Module II: Venture Capital Financing

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Module II Venture Capital Financing

• Week 5 September 23 and 25, 2002

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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

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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

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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.

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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

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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

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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.

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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.

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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 VCs rate of return

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Computation
Notice that we use the PV of warrants in year 0
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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?

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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

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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

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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

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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

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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

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Financing an LBO
Mezzanine Financing
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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

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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

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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

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LBO Targets

• Firms with large cash flows
• Firms in less risky industries with stable
  profits
• Firms with unutilized debt capacity
• Example
• O. M. Scott

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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.

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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

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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

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Free Cash Flow Argument

• When the firms 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

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The Trigger Strategy
Red arrows mark the amount of firm value that can
be lost without triggering bond-holder action
Retained Earnings
Equity Paid In
Debt
High Debt
Normal
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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.

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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 RD costs and high
  capital expenditures, you may cut muscle with the
  fat.

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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

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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

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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

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Empirical Evidence

• LBOs 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

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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.

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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

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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

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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

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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

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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

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Results

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

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Caveats

• Debt also increased The leverage ratio rose
  from 27 to 74
• Orderly implementation LBO-like
• But, did it take too long?

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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

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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