AN INTRODUCTION TO THE CDVC APPROACH

Transcription

1 AN INTRODUCTION TO THE CDVC APPROACH A WORKSHOP PRESENTED BY THE COMMUNITY DEVELOPMENT VENTURE CAPITAL ALLIANCE 12 March 2014 Washington, D.C. 1

2 Christopher Reim Managing Director, CDVCA Managing General Partner, Innovate NY Fund, LP Tanmay Bhargava Associate, Investments and Fund Programs, CDVCA NEGOTIATING AND STRUCTURING VENTURE CAPITAL INVESTMENTS 2

3 SESSION GOALS 1. Discuss various types of venture capital investments 2. Clarify distinctions between debt and equity securities 3. Introduce key investment terminology 4. Briefly describe a range of debt, equity and near-equity investment structures 3

4 A GREAT TRAINING TOOL APPROPRIATE FOR STAFF, BOARD MEMBERS, STATE AND LOCAL ECONOMIC DEVELOPMENT OFFICERS, LENDERS, AND COMMUNITY LEADERS. 4

5 Positive Cash Flow Negative FINANCING BUSINESS GROWTH Startup Early Stage Time Expansion Stage Growth Stage 5

6 TYPES OF VENTURE CAPITAL INVESTMENTS Debt Senior debt Subordinated debt Subordinated debt with warrants Convertible debt The Capital Stack Increasing Asset Security, Focus on Repayment Wages / Payables Senior Debt Subordinated Debt Preferred Equity Common Equity Equity Preferred stock Series A, B, C.. Convertible preferred stock Common stock Increasing Risk, Focus on Business Growth Higher Expected Return 6

7 DEBT VS. EQUITY Debt Capital supplied in form of loan (a claim against company assets) Fixed time period, interest rate and fees Investor focus on predictability of repayment through cash flows (debt service) Borrowers pledge assets as collateral in the event cash flow is insufficient to retire debt Lender more interested in repayment than in business growth 7

8 DEBT VS. EQUITY DEBT VS. EQUITY Equity Capital is supplied as investment in exchange for ownership in the company Returns are derived from profit growth and increased value of company, which translates into higher equity value to investor Investors seek to exit investments by selling their equity at a higher value Maximize potential return 8

9 RISK/RETURN TRADEOFF Venture Capital Public Equities Unsecured Debt Secured Debt Gov t Debt 9

10 INVESTMENT DECISION PROCESS FOR DEBT Credit analysis determination of ability to pay Historical and future cash flow Collateral value 10

11 INVESTMENT DECISION PROCESS FOR EQUITY Valuation: what is the business worth? Future potential/growth Types of Risks: technology, market, execution Management 11

12 RETURN ON INVESTMENT Debt Limited, even if company performs well Equity Depends on company performance Potentially high Can be zero 12

13 COST OF CAPITAL Debt Lower than equity Effected by various factors Equity Senior vs. subordinated Secured vs. unsecured Guaranteed vs. not guaranteed Fixed vs. variable Higher than debt Loss of ownership and potentially control 13

14 RELATIONSHIP WITH MANAGEMENT/OWNER Debt Minimal Review of financial statements Compliance with loan covenants Lender liability issues Equity Significant Board seat Involvement in day to day business operations Investor brings more than money to the table 14

15 REPAYMENT OR EXIT Debt Repayment of debt from cash flow Senior vs Sub Refinancing Equity Sale to strategic or financial buyer Sale to management/owners Initial public offering Put or repurchase option 15

16 TYPES OF NEAR EQUITY INVESTMENTS Debt with Warrants: Fixed income plus a right to buy into upside Convertible Debt: Right (or requirement) to exchange fixed debt for equity Debt with Royalty Fixed income with return enhancement from a share of the sales or profits 16

17 DEBT WITH WARRANTS A loan with the option to purchase equity at a pre-negotiated price Principal repayment plus interest and warrant for additional return Warrant is the governing document Spells out the terms and conditions governing stock purchase Governs the process of exercising and registering the warrants Identifies the restriction and notification requirements of both the investor and the company 17

18 KEY TERMS IN A WARRANT Exercise price Exercise period Number of shares Triggering events Legal protections Cash or Cashless exercise 18

19 ADVANTAGES OF DEBT WITH WARRANTS To the Investor Low-cost access to upside with security of debt Current income from debt component Put agreement provides method for liquidity To the Company Minimizes dilution of ownership Lowers interest rate due to equity kicker No impact on cash flow which can fuel future growth Exercise of warrants can provide additional cash Interest expense is tax deductible 19

20 CONVERTIBLE DEBT A loan that is convertible into preferred or common equity Principal repayment with interest or ability to convert into equity Loan Agreement/Securities Purchase Agreement is governing document Spells out terms and conditions governing both the loan and its conversion to equity Details the rights, restrictions and notification requirements of both the investor and the company 20

21 KEY TERMS: LOAN/SECURITIES PURCHASE AGREEMENT Conversion period Conversion price Conversion of the security interest Common or preferred stock Triggering events Put option Legal protections Adjustments Performance Anti-dilution 21

22 ADVANTAGES OF CONVERTIBLE DEBT To the Investor Potentially lower initial risk profile relative to equityonly investment Gives the investor time to decide whether to convert To the Company Does not require valuation exercise. Therefore, useful in Seed stage Quicker and less expensive than equity investment May have to give up less ownership and control May be able to force conversion to avoid repayment 22

23 DEBT WITH ROYALTY PARTICIPATION A loan with the right to a percentage of company sales or profits Principal repayment with interest and royalty payments for additional return Participation Agreement is governing document Defines whether royalty amount is based on profits or revenues States whether royalty is tied to the total amount or to incremental growth in profits and revenues References due dates for sales or profit statements, as well as royalty payments 23

24 ADVANTAGES OF DEBT WITH ROYALTY STRUCTURE To the Investor Debt protections to mitigate risk Exit predetermined Income from interest and royalty payments To the Company No equity dilution Tax deductible interest and royalty payments To Both Does not require valuation exercise Debt-like structure easier to understand 24

25 TYPES OF EQUITY INVESTMENTS Preferred Stock Superior position to founders equity Convertible Preferred Stock Transition equity position Common Stock The primary form of equity interest 25

26 KEY TERMS: PREFERRED STOCK Dividends Liquidation preference Voting provisions Board seat Redemption/put and call Adjustments Performance Anti-dilution 26

27 DIVIDENDS The preferred return: Mandatory vs. as declared Cumulative vs. non-cumulative Return Rate and timing The company would only offer dividends if it is reliably cash-flowing 27

28 LIQUIDATION PREFERENCE Ranks ahead of common stock Sale of company is a liquidation In the event of bankruptcy, a senior claim after debt is satisfied Receives a minimum multiple of the preferred stock value in the event of a sale 28

29 VOTING Right to elect director(s) Limits ability to change corporate documents without approval Control provisions Sale of company or assets Budgetary Change in senior management Changes in compensation 29

30 REDEMPTION/PUT AND CALL Investors have liquidity if no sale arises Investor can force a company to repurchase its shares Price and timing conditions Provisions in the event of default 30

31 ANTI-DILUTION Price dilution vs. Percent dilution Protect the investor from down rounds of financing at a price lower than they paid best price available guarantee Anti-Dilution can cause a pricing death spiral Future equity or equity-like issuances Weighted average vs. Ratchet Pay to play provisions A Conditional Protection: only investors that participate in the dilutive financing are entitled to the benefit of the anti-dilution formula in effect 31

32 ADVANTAGES OF PREFERRED EQUITY To the Investor If regularly paid, dividends provide current income In liquidation event, preferred has preference over common shareholders Redemption feature may provide viable exit Conversion to common stock allows participation in upside To the Company Equity shores up balance sheet allowing greater leverage of debt Protective features of preferred may permit concession by investor on level of equity ownership Investor devotes time and expertise to help management build value 32

33 KEY TERMS: COMMON STOCK Percentage ownership of business Voting provisions Board seat Redemption/put and call Adjustments Performance Anti-dilution Other Investor rights 33

34 EQUITY INVESTOR RIGHTS Co-investment (if invested as an LP in a fund) Drag-along Right (protection for majority owner) Tag-along Right (protection for majority owner) Registration Rights (transferability, public trading) 34

35 ASSESSING BUSINESS RISK Management risk Market risk Technology risk Production risk Financial risk Exit risk Policy risk (regulation) 35

36 METHODS OF VALUATION Comparable public company multiples Comparable M&A multiples Discounted Cash Flow Replacement Value Weighted Average of different methods Multiples Sales Earnings (EBITDA, EBIT, Net Income) Industry rules of thumb multiples 36

37 BUSINESS VALUATION CONSIDERATIONS What is the value of the intellectual property, patent, customer base, etc.? What is the size of the market and what percentage can the company capture? What is the upside opportunity and on what is it based? What other intangible asset values does the company have? Are there any government or tax incentives? 37

38 MECHANICS OF INVESTING Identify the company and their need Perform preliminary due diligence Determine preliminary structure Propose and negotiate terms and conditions Perform additional due diligence Document and fund the investment Manage the investment Exit the investment 38

39 COMMUNITY DEVELOPMENT IMPACT Venture capital investing offers an opportunity to have a positive impact on community development issues Job creation Quality jobs Local revitalization Capacity-building for Low-income communities 39

40 ELEMENTS OF SUCCESSFUL TRANSACTIONS Successful deal structuring involves balancing returns social and financial with the risk presented by a company and a particular investment A well-structured and documented deal affords the investor legal protection and is a critical step in the investment process There is no substitute for a good screening process (criteria), a complete and thoughtful due diligence review Post investment value creation, monitoring and mentoring program that tracks operating and financial performance is critical to a successful exit 40

41 Questions For more information, contact us at: 41