DOING DEALS ANDE ORIENTATION TRAINING

DOING DEALS ANDE ORIENTATION TRAINING Bob Webster Chief Operating Officer and Investment Advisor Grassroots Business Fund June 3, 2013 www.gbfund.org

Course Objective Provide basic understanding of principles of doing impact investing deals Target Audience Recent impact investment fund hires Foundation, government or donor staff needing better understanding Anyone else sharing the above objective! Financial Instrument Focus Mezzanine Debt What Course Will NOT Do! Make someone an investment officer! Doing Deals Course Objective

Please participate! Let others participate Be patient with me Be quick on forming break-out groups Cell phones off! Doing Deals Rules of the Pool

Due Diligence Private Equity? IRR? Working Capital Social Return? Quasi- Equity? Social Investing? Blocking Rights? Convertible Debt? Doing Deals What s It All Mean?

Part I: Part II: Part III: Part IV: Part IVa: Part V: Doing Deals An Overview Finding and Screening Leads Due Diligence Structuring and Valuing Deals Lending Quick-View Adding Value Doing Deals The Agenda

DOING DEALS ANDE ORIENTATION TRAINING Part 1: Doing Deals An Overview

Impact Investing What is it? Impact investments are those that seek not only financial returns to investors but socio-economic returns to a low income community, all in a sustainable manner Investors Donors $ $ Fund Enterprise 7 7

Common Impact Investment Fund Structure Lender? Donor? Other? Capital $ $ Distributions/payments Fund management Doing deals Monitoring investments Exits Reporting Capital NGO $ $ Dividends, interest, fees, sale proceeds Ownership % Investee Investee Investee Investee 8 8

Conventional Private Equity Fund Structure Fund Manager (GP Investor) Fund management Doing deals Monitoring investments Exits Reporting $ $ LP Investor Capital Capital LP Investor $ $ Ownership % Private Equity Fund Limited Partnership $ $ LP Investor Distributions Pension funds Insurance companies High net worth folks Fund-of-funds Int l financial institutions Donors/foundations Dividends, interest, fees, sale proceeds Ownership % Investee Investee Investee Investee 9 9

Investment Fund Life Cycle Exiting investments Adding value (pre & post investment) Investment period O 1 2 3 4 5 6 7 8 9 10 Fund launched Years Fund closed 10

Formal Fund or Not-for-Profit Does it matter? Pros and Cons of Each? 11 11

Impact Investing Spectrum Conventional Investing Double Bottom-line Investing Triple Bottom-line Investing Financial returns Financial returns Financial returns Typical PE/VC Job creation SEAF Root Capital Job creation Social/environment al returns Acumen Fund E+Co 12 12

Impact Investing Spectrum Conventional Investing Double Bottom-line Investing Triple Bottom-line Investing Financial returns Financial returns Financial returns Typical PE/VC Angel investors Job creation SEAF Grofin Fidelity Capital SBA Job creation Social/environmental returns Grassroots Business Fund Root Capital Acumen Fund ResponsAbility 15 15

Types of Enterprise Financing Financing Financing Characteristics Business Characteristics Debt Equity Grants/Gifts No ownership, no upside Fixed payment & term Collateral Limited control Recourse priority Ownership rights Return upside Downside risk Different forms: seed, growth capital, mezzanine No repayment No control Established Predictable cash flow LOWER RISK Start-up Early Stage Growth/Expansion Strategy Financial reengineering Social mission Relationships 16 16

Types of Enterprise Financing Financing Financing Characteristics Business Characteristics Debt Private Equity Grants/Gifts No ownership, no upside Fixed payment & term Collateral Limited control Recourse priority Ownership rights Return upside Downside risk Different forms: seed, growth capital, mezzanine No repayment No control Established Predictable cash flow LOWER RISK Start-up Early Stage Growth/Expansion Strategy Financial reengineering Social mission Relationships 17 17

Types of Enterprise Financing Financing Financing Characteristics Business Characteristics Debt Equity Grants/Gifts No upside Fixed payment & term Collateral Limited control Recourse priority Ownership rights, upside No fixed payment No collateral Limited recourse Different forms: seed, growth capital, mezzanine No repayment No control Established Predictable cash flow LOWER RISK Start-up Early Stage Growth/Expansion Strategy Financial reengineering HIGHER RISK Social mission Relationships 18 18

Types of Enterprise Financing Financing Financing Characteristics Business Characteristics Debt Equity Grants/Gifts No upside Fixed payment & term Collateral Limited control Recourse priority Return upside No fixed payment No collateral Ownership rights Limited recourse No upside No repayment No control, recourse, rights Established Predictable cash flow LOWER RISK Start-up Early Stage Growth/Expansion Strategy Financial reengineering HIGHER RISK Social mission Relationships RISK? 19 19

Required return Risk-return continuum of financial instruments Mezzanine High-yield debt Unsecured debt Secured debt Convertibles Ordinary shares Preference shares Quasi-equity Perceived risk 20

Enterprise Life Cycle More risky Less risky Concept Stage Start-up Early Stage Growth Stage Mature Stage Declining Entrepreneur quietly pursues business idea. Idea pursued rigorously, small team built to pursue idea. First customers & beta test Firm generates customer base & refines sales strategy. Professional mgmt. perhaps brought in. Grows client base, develops new products or applications. Firm may be acquired or go public. Growth slows & depends on mgmt. & innovation to survive. Could this way remain for decades. Firms declines from changing tastes, inability to adapt, bad mgmt., etc. 21 21

Enterprise Life Cycle & Financing More risky Less risky Concept Stage Start-up Early Stage Growth Stage Mature Stage Declining EQUITY Founder F/F/F Partners EQUITY F/F/F Partners Angel or seed EQUITY F/F/F Partners Angel or VC DEBT Bank loan Gov t. gty. Sub. debt DEBT Bank loan Bond issuance Sub. debt DEBT Bank loan Bond issuance Debt Personal loan Credit card Other Grants Debt Personal loan Other Grants Debt Personal loan Govt. gty. Other Grants EQUITY VC or angel investor IPO Equity IPO Other Public subsidy or bailout 22 22

Factors in Determining Financial Instruments Business life cycle Profitability Growth prospects Collateral available Entrepreneur s goals Amount, term and purpose of funds Source of repayment/exit Fund s mission & governance 23

Required return Risk-return continuum How do you get out? Mezzanine High-yield debt Unsecured debt Secured debt Convertibles Ordinary shares Preference shares Quasi-equity Perceived risk 24

Exits Debt Primary repayment - Interest and principal paid with cash flow Secondary repayment collateral or guaranty Equity Trade sale (to a strategic investor, often larger company) Exit to larger or later stage PE investor Buy-backs, put option, or MBO to sponsors Initial public offering (IPO) Mezzanine or Quasi-Equity Combination of the above! 25

ABC Coffee Co. (Ghana) Purchase Order Financing Business Coffee semi-processor and exporter in Ghana Purchase coffee beans from small-holder farmers and semi-processes them Exports finished product to major western buyers Sales around $2M Amount $80,000 Purpose Finance the purchase of $100,000 of coffee beans until paid by major international buyer 90 days later Debt or equity? 26

ABC Coffee Co. (Ghana) Equipment Financing Business Coffee processor and exporter in Ghana Purchase coffee beans from small-holder farmers and semi-processes them Exports finished product to major western buyers Sales around $2M with modest profitability Amount $250,000 Purpose Replace three trucks and two washing stations that cost $300,000 Debt or equity? 27

ABC Coffee Co. (Ghana) Growth Financing Business Coffee processor and exporter in Ghana Purchase coffee beans from small-holder farmers and semi-processes them Exports finished product to major western buyers Sales around $2M Amount $1,250,000 Purpose Open a chain of retail Starbucks like shops First in Ghana and later in Nigeria Finance shop equipment & leasehold improvements and working capital for 12 shops Would leverage supply of coffee & export knowledge Debt or equity? 28

Required return Risk-return continuum of financial instruments $250K equipment loan $80K PO loan Mezzanine High-yield debt Unsecured debt Secured debt Convertibles Ordinary shares Preference shares Quasi-equity Perceived risk 29

Required return Risk-return continuum of financial instruments $1.25M growth financing $250K equipment loan $80K PO loan Mezzanine High-yield debt Unsecured debt Secured debt Convertibles Ordinary shares Preference shares Quasi-equity Perceived risk 30

Required return Risk-return continuum of financial instruments $1.25M growth financing $250K equipment loan Ordinary shares Preference shares $80,000 PO loan Convertibles Mezzanine High-yield debt Unsecured debt Secured debt Quasi-equity Perceived risk 31

ABC Coffee Co. (Ghana) Growth Financing Amount $1,250,000 Purpose Instrument Shop equipment & leasehold improvements and working capital 6 year debenture (debt) with kicker Principal grace period of two years Pricing Interest rate (6%) plus a closing fee (1%) Plus a royalty (1%) on sales with IRR cap of 20% Collateral Other Conditions Company assets? Personal guaranty or sponsor support Loan proceeds directly made to vendors ABC pays for closing costs 32

Royalty Revenue Example Assumptions Total Financing $1,250,000 Financial instrument Term Loan with royalty payment 6 years with two years grace on principal payment Interest 6.0% Royalty 2.0% Loan 2013 2014 2015 2016 2018 2017 Beginning principal balance 1,250,000 1,250,000 1,250,000 937,500 625,000 312,500 Interest 75,000 75,000 75,000 56,250 37,500 18,750 Principal payment 0 0 312,500 312,500 312,500 312,500 Ending principal balance 1,250,000 1,250,000 937,500 625,000 312,500 0 Loan Flows to Investors 75,000 75,000 387,500 368,750 350,000 331,250 Royalty Upside 2013 2014 2015 2016 2017 2017 Projected Sales 2,797,152 4,176,906 6,275,781 6,585,468 6,910,639 7,252,069 Actual Sales 2,500,000 3,200,000 5,500,000 7,000,000 7,200,000 7,300,000 Royalties to Investor 55,943 83,538 125,516 140,000 144,000 146,000 Total Payments to Inves (1,250,000) 130,943 158,538 513,016 508,750 494,000 477,250 Internal Rate of Return 17% 33

DOING DEALS ANDE ORIENTATION TRAINING Big Investment!eet Finding leads Screening deals Due diligence Structure & closing Adding value Exit Doing Deals The Process

DOING DEALS ANDE ORIENTATION TRAINING Finding leads Screening deals Due diligence Structure & closing Adding value Exit Part 2: Finding & Screening Leads

Doing Deals Finding Leads Leads are critical - 100:1 ratio for PE Need to efficiently 1. Generate leads and 2. Screen out the no-gos Time is money - literally Lead Lead Lead Pro-active approaches????? Closed Deals! 36 36

Doing Deals Finding Leads $1,500,000 Exit IRR = 20% after 6 years $500,000 Investment O 1 2 3 4 5 6 37 37

Doing Deals Finding Leads $1,500,000 Exit IRR = 25% after 5 years $500,000 Investment O 1 2 3 4 5 6 38 38

Doing Deals Finding Leads Lead generation mechanisms Use brokers Organize & attend entrepreneur events Join investor network groups Work with banks, accountants, lawyers, consultants Business plan competitions e.g. Africa Challenge Fund Strategic research Marketing/communication collateral (e.g. website) Business associations, chambers of commerce, etc. Major buyers 39 39

Doing Deals Screening Leads Initial screening: Establish & communicate criteria for self-selection Investment size Geography Market sector, social mission Typical deal structure More progressive screening Fund criteria Management strength Business strength/model Financial returns/profitability Social impact commitment Exit potential Lead Lead Lead Closed Deals! 40 40

Finding & Screening Deals Key Issues Managing productivity Think marketing Setting right expectations Communications Process Timeline Information BUT, you can get a lot of chaff before you get to the wheat! Lead Lead Lead Closed Deals! 41 41

What do we THINK we know now? 42 Management Market Strength Financial Returns Exit Potential There appears to be. Entrepreneurial vision Track record of success Management depth Growth market Competitive advantage Basic product line Satisfactory revenue growth Credible future profitability Acceptable cash needs Plausible exit routes Feasible follow-on investing Satisfactory exit value

Is It a Go to DD? - Need Term Sheet! Term Sheet Finding leads Screening deals Due diligence Structure & closing Adding value Exit 43

Term Sheet The Basics A Term Sheet outlines the material terms and conditions of a deal Often in bullet point form Non-binding (except for certain provisions) Subject to further due diligence Guide to legal counsel to prepare final transaction documents Mutual clarity and understanding at term sheet stage can save a lot of trouble in final negotiations and agreement execution. Term Sheet Finding leads Screening deals Due diligence Structure & closing Adding value Exit 44

Term Sheet The Basics Price and investment structure Conditions precedent Representations & warranties Protective provisions (blocking rights, covenants) Corporate governance structures Information and access rights Governing law and mechanisms for conflict resolution Exclusivity, confidentiality 45

DOING DEALS ANDE ORIENTATION TRAINING Finding leads Screening deals Due diligence Structure & closing Adding value Exit Part 3: Due Diligence

DD What do we THINK we know? 47 Management Market Strength Financial Returns Exit Potential There appears to be. Entrepreneurial vision Track record of success Management depth Growth market Competitive advantage Basic product line Satisfactory revenue growth Credible future profitability Acceptable cash needs Plausible exit routes Feasible follow-on investing Satisfactory exit value

48 DD What DON T we know? Are the customers satisfied? Are suppliers paid on time? Are all tax payments current? Who really owns the business? Any related parties? Is the entrepreneur a criminal? And a whole lot more!

Due Diligence What is it? Confirming what you think you re buying (i.e. don t get screwed!) Risk management inquiry: Market DD Financial DD Operations DD Legal DD Social mission DD Repayment/Exit potential Significant domain overlap Financial Operations Market Legal 49 49

Due Diligence Key Domains 50 Market DD looks at the market in which the company is operating and its position within it Financial DD is ensures the firm s financial strength, its financial management and its financial future Operational DD reviews the business non-financial resources to realize its growth potential Legal Legal DD reviews issues of ownership, governance, liabilities, etc. Social DD verifies that activities and key performance indicators align with mission Financial Joint goal is to create a view on the likely future performance of the target business Operations Market

Due Diligence The Basics (cont d) 51 But, due diligence is not all about managing the downside! Building trust Establishing working relationship Form of technical assistance Hidden Value! Financial Operations Market Legal

Due Diligence The Basics (cont d) 52 Divide into groups of 5 to 6 Designate a spokesperson and note-taker For your domain, explore for YOUR due diligence: What do you need to understand? Why is this important? What info do you need and how will you get ti? General principles and issues from case Take 20 minutes We will selectively report back

Due Diligence Final Thoughts Culture matters Focus on the major, not the minor Avoid duplicate requests for information Discrepancies don t mean dishonesty Have a good DD plan Clear responsibilities & timeline Ensure good communication Talk to people! Cross-check information Concise report with action items Market Financial Operations Again, opportunity to demonstrate value and build partnership DD begins from day one and never ends! Legal 53 53

DOING DEALS ANDE ORIENTATION TRAINING Finding leads Screening deals Due diligence Structure & valuation Adding value Exit Part 4: Structuring & Valuing Deals

Required return Debt-equity continuum of financial products Mezzanine High-yield debt Unsecured debt Secured debt Convertibles Ordinary shares Preference shares Quasi-equity Perceived risk 55

Quasi-Equity Instruments Mezzanine debt Any debt between equity and senior (secured) debt typically has a high yield and may have other features (warrants, convertibility) attached. Subordinated debt the simplest form of quasi-equity. It is unsecured debt or debt which is junior to secured debt. Convertible debt debt that is redeemable or convertible into ordinary or preference shares Royalty/profit participation An income note or other redeemable instrument that attracts a return linked to the revenue or profit performance of the investee. Preference shares Share capital that attracts a stated dividend return, subject to available cash flow, being cumulative or non-cumulative. Preference shares may be redeemable or non-redeemable into ordinary shares. 57

Royalty & Demand Dividend Structure A lump-sum investment bounded by a specific repayment period Interest bearing at a fixed rate over the term of financing Royalty payments tied to greater of forecasted income or actuals Payments may start after a grace-period A small amount of equity can be purchased at each origination Equity can be re-purchased by the company after all other payments 59

New Structures: Royalty & Demand Dividend Advantages Maintains an alignment of interests between the company and investors The entrepreneur makes regular payments Payments increase in line with increases in sales The exit is much simpler Entrepreneur retains control over the enterprise without much hassle It is easier for investors to estimate cash-flow prior to the financing Complexities of estimating profit and company valuation are avoided Avoids dilutive effect on ownership from early equity raise What are the Disadvantages? 60

Required return Valuation How Does It Come In? Mezzanine High-yield debt Unsecured debt Secured debt Convertibles Ordinary shares Preference shares Quasi-equity Perceived risk 61

Enterprise Valuation The Basics Objective of valuation Determines price investor must pay for equity Based on due diligence and resulting financial projections Pre- and post-money valuations Valuation is subjective Different investment objectives, synergies & risk profiles Investors are people and people are subjective! Valuation methods Book value method Comparable sales method Sales/profitability multiples method Internal rate of return (IRR) method Discounted cash flow (DCF) method 62 62

Sales/EBITDA Multiples Valuations Sales/EBITDA Multiples Pre-money valuation based on sales/ebitda multiple e.g. 1x sales or 4x EBITDA Sales multiples often used for rough preliminary value to screen deals or estimate value In developing markets, benchmark EBITDA multiples are often developed market multiples discounted for illiquidity, political risk, etc. Multiples also used in conjunction with other valuation methods 63

IRR Valuations Internal Rate of Return (IRR) Valuation satisfies a target internal rate of return from projected cash flows Target IRR can be tiered according to established risk levels Use projected cash flows of company or your investment? 64 64

Doing Deals ABC Company Example Suppose entrepreneur will give 40% ownership for $1.25M Entrepreneur s Valuation of ABC (current, or pre-money ) Step 1: Fund investment Amount $1,250,000 Step 2: Percent ownership offered 40% Step 3: Post-money valuation [$1,250m000/.40] $3,125,000 Step 4: Pre-money valuation [$3,125,000 1,250,000] $1,875,000 Entrepreneur s pre-money valuation: $1,875,000 What do we think about this? 65

ABC Co. Valuation - Sales/EBITDA Multiples ABC Company Revenues $1,900,000 EBITDA Negative Pre-money Valuation 1x sales valuation $1,900,000 4x EBITDA valuation Zero! Do we like the entrepreneur s offer? 712000=285000/.4 67

ABC Company Valuation - Discounted Cash Flow 1. Project Free Cash Flow Net income + Interest + Depreciation/amortization - Change in net working capital - Capital expenditures Free Cash Flow 2. Discount it back for discounted FCF 3. This present value is the valuation 68 68

ABC Valuation - Discounted Free Cash Flow Method 2013 2014 2015 2016 2017 2017 Thereafter Revenues 2,797,152 4,176,906 6,275,781 6,585,468 6,910,639 7,252,069 37,348,156 Net income (111,341) 134,280 595,615 653,104 726,518 807,750 4,159,910 Free Cash Flow (167,957) (122,621) 218,028 587,270 660,295 740,580 3,813,986 Discounted FCF (139,964) (85,153) 126,174 283,213 265,358 248,019 1,064,414 Discount Rate 20% Present Value 1,762,059 Growth Rate 3% Our Valuation by Discounted Free Cash Flow? 69 69

ABC Valuation Comparative Analysis Entrepreneur s Offer GBF Valuation Investment Amount 1,250,000 1,250,000 Percent Ownership 40%??? Pre-money Valuation 1,875,000 1,762,059 Post-money Valuation 3,125,000 3,012,059 Implied Discount Rate 19.6% 20% Are we close to an agreement? What are the key drivers of the valuation? 70 70

DOING DEALS ANDE ORIENTATION TRAINING Finding leads Screening deals Due diligence Structure & valuation Adding value Exit Part 4a: Lending Quick-View

Required return Debt-equity continuum of financial products Mezzanine High-yield debt Unsecured debt Secured debt Convertibles Ordinary shares Preference shares Quasi-equity Perceived risk 72

5 Cs of Credit Capacity Capital Collateral Conditions Character 73

5 Cs of Credit Capacity to repay from cash flow is the most critical of the five factors. Capital is the money personally invested in the business and is an indication of how much at risk should business fail. Collateral or guarantees are additional forms of security you can provide the lender. Conditions focus on the intended purpose of the loan and local economic climate and conditions within your industry. Character is the extent to which the borrower is sufficiently trustworthy to repay the loan or generate a return on funds invested in your company, even when times get tough. 74

5 Cs of Credit - Capacity Capacity to repay from cash flow is most critical of the 5 factors Debt service ability to service debt payments DSCR = (Net income + depreciation/amortization)/(interest + principal) Liquidity of balance sheet ability to meet ST liabilities Current Ratio = Current assets (cash, A/R, inventory)/ Current liabilities (A/P, ST debt) A/R, A/P and Inventory Days Outstanding Leverage ability to take on more debt if needed Debt-to-worth Ratio = Total liabilities/total equity 75

5 Cs of Credit Credit Risk Benchmarks Credit Risk Ratio Benchmark (India) Key Ratios Low Risk Medium Risk High Risk Current Ratio >1.40x 1.20 -!.40x <1.20x Debt-to-worth <2.00x 2.00-3.50x >3.50x Debt Service Coverage >2.00x 1.25-2.00x <1.25x Interest Coverage >3.50x 2.00-3.50x <2.00x A/R Days <45 days 45-90 days >90 days Inventory Days <60 days 60-90 days >90 days 76

5 Cs of Credit - Collateral Collateral or guarantees are additional security for the lender In developed markets, the following loan-to-values (LTVs) might apply: Real estate loans 80 to 90 percent Equipment loans 60 to 70 percent Working capital loans 50 percent In developing or emerging markets, perhaps the following: Real estate loans 50 percent Equipment loans 30 to 50 percent Working capital loans?!?!?!?!? Why is this? 77

ABC Coffee Co. (Ghana) Equipment Financing Business Coffee processor and exporter in Ghana Purchase coffee beans from small-holder farmers and semi-processes them Exports finished product to major western buyers Sales around $2M Amount $250,000 Purpose Replace three trucks and two washing stations that cost $300,000 Would a bank lend $250,000 to ABC? 78

ABC Coffee Co. (Ghana) Equipment Financing Would a bank lend $250,000 to ABC? 79

DOING DEALS ANDE ORIENTATION TRAINING Finding leads Screening deals Due diligence Structure & valuation Adding value Exit Part 5: Adding Value

Defining Business Development Assistance Services that improve the performance of the enterprise, its access to markets, and its ability to compete. *Committee for Donor Agencies in Small Enterprise Development renamed Donor Committee for Enterprise Development in 2005. 81 81

Areas of Business Development Assistance Marketing & sales Human resources Quality Production Strategic planning Social impact metrics Financial management Planning Accessing finance Business processes MIS Governance 82 82

Focus on Value - Urgency & Importance High X Urgent Low Low High Important 83 83

What Type of Fund Are You? Financial Returns Social Returns Debt Equity 84 84

Where are the BDA Priorities? Entrepreneur High X Low Low High Investor 85 85

High Aligned Interest BDA Tools Cash Management 1. Liquidity dashboard 2. Cash flow/budgets 3. Inventory analysis 4. Contribution margins 5. Additional financing 6. MIS 7. Cost reductions Marketing/Sales 1. Customers 2. Sales staff incentives 3. Marketing plan 4. Introductions 5. Promotional materials 6. Branding 7. Distribution 86 86

Other BDA Prioritization Factors What is most urgent and important Key success factors Think with exit in mind For individual investees and portfolio Take advantage of investment staff know-how But, beware of solutions looking for a problem! Identifying BDA opportunities 87 87

Don t Underestimate Value of. Problem-solving Financial analysis Power of data Unexpected opportunities Your network & connections Time spent with entrepreneur 88 88

BDA Let s talk funding Management fees Donor funded technical assistance pool Deal funded Investment fund staff as resource Vouchers Cost-sharing 89 89

BDA Planning Fund BDA Plan Mission and strategy Policies, procedures and responsibilities Budget Metrics for success Investee BDA Plan Prioritized BDA needs Action plan for delivering BDA Funding (budget, cost-share, etc.) Entrepreneur sign-off 90 90

Monitoring and Evaluation Annual business plan Actual-to-budget monitoring/forecasting Financial reports Social impact reports Scheduled & surprise visits to business Board seat(s) Downtime with entrepreneur 91 91

BDA Final Thoughts Align fund goals with entrepreneur s Planning Leveraging funding Deliver Value! Cost vs. benefit Data & Analysis Urgency & importance 92 92

DOING DEALS ANDE ORIENTATION TRAINING Bob Webster Chief Operating Officer and Investment Advisor Grassroots Business Fund June 3, 2013 www.gbfund.org Thanks!