Module II: Venture Capital Financing

J. K. Dietrich - FBE 432 – Fall, 2002

Module II: Venture Capital Financing

Week 5 –September 23 and 25, 2002


Objectives of this Lecture

Discuss the role of venture capitalists in providing capital to new firms and to companies attempting to go private

Understand why leveraged buyouts are profitable and how LBOs are done

Analyze the impact of LBOs


Venture Capital Venture capital is a global phenomenon although

it is largest in the United States Venture capitalists invest in firms started by

entrepreneurs They are a temporary source of financing with a

limited time horizon They provide entrepreneurs with more than money

– Management advice and strategic planning

– Personnel services

– Additional financing


Venture Capital

Venture capital is early stage financing of new and young firms looking to grow quickly

Venture capitalists are an important source of funds for these firms

Venture capital is also critical when a company goes private.


Types of Venture Capitalists

Venture capitalists supply capital; there are several types:– High Net Worth Individuals (“Angels”) and

Families– Private Partnerships and Corporations

» Arthur Rock & Co.

– Large Industrial or Financial Corporations» Example: Citicorp Venture Capital


Venture Capital Financing Stages

Several distinct stages– Seed money: to “prove” the product or concept– Start-up: Funds for marketing and product

development for new firms– First-Round Financing: Supplements to

start-up funds to begin sales and manufacturing


Venture Capital Financing Stages

– Second-Round Financing: Funds earmarked for working capital beyond first-stage financing

– Mezzanine Financing: Financing for a profitable firm contemplating expansion

– Bridge Financing: Funds for firms likely to go public within a year.


Venture Capital

In IPO situations, venture capitalists often require rates of return of 25-50% on an annualized basis

To achieve this with loans, they usually demand and get warrants (“equity kickers”) that effectively give them an equity stake as well.


Example

In 1999, EDT Inc. decides to go private. – It obtains a loan of $30 million from a venture

capitalist in the form of a zero coupon bond with maturity 2002 and face value $50 million.

– In addition, the VC demands warrants that can be exercised in 2002. Using the Black-Scholes formula, these warrants are valued at $11 million currently.

Determine the VC’s rate of return


Return to Venture Capitalist (Millions of dollars)

1999 2000 2001 2002

Loan 50Value of Warrants 11Initial Cash Flow -30 Total -19 0 0 50

Internal Rate of Return 38%

Computation

Notice that we use the

PV of warrants in year 0


Issues in LBOs

Why do LBOs occur? How are such deals structured? How can venture capitalists obtain their

required rates of return? What is the source of value?

Do LBOs represent an expropriation of shareholder wealth by management? Do they hurt minority shareholders?


Types of LBOs

Going Private: This occurs if the entire public stock interest of the firm is bought by management exclusively; this is sometimes known as a management buyout

LBO: Ownership in the subsequent private firm is shared by management and third-party investors


Anatomy of Going Private

Merger: Management forms a shell that merges with the original firm, paying with cash or securities; requires shareholder approval.

Asset Sales: Similar in that a vote is required, and assets are purchased by a shell corporation owned by management


Anatomy of Going Private

Tender Offer: No vote required, and minority shareholders are not required to involuntarily surrender their shares

Reverse Stock-Split: requires holders of fractional shares to sell their ownership back to the firm -- rare


Anatomy of an LBO

Leveraged buyouts involve purchase of the entire public stock interest of the firm

Typically, the transaction is heavily debt financed; additional sources of funds are often found in the cash reserves of the firm itself


Financing an LBO

LBOs are often financed with several layers of non-equity financing such as senior debt, subordinated debt, convertible debt, and preferred stock.

Mezzanine level financing refers to the securities between senior debt and common stock, e.g., subordinated and convertible debt


Financing an LBO

Subordinate Debt

Preferred Stock

Convertible Debt

Senior Debt

Common Stock

Strip Financing

Mezzanine Financing


Financing an LBO

Strip financing is common in LBOs This requires that a buyer purchasing, say,

12% of any mezzanine level security must also purchase 12% of all mezzanine level securities and some equity


Financing an LBO

Strip Financing has two advantages– As each level of financing senior to equity goes

into default, the strip holder automatically gets new rights to intercede in the organization.

– Eliminates conflicts between senior and junior claim holders


Sources of Financing

Senior Debt: Usually banks Equity: Venture capitalists (up to 80%)

and management; venture capitalists usually get warrants attached to bonds

Mezzanine: Third-party financiers, holding strips and maybe equity as well


LBO Targets

Firms with large cash flows Firms in less risky industries with stable

profits Firms with unutilized debt capacity Example

– O. M. Scott


Gains from LBOs

Reduced regulatory and listing costs:– Exchange registration and listing costs and

shareholder servicing costs are eliminated– If costs are, say, $200,000 annually, the present

value at 10% is $2 million, which may be significant for small firms

– For large firms, these gains may be insignificant.


Gains from LBOs

Reduction in agency costs: – LBOs align the interests of management and

shareholders, increasing management performance

– Management has strong incentives to cut costs given the high ratio of interest expense to cash flow -- this may lead to “downsizing” that hurts other stakeholders


Gains from LBOs

Increased monitoring: – High debt provides strong incentives for

outside auditing by the lenders and venture capitalists

– The conflicts between stockholders and bondholders may be reduced; strip financing allows quick replacement of management


Free Cash Flow Argument

When the firm’s actual growth rate is less than its sustainable growth rate, cash accumulates within the corporation:– Although this belongs to shareholders, it is

controlled by management– Jensen observes that managers may waste

shareholder wealth High debt places limits on such managerial

“excess”


The Trigger Strategy

Debt

Equity Paid In

Retained Earnings

Red arrows mark the amount of firm value that can be lost without triggering bond-holder action

Normal HighDebt


The Trade-Off

The costs of financial distress may be reduced as reorganization is triggered earlier.

But the commitment of free cash flow to service debt reduces management discretion.


Evaluation

The free cash flow argument will work for companies that derive value from assets in place rather than discretionary investment

For companies with high R&D costs and high capital expenditures, you may cut muscle with the fat.


Example of O.M. Scott

O.M. Scott was a division of ITT; in 1986, there was a divisional LBO

Venture capitalists were Clayton and Dublier, with 70% of equity

Post-buyout leverage was 90%


O.M. Scott

Operating performance increased in 1986-1988– EBIT rose 56% (Baker and Wruck)

Organizational changes focused on incentives– Bonuses for top managers increased dramatically

– There was increased monitoring because of covenants


Empirical Evidence

LBOs can be very profitable for the new owners– Kohlberg, Kravis, Roberts & Co. (KKR) earned

an average annualized return over 60% on its equity in highly levered transactions

– DeAngelo, DeAngelo, and Rice report that buyout specialist Carl Ferenbach has a required rate of return of 50% on its equity investment


Empirical Evidence

LBO’s involve a potential conflict of interest– Managers are insiders and may make deals at

the expense of minority shareholders– Managers may also have better information

than the shareholders; – Managers often have majority voting rights


Empirical Evidence

One way to assess the relative importance of the positive and negative effects is to look at the share price reaction when an LBO is announced

Focus on abnormal (excess) returns

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Empirical Evidence

There are positive excess returns following LBO/private announcements

DeAngelo, DeAngelo, and Rice find a two-day excess return of 22% following the initial announcement of an LBO.

Accounting for leakage in the 40 trading days before the announcement, the cumulative excess return is 30%.


Empirical Evidence

However, these returns are below the 56% average premium offered in LBO transactions

The difference is explained by the high percentage of offers (23%) withdrawn following announcement


Problems

The problem is that we cannot separate the effect of good insider information from the other benefits such as the reduction in agency costs

Accordingly, research has focused on whether minority shareholders win or lose


Minority Shareholders

For offers that are subsequently withdrawn, prices fall by 9%

Clearly, even minority shareholders benefit from LBOs

The division of the gains is still an open question


Alternatives to LBOs

Cost-cutting associated with LBOs often gives them a bad name

One option is a voluntary restructuring Donaldson discusses the case of General

Mills


Restructuring and General Mills

In the 1980s, the company was over-diversified and lacked focus

They decided to concentrate on core areas Change in incentive compensation to focus

on ROE


Results

In 1980, General Mills had a ROE of 16.7% By 1989, ROE had risen to 56.6% Positive stock Market response


Caveats

Debt also increased: The leverage ratio rose from 27% to 74%

Orderly implementation “LBO-like” But, did it take too long?


Conclusions

Highly levered transactions are a source of value; restructurings may do the same

Although they can be highly profitable, the evidence is difficult to interpret

There is no evidence that minority shareholders are hurt as a result of LBOs - the same cannot be said of other stakeholders


Next Week – September 30 and October 2, 2002

Review RWJ, Chapter 21 and 23, sections 1 to 3

Read Term Sheet Negotiations for Trendsetter Inc. case and begin to think about the issues

Review course materials and cases for weeks 1 to 5

Documents

Module II: Venture Capital Financing