPO don’t have to be equity or corp 2. decisions to be made by entrep group a. whether to go public 1. general considerations a. what mgt goals are b. have to look out for shareholder value as public co. c. potential liabilities under state law of incorp w/higher scrutiny 1. mgt more obligations to shareholders for which personally liable - duty of no conflict of interests, informed, corp opportunity doctrine, fiduciary duty 2. pros of being public co. a. future investors 1. liquidity - easy to enter & exit, investors pay premium for this b. co. 1. cash source - fair value, cheaper than VC, angel b/c investors looking for different than those other parties 2. improves net worth - increases access to other financial sources 3. acquisition currency - ascertainable value so can use stock to make acquisitions 4. e-e compensation or retention via stock options 5. PR/prestige - name recognition can help w/sales or attracting investors 6. more control over assets - dispersed shareholder base 7. comparability - can also be disadvantage 8. estate planning - more important for lg private co. c. private investors/enterp
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1. can cash out to limited extent in IPO by selling secondary shares - investmt bank & mrkt doesn’t like to see complete cashing out a. demand rights - they can force registration statemt to be filed b. piggyback rights - can register their shares to co. share registration, may take a little longer 2. becomes part of net worth one can leverage 3. cons of being public co. a. co. 1. may be pushed prematurely - stock price will get slammed, more susceptible to liabilities b/c no internal legal infrastructure biggest disadvantage 2. expensive process - 7% investmt banker fee, legal fees, accounting fees, printing, mgt time $600k w/out banker spread 3. constraints of mgt of co. b/c short-term orientation of mrkt 4. misinfo from mrkt - mrkt doesn’t always read situation correctly 5. disclosure of info may hurt competitive edge 6. increased liability exposure 7. increased potential for takeover 8. additional costs after - continual filings, services of accountants & legal advice - amt to few $100k/yr 9. additional time after - mgt dealing w/shareholders, analysts, regulators b. when to go public 3. process of going public a. make decision to go public b. find underwriter - not that easy b/c some co. more attractive to banks, usually via investor relationship c. clean up co. - K, capital structure, board, disclose relationships w/affiliates 1. complexity will require discount in stock price 2. required by investmt bank b/c liable d. write prospectus - narrative, financials 1. required in order to sell shares 2. potential liability under §11 if not complete or misleading - joint & severally for directors, officers, underwriters, experts, accountants e. registration statemt - usually by issuer’s outside counsel 1. §11 liability for material misleading statemts or omission a. issuer - strict liability b. directors, officers, underwriters, accounting experts - have due diligence defense of having reasonably investigated c. damage amt - amt of $ lost (stock price decline), punitive damages if gross misconduct f. on-going filings - annl audited & MDNA 10K, 10Q, 8K, proxy statemts - Reg. S-K 1. more MDNA required 2. Rule 10b-5 liability for material misstatemt or omission of any public statemt a. duty to correct no longer accurate info b. requires recklessness or intent (also criminal liability) main source of liability once public 3. Rule 10b-5 insider trading rule - trading while in possession of undisclosed info a. short swing profits - trades w/in 6mos. of disclosure have to disgorge profits & other potential liabilities b. IPO experience - John Bailye (Dendrite) -co. 1. business a. software w/support services to improve sales performance of sales rep of pharmaceuticals b. mrkt - $3b in sales, growing 30%/yr c. current #s - current mrkt cap $600m, trading at P/E 50, sales $110m, growth 30%/yr, almost 1k e-es, 17 countries great business plan - rich clients in natural growth industry
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2. financing sources a. partner1 w/Australian corp conglomerate fell apart - sold too much equity 30% for debt mistake! b. partner2 w/US VC - toubht them a lot about mrkt, accounting, etc. great! 1. hired sm merchant bank mistake b/c should’ve hired lg merchant bank 2. interviewed as many as can 3. factors considered - long term fund, active participant, same state, previous successful IPO, handle greatly bad investmts 3. IPO process - out at $7, 70% institutional investors a. decision to go public - permits growth but not exit strategy for entrep 1. success requires top & bottom line predictability w/in $100k for 16 successive quarters 2. picked investmt bank - researched banks & support services a. important to pick more than 1 to keep abreast of mrkt & keep mrkt informed about you via analysts challenge to give them enough info but not so much to make them insider 3. have to give up 1yr of life a. hire banks, accountant, law firm b. write prospectus c. road show for 2wks b. decision when to go public 1. when IPO mrkt open & when something big on horizon 2. when can bear costs - $1m 4. maintaining successful public co. a. brought in CFO & professional finance team b. danger of missing #s for quarter 1. being slammed in stock price can lead to shareholder derivative suits (didn’t have in this case fortunately) 2. flat spin - sales prospects freak out can lead to missing another quarter #s (didn’t happen b/c shared their plans w/them) c. know when to split stock - otherwise public float too sm where institutional investor can screw up price w/1 transaction, also sign of doing well -lessons learned 1. successful financing a. venture/private equity - very important for start-ups w/out access to other capital b/c w/out wouldn’t be able to develop/grow b. taking on partner - $ is less valuable thing they can give you c. requires entre & financer to have same goal 2. awards won - important for rep 3. now a. when right time for entrep to exit mging lg public co. - entrep good at leading & focusing but bad e-e b. keeping mgt incentivized to continue working hard when so much paper wealth c. IPO analysis -comparison btwn Dave Phillips (CCCIS) & John Bailye (Dendrite Corp) 1. similarities - general factors 2. differences a. VC ownership (used preferred stock converted to common stock) - David 75%, John 61% a. decision to go public - Dave forced by shareholders, John wanted to go public b. time went public - David was negative $51m over last 5yrs, John was positive $25m c. use of funds - David to repay debt, John didn’t really need $ but good to have access e. % shares sold by shareholders/investors - John higher at 40% d. current #s - David IPO size twice as big as John’s but now John’s mrkt cap twice as big as David’s, David less than 6% ownership, John 19% ownership -entrep getting money out 1. real exit - when turn stock into cash 2. benefits of IPO
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a. can liquidate some stock limited to certain restrictions by investmt banks & law 1. Rule 144 - restricts insiders from selling, can only sell in sm amts & have to report 2. Rule 144A - private placemt limited to big players, restricted in resale b. puts valuation on stock - important for getting investors who are mostly OPM (people managing other people’s money) c. lead to growth in value via increase in stock price -successful IPO 1. factors investors are considering when deciding whether to buy stock a. co. w/strong earning power most important thing 1. not looking just at sales b/c in growth period sales increase not commensurate w/profit increase b/c of mistakes & investmts in future b. customer base & what customers of co. think of co. & its product c. big enough offering to create min public float of $35m for liquidity here even though equity is most expensive form of financing & didn’t really need money (look at use of proceeds) but probably good as reserve for future & creation of public mrkt for stock (liquidity, sufficient public float, valuation) 2. info investmt bankers are looking for a. info found in prospectus 1. cover page - risk factors, other key elemts of issue 2. financials d. refinancings, mezzanine finance & LBOs -mezzanine financing 1. study of computer IPOs - 50% of co. were 45% owned by VC a. ave. length investmt - 2yrs making them private equity & not traditional VC 1. private equity - bridge financing before IPO & not in start-up phase b. returns - 150%, 35% average on portfolio meaning 1/3 of investmts are good, 2/3 not great 1. insufficient return adjusted for risk (illiquid, sm cap, fragile co.) when for period 1992-1996 S&P 500 return was at least 24% c. why so these funds still have lots of $? 1. expecting higher return in longrun 2. big investors looking alternative investmts -LBO 1. LBOs a. description - going private by buying equity for debt b. purpose 1. use opportunity to change shareholders 2. creating value going in different directions - up the mountain of debt & down the mountain of debt c. flaw 1. can over squeeze cash & not reinvest sufficiently to keep co. growing & healthy 2. Playtex Co. example a. history - 1974 acquired by Millo, 1984 parent co. of Millo bought by Beatrice, Beatrice bought by KKR who sold off pieces, 1988 LBO to individual, 2 more LBO’s w/in 1yr b. LBO1 - seller carried interest 20%, bank, institutional investors, individual & mgt the rest 1. sold off some assets 2. managed co. for cash c. LBO2 - changed investors - financial investors exit & operators took over d. LBO3 - mgrs took back e. selling out - sm company & M&A mrkt -French Fry case 1. business - sold french fries exclusively to McDonalds West Coast branches 2. case - about mgt looking for exit for unsuccessful LBO a. unsuccessful LBO b/c investor paid $32m ($24m debt, $2.6m equity) 5yrs ago but over yrs added more equity w/trivial reduction in debt
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1. sales went up w/minimal increase in cash flow a. justification - better yr next yr b/c McDonalds will have big yr & poor previous yrs b/c required high expenses in preparation questionable 2. didn’t squeeze enough cash at end of day & needed more financing left w/co. w/lg equity & big debt a. paid too high a premium - not enough to cut out b. was inefficient about it 3. concerns of buyers a. have too many areas been cut to keep business going successfully 1. have they sold off core assets 2. have they failed to invest in PPE & R&D find out via due diligence b. mgt of co. - same pre-LBO mgt 4. reasons to buy a. potential incremental value due to synergies even if all control premium has been exhausted 1. control premium - value over fair value of co. that permits buyer to make any changes -selling co. 1. reasons to sell a. achieve exit at significant profit b. take advantage of mrkt conditions when favorable 1. stock mrkt a. ie, Gibson Greeting Cards bought by notable figures did IPO after less than yr of holding w/out making any changes (intent to sell to someone else) but made lots of $ 1. best when high return over short time w/out doing anything b. here 1986 good time b/c public mrkt didn’t crash until 1987 c. reasons not to do IPO 1. mgt may not be able to get out fully even if they want to 2. converting from illiquid LBO to limited liquid stock 2. interest rate change a. value of co. (stock prices) goes up a lot if own lots of debt & interest rates go down b. here interest rates are down so should want out now c. get out of potential bad investmt riskiest - $ in overleverage, illiquid, concentrated, fragile co. d. prevent mgt/ownership conflict - most relevant for family owned business 1. 27k mergers in last yr w/public info & 27k mergers of private co. which are mostly family owned businesses in next second generation 2. usual sell out reasons - tax advantages, prevent fighting, realize gains not that don’t have enough people to run it but problem of some wanting to get out 2. representation by investmt bank a. banks mostly represent seller rather than buyers b/c only get fee if deal gets done & sellers most likely to sell than buyers buy b. reasons for necessity of bank representation 1. expert on establishing values - big range & have walk away price a. hedge price quote - mrkt could change tomorrow, depend on due diligence, which price is absolute lowest (consider sell another time or why think too low) 2. can negotiate effectively w/other party & protect client via reps & warranties 3. can put together list of potential buyers from their clients, etc. c. terms of representation 1. want exclusive sales K 2. retainer & fee specified - should ask how long retainer (applied to total fee) is going to last - usually 2yrs 3. representation by lawyers you need to identify legal issues to know when to contact lawyers a. times when representation necessary b/c liability may be present
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1. process of engaging in merger a. mgt liability under corp law for adequate care & good faith (no conflict of interest) - best price, fair price 2. structure of transaction - so business & legal issue a. K liabilities arising under corp law b. K liabilities arising under regulatory law - succession to target’s liabilities & assets, rights 3. merger agreemt a. reps & warranties - diligence tool to find out more info about the other party, issue usually is whether they survive closing but can K for it 4. disclosures & filings of merger may be required a. insider trading liability if public co. -sum 1. characteristics of each exit not necessarily interchangeable a. mergers provide real $ f. course review -review of course 1. debt part a. start ups - restricted availability 1. against collateral - liquid assets or mrktable securities 2. guarantees - can be onerous if lender thinks you are worth something even if not too relevant in determining credit worthiness b. provided mostly by finance co. c. examples 1. Auto America - finance co. 2. potted plant - borrowed at 13% (prime + 5%), also can give tax benefit 3. Sirrom - finance co. to sm co. also 5% over prime a. sm co. loans $1-5m w/equity kickers (warrants) - wanted short turn around bridge financing b. didn’t require much mrktg b/c already savvy VC & enterp c. problem - missed quarter b/c warrant pool devalued & 2 larger loans in trouble & didn’t have reserve b/c using warrant pool as reserve (unrealized, high leverage pushing it using this as cushion) 2. opportunities exist when they don’t look like opportunities 3. restructuring a. execution is difficulty & not opportunity recognition 1. activity - through leveraging up, can change lots of different factors if have power & change profitability of co. 2. essential factors a. legal & financial techniques & people are essential b. operators are essential c. wealth creation from lots of different sources - buy cheap, generate value, restructure to create value -big picture 1. wealth can be created from many different sources but dependent on individual a. eclectic batch of entrep b. start-ups - everything can be start up when something new is started 1. need good business plan - hopefully that has been tested 2. be cognizant of difficulties of getting financing - b/c no track record c. opportunity recognition - depends on perception track things to test ability d. flexibility & adaptability most important - already have this advantage by being sm e. wealth can be created up & down the risk curve f. don’t be overconfident unless can create wealth in bear mrkt -exam
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1. 2. 3.
multiple choice questions w/short answer option - 60% 2 essay questions - 40% weight btwn midterm & final - better one to be weighted 60% of grade
THE END!!!!
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