Valuing the business
- Calculate value of company in comparison with values of similar companies on Stock Market. P/E Ratio
- Calculate value of company that will give VC required rate of return over predicted investment period
P/ E ratio
Current Share Price / Historic Post-Tax Earnings Per Share
Vary by:
- industry sector
- company size
- investor sentiments towards company
- management + prospects of company
- timing of year-end results
Unquoted P/E ratio < Quoted as:
- Shares cannot be bought and sold at will
- Shorter track record
- Less experienced management team
- Higher cost of making/monitoring investment
But unquoted P/E ratio raised if:
- Higher than normal project growth
- Fashionable sector
- Competition for investment
Required IRR depends on:
Annualised rate of return achieved over the life of investment based upon cash flows and valuations
- Risk associated with investment proposal
- Higher the risk – the higher rate of return required: could be as much as:
Seed / start-up: 50% + pa
Early stage: >40% pa
Expansion: 30-40% pa
MBO/MBI: >20% pa - Length of investment period
- Likely ease of realisation of investment
- Competition for investment
Structuring a VC deal
- Management want highest proportion of equity possible
- VCs want to exit with high IRR, depending on risk level
- Banks want excellent security on their loans
- Determine how much finance required
- Ascertain how much can be taken as debt – level of interest cover / available security
- Determine how much management can invest
- Balance is supplied by VCs
- “Envy ratio” shows how “generous” the VCs are being: value of company based on proportion of initial investment put in by VCs and management
Types of equity financing structure
Equity:
- Ordinary shares
- Preference shares
- Preferred ordinary (A)
Split between prefs and ords open to negotiation
Ordinary Shares
Equity shares that are entitled to all income and capital after the rights of all other classes of capital and creditors have been satisfied.
They have votes and usually held by management and family shareholders rather than PE firm.
Preference Shares
These shares rank ahead of all classes of ordinary shares for both income and capital but carry no voting rights.
Income rights are defined and usually entitled to a fixed dividend.
The shares may be redeemable on fixed dates (or even a fixed premium) or irredeemable
May be convertible into a class of ordinary shares.
Preferred ordinary shares (‘A’ ordinary shares)
Cumulative convertible participating ordinary shares
OR
Cumulative preferred ordinary shares
These are equity shares with preferred rights, typically rank ahead of ordinary shares in income and capital, with voting rights as well.
Once preferred ordinary then the ordinary share capital has been repaid. The two classes would then rank pari passu in sharing any surplus capital.
Income rights may be defined, entitled to fixed dividend and/or right to defined share of company profits (participating dividend).
Usage of preference shares
- Reduce exposure of investor in downside
- Permit various terms
- Allow management sufficient incentive through ordinary share holding.
VC can:
- attach various rights, not available to ordinary shares
- OR right to receive cumulative or non-cumulative dividends
- OR right to convert preferred into ordinary (when IPO happens as well as anti-dilution provisions to protect VC)
Pref shares protect VC investments from liquidation or sale soon after investment. Having preferred and ordinary, VC can protect his downside exposure and benefit from upside potential.
Downsides of preferred shares
Demotivating on management as priority is given to exit proceeds of investor priority
Negotiation of subsequent funding rounds is more difficult as existing shareholders try to hold on to income and redemption rights.
Types of Preference Shares
Cumulative - dividends accumulate if not paid
Participating - based on level of profits
Redeemable - repayable on agreed date, sale or listing (company must buy them back after set no. of years if exit not reached)
Convertible - convertible into ordinary share capital at option of investor
Liquidation preference rights - entitle investor to multiple of pref cost on redemption
Tweaking a VC deal
Dividends - increase IRR for VCs by taking dividend return as well as capital gain on exit
Ratchets - proportion of equity held by management team is altered depending on profits (or other targets) achieved: can be positive or negative ratchets
Stage finance - in tranches, e.g.:
- Product development and market research
- Product launch, initial marketing, proof of concept
- Major marketing offensive, turnover growth to break even
- Working capital for continued revenue growth
- Finance for geographic and product diversification
Negotiating the deal
- Stock options – the right to acquire ordinary shares at specified time and price. Used to incentivise team. Used to give VC right to increase shareholding if target milestones not met
- Seat on the board/independent director
- Votes ascribed to VC’s shares
- Level of warranties and indemnities
- Completion fees
- Costs of external due diligence
Convertible debt
- Often used for seed finance
- Avoids having to value business initially
- Takes form of promissory note
- Converts to equity at first equity finance round above qualified minimum (eg £1m)
- Conversion is automatic or at discretion of note holder
- Usually has discount on conversion, eg price paid for shares is 80% of price paid by equity investor.
Term Sheet
- Letter of intent – outlines framework for final deal but is not binding (except for exclusivity, confidentiality and fees)
- Represents the VC’s preferred terms
- VC may change terms as negotiations progress, eg valuation
- Incorporated into shareholders’ agreement at end of negotiations
Reasons for having a term sheet
- Risk Management
- VC policy
- Deal syndication
- Exclusivity
Term sheet will cover:
- Amount to be invested, instruments (eg convertible preferred shares), valuation (may be pre-money), capital structure
- Liquidation preferences, Dividend rights, Conversion rights, Anti-dilution protection, Redemption rights, Lock-ups, Pre-emption rights
- Board composition, Consent rights, Information rights
- Warranties, Vesting, Option pool, Milestones
- Confidentiality, Exclusivity, Fees, Conditions precedent.
