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

Transcription

1 RAISING CAPITAL

2 RAISING CAPITAL by DAVID E. VANCE Rutgers University School of Business, Camden, NJ, USA

3 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: X e-isbn-10: Printed on acidfree paper. ISBN-13: e-isbn-13: 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 SPIN springeronline.com

4 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 1 1 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

5 vi Chapter 4 SMALL BUSINESS ADMINISTRATION Contents Introduction 5 5 Overview 55 Eligibility 56 Mechanics 57 Underwriting 5 8 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 What is an Angel Investor? 1 11 Angels Go Where Others Fear to Tread 112 What is the Profile of an Angel? 113

6 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? 14 1 Scope of Venture Capital Investments 14 1 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 17 1 Modeling 174 Intellectual Property 176 Securities 177 Payoff Analysis 179 Exit Provisions 183 Other Investment Agreement Issues 187

7 ... 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

8 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

9 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 Future Value Interest Factor 365 Appendix B Future Value Interest Factor for an Annuity 366 Appendix C Present Value Interest Factor 367 Appendix D Present Value Interest Factor for an Annuity 368 Appendix E CD Table of Contents 369 Index 371

10 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.

11 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

12 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.

13 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.

14 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.