Financing in an Entrepreneurial Context

Financing in an Entrepreneurial Context

• This presentation explores different financing options for entrepreneurial and family firms, including debt instruments, private equity, seasoned offerings, and IPOs.
• Key goals include refreshing knowledge on debt financing (i.e., bank loans and bonds), understanding private equity funds' structures and strategies, exploring different types of seasoned offerings and their valuation, and analyzing IPOs and their pros and cons for entrepreneurial and family firms.

Debt Financing

• Sources of debt financing include banks, bond markets, and other stakeholders (e.g., insurance companies, suppliers).
• Long-term debt financing, like bank loans, involves careful credit assessment and often requires collateral.
• Types of bank loans include bullet repayment, installment loans (constant principal repayment), and annuity loans (constant debt service).
• Interest rates can be fixed or variable (e.g., 3m-Libor + margin).
• Loan agreements contain covenants that specify conditions borrowers must meet or actions they must avoid.
• Affirmative covenants require borrowers to take specific actions, whereas negative covenants restrict them.
• Financial covenants require adherence to specific financial figures.

Debt Financing by Bonds

• A bond is a debt instrument promising periodic interest payments and principal repayment at maturity.
• Typically listed on stock exchanges, though SME bond markets exist.
• Bond values can be below, above, or equal to par value but can differ from redemption value.
• Criteria for bonds include time to maturity, coupon payments (fixed or variable rate), terms of redemption, and yield (return).
• The example of a Microsoft bond issue in 2012 highlights how individual groups of bonds can have varying maturity dates and interest rates.
• Straight/Plain Vanilla bonds are repayable at maturity, usually unsecured but with senior/first rank status in case of default, and are tradeable before maturity.

Bonds Terminology

• Yield-to-maturity considers capital gains or losses if held until maturity.
• Nominal value is the face value of the bond.
• The repayment/redemption/maturity date is when the bond is repaid to investors.
• Coupon is the interest rate paid on the bond's face value, which may not be identical to yield.
• Pricing models like NPV (Net Present Value) are used to verify yield calculations.
• Bond prices inversely respond to interest rate changes; rising interest rates lower bond prices to align their yield with alternatives.

Sources of Equity Financing

• Equity financing sources include family, friends (and fools), private equity/venture capital firms, and business angels, and the stock market.
• Venture capital funds are often involved in early-stage financing, typically taking minority stakes (10-49%) and offering active investor roles.

Equity Financing for Non-Listed Companies

• Private equity is an investment in non-publicly traded companies.
• Venture capital focuses on early-stage financing, including seed finance for product development, start-up/expansion stage finance, and growth capital for mature companies.
• Leveraged buyouts utilize significant debt financing to acquire companies, appealing to SME owners seeking an exit strategy.
• Distressed assets are investments in companies facing financial hardship or default.

Characteristics and Strategies of Private Equity Funds

• Private equity funds usually have a fixed term (10-12 years) with an investment period (commitment period) of 5-6 years and often have a focus on venture capital, growth capital, buy-outs or distressed or mezzanine financing.
• Fund structures involve limited partnership agreements.
• Investment strategies frequently prioritize minority stakes in venture capital or majority control in buyouts, often over a horizon ranging from 3 to 7 years.
• Exit strategies often involve trade sales, IPOs, secondary sales, or share buybacks.

Structure and Funding of Private Equity Funds

• Private equity funds operate as limited partnerships.
• Limited partners provide capital for investments; general partners manage investments and investments are made in companies like Company 1, and Company y.
• General partners receive carried interest and manage investments.

Fixed Term Private Equity Funds

• Fixed-term private equity funds have a defined investment period (5-6 years) followed by a harvesting period (10-12 years) focused on value creation and exit strategies.
• Drawdowns occur during the investment period.

Cash Flow Profile of Private Equity Funds

• Private equity fund cash flow profile typically exhibits a J-curve pattern, with significant negative cash flows initially, followed by positive cash flows later.

Characteristics of Venture Capital Investing

• Venture capital focuses on financing early-stage companies (seed, startup, or expansion).
• VC firms are active investors, typically holding minority stakes and participating in company boards.
• Venture capital investing is marked by high risk and uncertainty.

Private Equity Financing for Entrepreneurial/Family Firms (I)

• Private equity funds prefer controlling stakes, whereas entrepreneur/family firms are reluctant to cede control.
• Shareholder agreements (SHAs) address minority ownership, specifying rights and exit strategies for both parties.
• Veto rights and information rights (e.g., access to business plans and financial statements) are common provisions in SHAs.

Private Equity Financing for Entrepreneurial/Family Firms (II)

• Exit rights, particularly drag-along and tag-along clauses, are critical sections of SHAs.
• Drag-along clauses allow majority shareholders to force minority shareholders to sell their shares if a third party makes an offer.
• Tag-along clauses allow minority shareholders to sell their shares along with controlling shareholders in a sale to a third party.

Costs of an IPO

• Underwriting spread, legal/auditing fees, printing costs, stock exchange fees, roadshow, travel and organization costs represent direct IPO costs.
• IPO underpricing, considered a cost in economic terms, is not an accounting cost.

Rights Issues and Valuation of Rights

• A company issues new shares to existing shareholders as a capital increase.
• The price of the new shares is usually lower than the price of existing shares to encourage participation.
• The value of rights is calculated subtracting the price of new shares from the price of pre-issue shares, divided by the exchange ratio plus one.

IPO League Table

• This table demonstrates the breakdown and ranking of equity IPOs by firm.

Book Building Process

• This process determines the optimal IPO price.
• It begins with initial market research conducted by underwriters to define a range for the IPO price to be set.
• Presentation of the company is essential for gaining investor interest.
• The price is determined through a dynamic process as investment banks gauge market interest.

IPO Valuation

• Comparable companies and various multiple methods are employed.
• Company-specific factors (e.g. growth expectations, profit margins, balance sheet assets) play a role in determining valuation.
• Discounted cash flow method is frequently used.

Participants in an IPO

• Various parties participate in the IPO process, including the Company's management team, shareholders, legal counsel, investors, investment bank teams, equity research teams, and lawyers.

Greenshoe Over-allotment Option in an IPO

• The greenshoe allows underwriters to sell more shares than originally agreed, typically up to 15%.
• This gives underwriters the ability to maintain share price during the aftermarket.
• Support purchases occur during the aftermarket and involve the repurchase of shares by underwriters to stabilize the price.

Alibaba Case Study Questions

• Calculate primary and secondary share percentages in the Alibaba IPO, including the over-allotment option.
• Calculate the total proceeds raised by Alibaba during the IPO.

IPO Process Stages

• The IPO process generally progresses through distinct stages: structuring phase, informal marketing, external marketing, and final stage. Each stage contains key steps like engagement with underwriters, investor presentations, and setting a price.

IPO Motives

• Companies go public for various reasons, including funding growth, creating employee participation mechanisms, developing a broad investor base, establishing a liquid acquisition currency, and generating investor-driven liquidity for shareholders, all aimed at maximizing long-run firm value.

Listing/IPO for Entrepreneurial/Family Firms

• IPOs for entrepreneurial or family-owned firms can offer advantages like share liquidity and increased transparency, which supports external stakeholder relationships.
• However, disadvantages include increased financial reporting requirements, investor-driven concerns about controlling stake changes, and potentially high operational costs.

Case Study (I & II): Private Equity versus IPO

• The case studies present decision scenarios in financing a company's expansion.
• Key decision points include the relative value and risks associated with a private equity deal compared to an IPO.
• A detailed evaluation involves considering the number of shares that need to be issued, the shareholding changes this necessitates and additional costs involved.