FIN_317 Paper

Slide 1

Introduction

Welcome to Financing Entrepreneurships. In this lesson we will examine and analyze a planned exit strategy for ventures.

Next slide.

Slide 2

Topics

The following topics will be covered in this lesson:

Venture operating and financial decisions revisited;

Planning an exit strategy;

Valuing the equity or valuing the enterprise;

Systematic liquidation;

Outright sale; and

Going public

Next slide.

Slide 3

Venture operating and financial decisions revisited

So you have made it. Not only through this course but metaphorically as the entrepreneur of a venture. Once a venture reaches a level of success, many of the investors and stakeholders will be looking for an exit or harvest opportunity. Harvesting is the process of exiting the privately held business venture to unlock the owner’s investment value. There are three ways in which a venture is harvested which we will cover. They are: through a distribution of assets to the owners; through a sale of the going concern to others; and lastly, through a private equity registration and sale also know as an initial public offering.

Before we start going into the harvesting process let’s take a look at how we got here. When we first started these lessons we were primarily concerned with early stage financing. Once an entrepreneur has an idea and a business plan they usually were passing out of the development stage and into the startup stage. They needed funding to get it off the ground. We saw how ventures can organize and how their organizational structure can impact the available funding.

We then had a brief overview of the financial statements. We primarily focused on the statement of cash flows because we found that cash is king in a new venture and we needed to make sure that the venture maintained an overall positive cash balance to keep it from going into financial distress. This is very important from the survival stage to the rapid growth stage. The cash flow was also important because we used this as the basis for our financial valuations.

We saw a successful venture was one that could endure and create rapid growth. At any point from development to maturity if a venture fails to meet the goals of its stage or finds itself in financial distress it could be forced to liquidate or completely abandon the venture. This is what makes these ventures such high risks.

Next Slide.

Slide 4

Check Your Understanding

Slide 5

Planning an exit strategy

This is a very simple point but it is very important. Entrepreneurs need to plan for harvesting scenarios right out of the gate. They need to realize that their investor’s only desire is to have a liquid outcome. When preparing the business plan real consideration needs to be given to not only to how a harvest could take place but when.

Often one of the major things a venture capitalist looks for when reviewing new investment opportunities is the harvesting opportunities that were considered in the business plan. Venture capitalists want to see that the entrepreneur is at least considering these possibilities. It is often helpful to the entrepreneur as well to have laid out what an acceptable harvest would look like beforehand. Acquisition and initial public offering opportunities specifically can come along very quickly and the market for these is very sporadic. Knowing where you want to go before you get there can help capitalize on these short lived opportunities.

Next Slide

Slide 6

Valuing the equity or valuing the enterprise

Previously when looking at valuing a venture we were looking at the present value of future cash flows. These can be for the entire enterprise as in the previous lecture or just for the equity value. When harvesting we need to know the value of the firm at the point of exit. After all, how much would be an acceptable offer. If you cannot answer this question how can you make an assessment of a potential acquisition or initial public offering? We also need to know how this value will be divided up between the different stakeholders.

We can determine the exit values based on cash flows as we have before or we can use relative valuation models. We have done variation on this before with discounting dividends that really won’t be paid and the like.

Let’s look at a relative valuation model that we can use to value more mature firms. The first thing we will need to do is determine the ventures value at the time of the harvest. A way of doing this would to be to use multiples of earnings before interest, tax, depreciation and amortization. This is used because it is an estimate of how much is available to both equity and debt stakeholder. The multiples are model constructs that analysts can used based on similar ventures and their exit valuations and returns.

Let’s look at a quick example of this. Let’s say that earnings before interest, tax, depreciation and amortization are one million dollars. Let’s say it is determined that a multiple of ten is a good rule of thumb to use for a business of this type, size and in this market. Simple multiplication gives us a harvest value of ten-million dollars.

Now let’s see how this would break down for a venture that has a couple forms of financing. If there is a long term back loan of five million dollars this has to be paid off in full leaving five million to be split among the equity holders. If the equity holder had invested in equal shares a total of two million dollars over five years, this gives us a rate of return for the holders of about twenty percent. Is this enough to make this harvest attractive?

Next Slide.

Slide 7

Systematic liquidation

Let’s start looking at ways a venture can be harvested. We will begin by looking at systematic liquidation. Systematic liquidation is a venture liquidated by distributing the venture’s assets to the owners. If a firm reaches maturity and is producing cash that exceeds the amount need for reinvestment this excess cash flow can be redistributed to investors directly. Once the profitability of such a firm declines and it becomes no longer viable the assets of the company can be liquidated and the business will be closed. All the remaining cash from the sale of assets and the paying off of debts can then be distributed to the investors.

Of all the ways to harvest a business this is perhaps the most uncommon. An example of where this might be used is in a dying industry where a venture can make a good profit in the short run but has no future in the long run. There are many examples of industries that are no longer viable as times and technology changes. The text gives the example of companies that make type writers either making as much money as they can before the business ceases to exist or moving into another industry. Pay phones would be another industry that has been replaced with a new technology. There was perhaps a period where a pay phone company could ride their revenues without investing further into the business until it became no longer profitable, and then they could liquidate. Can you think of other examples of industries in this scenario?

There are some real advantages in systematic liquidation as a harvesting strategy. The advantage for the entrepreneur is that they get to keep control of the venture all the way through the harvest to the close of business. This is often not true for other forms of harvesting. The harvesting itself can be spread out over a number of years which can offer a number of advantages. Also, the effort and cost of finding a buyer or taking the company public can be avoided.

There are serious disadvantages to this type of harvest and in most cases the disadvantages outweigh the advantages. The first of the disadvantages is taxation of the liquidation proceeds as income rather than capital gains. As a result a liquidating company could face the prospect of double taxation on their proceeds. First as income into the company and then as capital gains out to the investors. The second disadvantage is more along the lines of an opportunity cost. All the time money and energy that the entrepreneur puts into the dying venture could be put into another effort that could be more productive and profitable. And finally a business is most competitive when it is a growing concern. If it has chosen to forgo reinvestment and to distribute all excess cash flow, than other businesses in the industry will increasingly be able to outpace and outcompete. This will create an acceleration of the decline in the firm value.

In general unless the venture is in a declining industry the systematic liquidation strategy is the least attractive harvest option.

Next Slide.

Slide 8

Check Your Understanding

Slide 9

Outright Sale

Now let’s look at the outright sale of the venture. An outright sale is when a venture is sold to others, including family members, managers, employees or external buyers.

We will first start with the sale of the venture to family members. There is really two ways to transfer ownership here. One is to gift the venture to the family member and the other is selling it to them. As the entrepreneur you may not be concerned about getting the fair market value for your business and simply seek to give it to a family member for various reasons. The issue with this is that gifts are taxed at an extremely high rate, around fifty-five percent. As a result it may not make much financial sense to gift the business. In addition, it may be hard to come up with fifty-five percent of the ventures value at the time of purchase. The IRS code is also very clear that the ownership must be transferred at a fair market value, so undervaluing the business in an effort to reduce the tax burden isn’t possible and this will be taxed at the fair value instead of the stated gift value.

As a result of this, businesses are often sold, or a combination of gift and sale is preformed. The seller may assist in financing the purchase of the venture to assist the family buyer. The seller may even sell the venture as an annuity, breaking the payments down over a number of years to make the investment a little easier for the buyer to manage. The seller will be taxed on the proceeds of the sale which will sift the tax burden from what we see in the gift. The tax rate will be less progressive in this case as well.

Another potential harvest situation involving an outright sale may be for the management team to buy the venture. This may be something that was floated early on in the venture as a potential exit strategy. This exit strategy can help to attract high caliber management as well as incentivize the management to create the greatest value for the firm since they will ultimately be the owners. The problem with this situation again mimics that of the family members. The capital required for an outright purchase is likely to be large and outside the means of the management team. This is where the L-B-O or leverage buyout idea comes into play. A leveraged buyout is where the purchase price of the firm is financed largely with the debt financial capital. This could be from other private investors, banks or bonds.

In this scenario the equity holdings are greatly reduced because of the debt issue retiring the entrepreneur’s shares. This allows for the management to buyout the venture putting up only a small portion of the overall purchase prices and effectively financing the rest through the large debt issue. In situations like this where the leverage buyout is done by the firm’s top management and they continue to run the firm and have a substantial equity position in the reorganized firm it is termed an M-B-O or management buyout.

The biggest concern for this type of deal is the enormous debt load the venture has just taken on and the heavy debt service that will be required. The management team will need to exploit operating efficiencies immediately and maintain them to survive. Before moving forward with such a prospect the management team will want to make sure that they feel that their cash flow can meet the debt servicing needs and pay down the principle in a timely fashion to make the deal financially attractive.

Similarly employees in general may buyout the venture as a form of harvest. This is similar to the management buyout but the structure is a little different because in this case a leveraged employee stock ownership plan or E-S-O-P is established. The debt in this case is issued to the employee stock ownership plan as a legal entity and backed by the venture. The debt is not issued directly by the venture as in the leveraged buyout situation. Payments are made to the plan to retire the debt. These are made by the venture over time. The leverage plan allows the entrepreneur to get full payment for their ownership stake right away using the debt issue, and the venture then pays down the debt. A non leveraged plan would see the entrepreneur paid out over time as the venture pays into the plan. There is no debt to cover the entrepreneur in full up front.

Employee stock ownership plans were made possible by an act of congress. There are approximately nine thousand in use in private companies and a thousand in public companies.

Finally we turn to outside buyers. Outside buyers may be competitors looking to consolidate, or suppliers or even customers looking to integrate and absorb the ventures products or intellectual property. These types of acquisitions may be a consideration through the ventures life cycle. When a venture is well capitalized considering accusation offers may not be as serious as for a venture that is not as well capitalized. As we have said, in the early stages the venture wants to focus on building the business and making it a thriving and sustainable company. However, if the venture is not as well positioned financially, considering accusation offers or even soliciting them may be a serious consideration.

When it comes to acquisitions investment banks offer services that can help these deals move forward. They can give the venture an idea of the value to the potential acquiring firms as well as help in engaging them to solicit offers. The investment banks can create a list of potential acquirers and present them with promotional material. Those companies that are interested will submit bids and the venture can hopefully choose the offer they find most desirable. The desirability of the offer to the venture may be more than just the financials. There may be a lot of non monetary terms that the entrepreneur will use as deciding factors like reputation, whether then employees will be retained and managerial succession. There is also probably going to be a mix of how the financial terms will be structured with straight cash or equity holding etc. This can make it hard for a venture to truly compare apples to apples when looking at the offers from all the bidders. This is what makes this a lot different than a regular action. The highest bidder may not always win; it may even be hard to tell who the highest bidder is.

A couple of quick notes on the valuation of the venture in these deals. We have already looked at the ways to determine the value of a venture. In these acquisition scenarios there may be some premiums and discounts applied to the final number. Two of these would be the control premium and the illiquidity discount. The control premium is basically a premium that the acquiring firm many pay to have a controlling interest in the venture. There may be a perceived or real advantage to having this control and getting this control may be hard and expensive to do if the venture ends up going public and the acquiring firm would need to get the controlling interest on the open market.

The illiquidity discount may be given to the acquiring firm to compensate for the fact that there are resale disadvantages of private equity. If the firm is not publicly traded the acquiring firm may expect a discount for the lack of a liquid market for the acquired equity.

Next Slide.

Slide 10

Check Your Understanding

Slide 11

Going public

The final method of harvesting we will examine is going public. Going public involves an initial public offering or I-P-O. This is a venture’s first offering of SEC-registered securities to the public. As part of this offering new shares are issued which are termed the primary offering. If exiting or used shares are part of the initial public offering these shares are called the secondary offering.

When a venture goes public they will almost always employ the services of an investment bank. An investment bank is an intermediary assisting in the creation, sale and distribution of financial assets. However their main role is to find and match buyers for the venture’s securities. Investment banks are truly intermediaries meaning that they are not intended to be the target investor for the offering. They merely facilitate the transaction and really do not act or offer the services that a typical bank would, so don’t let the nomenclature mislead you.

Ventures going public employ the services of an investment bank because investment banks have a wide network of potential investors that they can use to both help establish a accurate issuing price for the sale of the securities as well as drum up interest in the purchase of the securities once they hit the market. Market forces will determine the price of the securities once they are on the market but the investment bank must make an accurate determination of what the securities should sell for before they hit the market so that they are not over priced and the venture and the investment bank can take full advantage of the demand for the securities, getting the highest price possible and returning the maximum amount of capital to the venture. Investment banks are incentivized to do this because they usually will buy newly issued shares from the company just before the public offering. This makes them invested in the mispricing risk.

Investment banks make their profits from the underwriting spread. This is the difference between what the investment bank gets from selling securities to the public investors and what it pays to the issuing form. This is usually around seven to ten percent. You can see that this could be a very lucrative deal for the investment bank, but they are also taking on a lot of risk here. If they end up selling the securities for an average price below what they must pay the company then they could take heavy losses. This has been known to happen, but not very often.

Investment banks generate interest and at the same time cover SEC disclosure requirements by advertizing. These are known as tombstone ads. The investment bank will also look to their wide network of potential investors to find interest. The venture going public will want their securities sold for a good value but they also want them disbursed over a large group of investors. They do not want too much ownership concentrated in the hands of a few investors of it could impact the operations of the firm and its management.

The investment bank provides a few other services. They assist with the SEC filing process and do the required level of due diligence. They can also provide advice and consulting services. This can cover reviewing investment plans or even finding acquisition targets.

There a lot of fees and costs to the venture going public so it is important for them to understand what they are looking at going into the offering process. We have talked about the mispricing risk that impacts the venture as well as the investment banks. We have also discussed the underwriting spread that is given to the investment bank. The nice thing about these fees is that they are incurred basically once the deal is done. The venture has to keep in mind that there are a lot of upfront costs that while they may not compare in significance to something like the underwriting spread, they can add up to a lot of money. These can be things like legal expenses and registration fees along with a host of other incremental expenses involved in getting the deal done.

Post IPO trading can be important to the price that a security will demand as part of the offering. Investors want to know that there investment is liquid and that it can be traded. This is why listing it with an exchange like the New York Stock Exchange is important. It can provide reassurance of its liquidity in secondary markets. Your text discusses some of the requirements of the different exchanges and the advantage they provide. We will not cover that here.

Finally it should be noted that once a company goes public it can be a big shock for the entrepreneur. The culture will change. The regulatory environment will change. What you can do and what you can say will change dramatically. Once a venture goes public the entrepreneur must understand and accept these changes. They will have to strike a balance between being more transparent and making financial information public and also being more guarded about what is said because of its impact on company perception and value.

Next Slide.

Slide 12

Summary

We have now reached the end of this lesson. Let’s take a look at what we’ve covered.

We started by reviewing the venture process. We looked at the stages from development through maturity. We also defined what harvesting is.

We discussed the importance of planning an exit strategy. You should know what your acceptable harvest scenarios are. This can be a good sign to venture capitalists that this is being considered. However, we know that the markets for harvests change, and change quickly

We took a quick look at valuing the enterprise. We looked at a new way to value mature venture by using the multiples of E-B-I-T-D-A method.

We also looked at the different ways that a venture can be harvested.

First we looked at systematic liquidation. We then looked at outright sale and finally we addressed the star of the show, going public.

This concludes this lesson.