Raising Capital
Raising Capital
This is an introduction to Raising Capital. Material includes a synopsis from multiple sources for easy reference for educational purposes.
Capital Raising Process
Businesses require debt or equity capital to accomplish their financial goals, including growth strategy, M&A transactions, shareholder liquidity, and refinancing costly debt.
We work with businesses to understand financing needs, evaluate funding options, and create & execute a fund-raising plan to secure the most cost-effective form of capital.
We look at your capital stack to figure out the optimal capital structure to ensure the lowest weighted average cost of capital (WACC) for your business.
We do Financial Modeling (Operations Modeling, M&A Modeling and LBO Modeling) and valuation to confirm your requirements and prepare relevant documentation to share with lenders.
Underwriting is the process where a bank raises capital for a corporation, or institution, from investors in the form of equity or debt securities.
Roadshow: This is the opportunity for management to convince investors of the strength of the business cases. Critical areas include: (a) Management structure, governance and quality, (b) Strategy, both tactical and long term, (c) funding requirements and purpose (cash in versus cash out), (d) thorough analysis of the industry & sector, and (e) key risks.
We work with commercial banks, credit companies, insurance companies, private investors and institutional investors to find the right lenders and lending programs.
We reach out to various lenders, shortlist them, and negotiate to secure the funding required for the transaction before deal closing deadline.
Corporate Finance
The ultimate purpose of corporate finance is to maximize the value of a business though planning and implementing management resources while balancing risk and profitability. This includes (a) Capital Investments (decide what projects to invest in to earn the highest possible risk-adjusted return), (b) Capital Financing (determine how to fund capital investments and optimize the firms capital structure), and (c) Dividends and Return of Capital (decide how and when to return capital to investors).
Players and Transactions:
Corporate Finance includes (a) Primary Market, and (b) Secondary Market.
Primary Market consists of (a) Corporations (that Raise Capital by selling Bonds or Shares), (b) Investment Banks (Sell Side), (c) Institutions (Buy Side Fund Managers) and (d) Investors (individuals).
Secondary Market consists of (a) Investment Banks (Fund Managers, who want to Buy or Sell), and (b) Stock Exchange or OTC (to execute transactions).
Market Participants include (a) Investors, consisting of (i) Retail Investors (high net worth individuals) or (ii) Institutional Investors (includes mutual funds, pension funds, private equity firms, venture capital firms, and seed or angel investors), and (b) Corporations, including (i) Public (traded on stock exchanges) and Private (owned and traded by a few private investors).
Types of Transactions include (a) Initial Public Offerings (IPO), (b) Follow-On Offering, (c) Private Placement, (d) Mergers & Acquisitions (M&A), (e) Leverage Buy-Out (LBO) and (f) Divestiture.
Valuing Capital Investments
Capital Investment is any investment for which the economic benefit is greater than a year, like opening a factory, entering a new market, acquiring another business, or research and development of new products. Capital Investments will increase the assets of a company.
Company needs to value the investments to evaluate if they are worthwhile for the company, and this is done using (a) Net Present Value (NPV) and (b) Internal Rate of Return (IRR).
(1) Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the entire life of an investment, discounted to the present.
NPV can be calculated by adding the ‘Present Value‘ of all future forecasted period cash flows + present value of the ‘Terminal Value‘.
Present Value = Future Value x 1 / (1 + i) ^n
where n = Period (so 1st Year will be ‘1’), and
i = Discount Rate (Represents Cost of Capital, so 10% will be 0.1)
(2) Internal Rate of Return (IRR) is the expected compound annual rate of return that will be earned on a project or investment.
Terminal Value is the value of free cash flow beyond the forecast period. There are two ways to calculate Terminal Value, including (a) Growing Perpetuity Formula, or (b) Exit Multiple Formula.
(a) Growing Perpetuity Formula:
Terminal Value = Free cash Flow x (1 + Growth) / (Cost of Capital – Growth)
(b) Exit Multiple Formula:
Terminal Value = x Multiple
(i.e. Earnings, EBITDA, Revenue) Drivers of Value:
Drivers of value are (a) free cash flow, (b) growth, and (c) cost of capital.
Free Cash Flow depends on business strategy, revenue, cost structure and asset utilization. Growth must be organic and sustainable. Cost of capital depends on risk, current capital structure and macro factors.
Enterprise Value: Enterprise Value is the Net Present Value (NPV) of the business and includes market value of equity and debt.
Enterprise Value = Market Value of Equity (Market Capitalization) + Market Value of Net Debt
Market Value of Equity = (Share Price x Outstanding Shares) = NPV of Business – Debt + Cash
Mergers and Acquisitions
Mergers and Acquisitions (M&A) is the process of buying, selling or combining companies. Benefits include cost savings, revenue enhancements, increased market share, and enhanced financial resources. Potential drawbacks include overpaying, large expenses associated with the transaction, and negative reaction to M&A.
Strategic Buyers are operating businesses that seek horizontal or vertical expansion, and they identify and deliver operating synergies.
Financial Buyers include Private Equity (financial sponsor) or professional investor (non-operator) that leverages (uses debt) to maximize equity returns. Most of the acquisitions are competitive or potentially competitive. Companies normally have to offer more than rival bidders, so Buyers need to “do more” with the acquisition, accept a lower expected return, or have a different view or forecast for the future.
Acquisition Valuation Process includes (1) Value the Target as stand- alone (Enterprise Value), then calculate (2) Value Synergies (Hard and Soft), and (3) Transaction Cost, then calculate (4) Net Synergies, then calculate the (5) Value Created.
Net Synergies = Hard Synergies + Soft Synergies – Transaction Cost
Stand Alone Enterprise Value + Net Synergies = Consideration (price paid) + Value created
M&A Synergies include (1) Soft Synergies (top line growth) like (a) Sales (volume and price), and (2) Hard Synergies (bottom line savings) like (b) EBIT margin (product mix, overhead reductions), (c) Operating Tax (tax efficiency, tax losses), (d) working capital (vendor relationships), and (e) capital expenditures (efficiencies).
M&A Synergies include (1) Soft Synergies (top line growth) like (a) Sales (volume and price), and (2) Hard Synergies (bottom line savings) like (b) EBIT margin (product mix, overhead reductions), (c) Operating Tax (tax efficiency, tax losses), (d) working capital (vendor relationships), and (e) capital expenditures (efficiencies).
Capital Financing
Capital Financing is any type of funding that is used to finance the purchase of an asset or project (an investment). It’s done using Equity or Debt. Capital Financing will increase the liabilities (debt) and or equity of a company. Companies go through a Business Lifecycle including (a) launch, (b) growth, (c) shake-out, and (d) maturity. Initially a company has more equity financing (less debt) and higher risk. As the stage of the firm’s lifecycle progresses, business risk reduces and debt financing increases.
Capital Structure is the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. In order to optimize its structure, a firm will decide if it needs more debt or equity and can issue whatever it requires. Low Leverage implies higher equity than debt, and High Leverage implies more debt than equity.
Optimal Capital Structure: The equity versus debt decision depends on a several factors, including (a) the current economic climate, (b) businesses’ existing capital structure, and (c) the businesses’ lifecycle stage. Having too much debt may increase the risk of default in repayment and depending too heavily on equity may dilute earnings and value of original investors. Companies are usually looking for the optimal combination of debt and equity to minimize the cost of capital.
Weighted Average Cost of Capital (WACC) is the proportion of debt and equity a firm has by their respective costs. Cost of Equity is the rate of return a shareholder requires for investing equity into the business. Cost of Debt is the rate of return a lender requires given the risk of the business. The optimal capital structure of a firm is often defined as the proportion of debt and equity that results in the lowest weighted average cost of capital (WACC) for the firm.
Debt: % Net Debt x Cost of Debt = Debt Contribution
Equity: % Equity x Cost of Equity = Equity Contribution
Weighted Average Cost of Capital = Debt Contribution + Equity Contribution
Capital Stack
Capital Stack is the mixture of business equity and debt that is used to optimally finance the capital investments.
Equity includes (1) Common Shares, (2) Preferred Shares, and (3) Shareholder Loans.
(1) Common Shares have last liquidation position and last dividend position, and thus have highest risk. These are typically the majority of a firm’s equity capital. They have proportional share of residual value of the business, proportional share of payment of common dividends, and have voting rights (or may not in some cases).
(2) Preferred Shares have higher liquidation and higher dividend priority (vs Common). These are becoming less attractive as they are more costly than common shares, and even if company has cash, payments may not be made if there is lack of distributable reserves. The ‘norm’ is for private equity to subscribe to preferred shares which have (a) liquidity preference, (b) have fixed dividend, and (c) have anti-dilution rights.
(3) Shareholder Loans have higher liquidation position, and no dividend, but pays interest. Shareholder loans are a means for private equity to invest sufficient equity into a buyout situation, while still allowing management a significant stake.
Sources of Equity include (1) Private Market, which comprises of (a) Founders, (b) Venture Capital, and (c) Private Equity, and (2) Public Markets, which comprises of (a) Institutional, and (b) Retail.
Private Equity Firms manage funds or pools of capital that invest in companies that represent an opportunity for a higher rate of return. Private Equity funds invest for limited time periods. Exit strategies include IPOs, or selling to another Private Equity Firm.
Private Equity firms are split into two categories, including (a) Venture Capital Fund, that typically invest in early stage or expanding businesses that have limited access to other forms of financing, and (b) Buyout or LBO Fund, that typically invest in more mature businesses, usually taking a controlling interest and leveraging the equity invested with a substantial amount of external debt. Buyout Funds are significantly larger than Venture Capital Funds. Typical Exit Routes for Private Equity include (1) Total Exit, including (a) Sale to Strategic Buyer, or (b) Sale to Sponsor, or (2) Partial Exit, including (a) Private Placement, or (b) Corporate Restructuring, or (3) Flotation or IPO.
Equity has no interest payment or mandatory fixed payments, no maturity dates (no capital repayment), has ownership and a degree of control over the business, has voting rights (typically), has a high implied cost of capital, expects a high rate of return (dividends and capital appreciation), has last claim on firm’s assets in the event of liquidation, and provides maximum flexibility.
Debt: Corporations use debt to lower the cost of capital and avoid equity dilution. Leverage is defined by Debt/Total Capital. As the Leverage increases, the WACC comes down to a minimal point, and then goes up – That’s the optimal leverage. As the company pays down debt over 3-5 years, the equity increases, thus increasing the equity return (increased IRR) of the investor.
Debt Capacity depends on (1) General Measures, including (a) level of EBITDA, (b) volatility or stability of EBITDA (due to capital expenditures, cyclicality, risk or competition), (2) Balance Sheet Measures, including (a) Debt to Equity, (b) Debt to Capital, and (c) Debt to Assets, and (3) Cash Flow Measures, including (a) Total Debt/EBITDA, (b) Senior Debt/EBITDA, (c) Net Debt / EBITDA, (d) Cash Interest Cover, and (e) EBITDA- Capex/Interest.
Debt includes (a) Senior Debt, and (b) Subordinated Debt.
Senior Debt includes (a) Revolver, (b) Term Loan A, (b) Term Loan B, (c) Term Loan C. Senior Debt Capacity is 2.0X to 3.0X EBITDA and 2.0X Interest Coverage. Senior Debt is typically provided by (a) Commercial Banks, (b) Credit Companies, and (c) Insurance Companies.
Subordinated Debt includes (a) High Yield Bonds, (b) Mezzanine Warrantless, (c) Mezzanine Warranted, (d) PIK Notes (Pay In Kind), and (e) Vendor Notes. These are listed in the order of increasing subordination, increasing return and increasing dilution. Subordinate Debt is used to fill the funding gap. Subordinate Debt Constraints include: (a) Total Debt / EBITDA = 5-6 times, (b) xEBITDA/Cash Interest = 2 times, (c) Equity Funding = 30-35%. The appropriate financial structure has to be constructed with these constraints.
Credit Rating Agencies like (a) Moody’s, (b) S&P, (c) Fitch, and (d) DBRS, provide credit ratings for corporate debt, as (1) Investment Grade (A & B, provides low risk, low returns, low fees), and (2) High Yield (B & C, provides high risk, high return, high fees).
Mezzanine Debt is a non-traded debt, which is subordinate to senior debt, bullet repaid, pays a cash and accrued return, and can have warrants attached. Examples: (a) debt with warrants, (b) convertible loan stock, or (c) convertible preference shares. Returns include (1) Contractual Return, including (a) Cash Pay interest, and (b) Accrued Interest, and (2) Warrants of post exit value (3-10%), so Total Mezz Debt Return may be IRR 14-20%.
Debt has interest payments, has a fixed repayment schedule, has first claims on a firms assets in the event of liquidation, requires covenants and financial performance metrics, contains restrictions on operational flexibility, has a lower cost than equity, expects a lower rate of return, prevents dilution of equity, and can push a company into default / bankruptcy.
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16192 Coastal Highway, Lewes, DE 19958
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