Financing and Raising Capital 9781472920386, 9781849300193, 9781472924681

Table of contents :
Cover
Half-title
Title
Copyright
Contents
Contributors
Best Practice—Issuing Debt
Optimizing the Capital Structure: Finding the Right Balance between Debt and Equity
Issuing Corporate Debt
Banks and Small and Medium-Sized Enterprises: Recent Business Developments
Capital Structure: A Strategy that Makes Sense
Capital Structure: Perspectives
Capital Structure: Implications
Credit Ratings
Raising Capital in the United Kingdom
Minimizing Credit Risk
How and When to Use Nonrecourse Financing
Understanding the True Cost of Issuing Convertible Debt and Other Equity-Linked Financing
Securitization: Understanding the Risks and Rewards
Using Securitization as a Corporate Funding Tool
What the Rise of Global Banks Means for Your Company
Public—Private Partnerships in Emerging Markets
Best Practice—Equity Investment
Sources of Venture Capital
Assessing Opportunities for Growth in Small and Medium Enterprises
Equity Issues by Listed Companies: Rights Issues and Other Methods
Attracting Small Investors
Raising Capital in Global Financial Markets
Financial Steps in an IPO for a Small or Medium-Size Enterprise
The Role of Institutional Investors in Corporate Financing
Understanding and Accessing Private Equity for Small and Medium Enterprises
Assessing Venture Capital Funding for Small and Medium-Sized Enterprises
Price Discovery in IPOs
How to Set the Hurdle Rate for Capital Investments
Private Investments in Public Equity
Understanding Equity Capital in Small and Medium-Sized Enterprises
IPOs in Emerging Markets
Managing Activist Investors and Fund Managers
Acquiring a Secondary Listing, or Cross-Listing
The Cost of Going Public: Why IPOs Are Typically Underpriced
Checklists—Issuing Debt
Assessing Cash Flow and Bank Lending Requirements
The Bond Market: Its Structure and Function
Financial Intermediaries: Their Role and Relation to Financial Markets
Franchising a Business
How to Manage Your Credit Rating
How to Use Receivables as Collateral
Maintaining the Banking Relationship
Measuring Gearing
Money Markets: Their Structure and Function
Overview of Loan Agreements
Raising Capital by Issuing Bonds
Steps for Obtaining Bank Financing
Understanding and Using Interest Coverage Ratios
Understanding and Using Leverage Ratios
Understanding Debt Cover
Understanding Fixed-Charge Coverage
Checklists—Equity Investment
Dealing with Venture Capital Companies
Investors and the Capital Structure
Options for Raising Finance
An Overview of Stockholders' Agreements
Raising Capital by Issuing Shares
Raising Capital through Private and Public Equity
Sovereign Wealth Funds—Investment Strategies and Objectives
Sovereign Wealth Funds—Profiles of the Top 10 Players
Understanding Capital Markets, Structure and Function
Understanding Capital Structure Theory: Modigliani and Miller
Understanding the Cost of Capital and the Hurdle Rate
Understanding the Weighted Average Cost of Capital (WACC)
Using Mezzanine Financing
Index

Citation preview

FINANCING AND RAISING CAPITAL

FINANCING AND RAISING CAPITAL

B L O O M S

B U R Y

Copyright © Bloomsbury Information Ltd, 2011 First published in 2011 by Bloomsbury Information Ltd 36 Soho Square London WiD 3QY United Kingdom All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or transmitted by any means, electronic, mechanical, photocopying, or otherwise, without the prior written permission of the publisher. The information contained in this book is for general information purposes only. It does not constitute investment,financial,legal, or other advice, and should not be relied upon as such. Nc representation or warranty, express or implied, is made as to the accuracy or completeness of the contents. The publisher and the authors disclaim any warranty or liability for actions taken (or not taken) on the basis of information contained herein. The views and opinions of the publisher may not necessarily coincide with some of the views and opinions expressed in this book, which are entirely those of the authors. No endorsement of them by the publisher should be inferred. Every reasonable effort has been made to trace copyright holders of material reproduced in this book, but if any have been inadvertently overlooked then the publisher would be glad to hear from them. pp. 41-44, "Raising Capital in the United Kingdom" copyright © Lauren Mills A CIP record for this book is available from the British Library. Standard edition ISBN-10:1-84930-019-4 ISBN-13: 978-1-84930-019-3

Middle East edition ISBN-10: -84930-020-8 ISBN-13: 978-1-84930-020-9

This book is produced using paper that is made from wood grown in managed, sustainable forests. It is natural, renewable and recyclable. The logging and manufacturing processes conform to the environmental regulations of the country of origin. ISBN 978-1-47292-468-1 (ePDF) ISBN 978-1-47292-467-4 (ePub)

Contents Contributors Best Practice—Issuing Debt Optimizing the Capital Structure: Finding the Right Balance between Debt and Equity Meziane Lasfer Issuing Corporate Debt Steven Lowe Banks and Small and Medium-Sized Enterprises: Recent Business Developments Sergio Schmukler, Augusto de la Torre, and Maria Soledad Martinez Peria Capital Structure: A Strategy that Makes Sense John C. Groth Capital Structure: Perspectives John C. Groth Capital Structure: Implications John C. Groth Credit Ratings David Wyss Raising Capital in the United Kingdom Lauren Mills Minimizing Credit Risk Frank J. Fabozzi How and When to Use Nonrecourse Financing Thomas McKaig Understanding the True Cost of Issuing Convertible Debt and Other Equity-Linked Financing Roger Lister Securitization: Understanding the Risks and Rewards Tarun Sabarwal Using Securitization as a Corporate Funding Tool Frank J. Fabozzi What the Rise of Global Banks Means for Your Company Chris Skinner Public—Private Partnerships in Emerging Markets Peter Koveos and Pierre Yourougou

vii l 3 7 11 17 25 31 37 41 45 49 53 57 63 69 73

Best Practice—Equity Investment 81 Sources of Venture Capital Lawrence Brotzge 83 Assessing Opportunities for Growth in Small and Medium Enterprises Frank Hoy 89 Equity Issues by Listed Companies: Rights Issues and Other Methods Seth Armitage 93 Attracting Small Investors Wondimu Mekonnen 97 Raising Capital in Global Financial Markets Reena Aggarwal 103 Financial Steps in an IPO for a Small or Medium-Size Enterprise Hung-Gay Fung 109 The Role of Institutional Investors in Corporate Financing Hao Jiang 115 Understanding and Accessing Private Equity for Small and Medium Enterprises Arne-G. Hostrup 123 Assessing Venture Capital Funding for Small and Medium-Sized Enterprises Alain Fayolle and Joseph LiPuma 129 Price Discovery in IPOs Jos van Bommel 135 How to Set the Hurdle Rate for Capital Investments Jon Tucker 141 Private Investments in Public Equity William K. Sjostrom, Jr 147 Understanding Equity Capital in Small and Medium-Sized Enterprises Siri Terjesen 151 IPOs in Emerging Markets Janusz Brzeszczynski 159 165 Managing Activist Investors and Fund Managers Leslie L. Kossoff Acquiring a Secondary Listing, or Cross-Listing Meziane Lasfer 169 The Cost of Going Public: Why IPOs Are Typically Underpriced Lena Booth 173 Checklists—Issuing Debt Assessing Cash Flow and Bank Lending Requirements The Bond Market: Its Structure and Function Financial Intermediaries: Their Role and Relation to Financial Markets Franchising a Business How to Manage Your Credit Rating How to Use Receivables as Collateral Maintaining the Banking Relationship Measuring Gearing Money Markets: Their Structure and Function

177 179 181 183 185 187 189 191 193 195 v

Financing and Raising Capital £ C £2 fi £.9

Overview of Loan Agreements Raising Capital by Issuing Bonds Steps for Obtaining Bank Financing Understanding and Using Interest Coverage Ratios Understanding and Using Leverage Ratios Understanding Debt Cover Understanding Fixed-Charge Coverage

197 199 201 203 205 207 209

Checklists—Equity Investment Dealing with Venture Capital Companies Investors and the Capital Structure Options for Raising Finance An Overview of Stockholders' Agreements Raising Capital by Issuing Shares Raising Capital through Private and Public Equity Sovereign Wealth Funds—Investment Strategies and Objectives Sovereign Wealth Funds—Profiles of the Top 10 Players Understanding Capital Markets, Structure and Function Understanding Capital Structure Theory: Modigliani and Miller Understanding the Cost of Capital and the Hurdle Rate Understanding the Weighted Average Cost of Capital (WACC) Using Mezzanine Financing

211 213 215 217 219 221 223 225 227 231 233 235 237 239

Index

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Contributors Reena Aggarwal is the Robert E. McDonough professor of business and professor of finance at Georgetown University's McDonough School of Business in Washington, DC. She specializes in international stock markets, demutualization of stock exchanges, initial public offerings, international investments by mutual funds, and international corporate governance and market valuation. She has been named among "outstanding faculty" in the Business Week Guide to the Best Business Schoob. She is also a faculty associate of the Capital Markets Research Center. Dr Aggarwal is a frequent guest on local and international radio and television stations. Her research and comments have been cited in the Wall Street Journal, the Washington Post, Business Week, and the Financial Times, among other media outlets.

financial services company), and five years as a founder of a corporate venturing project, which resulted in Providian establishing an entirely new business. Since 1994, Brotzge has been an independent consultant and an angel investor. He has an ownership position in several small/ start-up businesses and consults with a number of other companies.

Janusz Brzeszczynslri is a senior lecturer in the Department of Accountancy, Economics and Finance at Heriot-Watt University, Edinburgh, and specializes in internationalfinance,financial markets, and financial econometrics. Before joining Heriot-Watt, he held a Fulbright scholarship in the United States and worked as a visiting professor in the Department of Economics, Arizona State University. He was also a visiting scholar at the Swiss Institute of Seth Armitage is a professor of finance and Banking and Finance, University of St Gallen, director of the MSc in finance and investment at Switzerland, and assistant/associate professor the University of Edinburgh Business School. at the Chair of Econometric Models and His research is mainly in the area of corporate Forecasts, University of Lodz, Poland. Besides finance and includes projects on rights issues the Fulbright scholarship, he was also awarded and open offers, the cost of capital, the role of an ESKAS post-doctoral scholarship at the Swiss banks in funding companies, and mutual Institute of Banking and Finance and a DAAD financial institutions. He is author of The Cost of doctoral scholarship at Kiel University, Germany. Capital: Intermediate Theory (Cambridge Dr Brzeszczynski has published in a number of University Press, 2005). He was on the faculty of finance journals. the University of Edinburgh from 1989 to 2002, and before rejoining in 2007 he was head of the Augusto de la Torre is the chief economist for Department of Accounting and Finance at Latin America and the Caribbean at the World Bank. Since joining the Bank in 1997, he has held Heriot-Watt University. the positions of senior adviser in the Financial Lena Booth is associate professor of finance at Systems Department and senior financial sector the Thunderbird School of Global Management adviser for the Latin American and Caribbean and served as the first executive director of the regions. From 1993 to 1997 he was the head of the Thunderbird Private Equity Center (TPEC). Dr Central Bank of Ecuador, and in November 1996 Booth has been a member of the Thunderbird Euromoney nominated him as the year's "Best faculty since 1995 and has taught and presented Latin American Central Banker." From 1986 to research in many countries around the world. 1992 he worked at the International Monetary Her research interests lie mainly in capital Fund, where, among other positions, he was raising and security issuance by firms, with the the IMF's resident representative in Venezuela primary focus on initial public offerings. She has (1991-1992). De la Torre has published on a received several teaching and research awards broad range of macroeconomic and financial during her tenure at Thunderbird. Born and development topics. He is a member of the raised in Malaysia, Dr Booth holds a BBA from Carnegie Economic Reform Network. the National University of Singapore, an MBA from Northern Arizona University, and a PhD Frank J. Fabozzi is professor in the practice of (finance) from Arizona State University. finance at Yale School of Management and specializes in investment management and Lawrence Brotzge's business background structured finance. He is editor of the Journal of includes 11 years with Ernst & Young, 10 years as Portfolio Management and has authored and corporate controller and CFO for two major edited many acclaimed books, three of which divisions of Providian Corp (a Fortune 500 were coauthored with the late Franco Modigliani

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and one coedited with Harry Markowitz. Professor Fabozzi is a consultant to several financial institutions, is on the board of directors of the

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BlackRock complex of closed-end funds, and is on the advisory council for the Department of Operations Research and Financial Engineering at Princeton University. He was inducted into the Fixed Income Analysts Society Hall of Fame in November 2002 and is the 2007 recipient of the C. Stewart Sheppard Award given by the CFA Institute.

Alain Fayolle is professor and director of the entrepreneurship research center at EM Lyon Business School, France. He is also visiting professor at Solvay Brussels School of Economics and Management, Belgium, and HEC Montreal, Canada. His current research work focuses on the dynamics of entrepreneurial processes, the influence of cultural factors on organizations' entrepreneurial orientation, and the evaluation of entrepreneurship education. Professor Fayolle's most recent books are Entrepreneurship and New Value Creation: The Dynamic of the Entrepreneurial Process (Cambridge University Press, 2007) and The Dynamics between Entrepreneurship, Environment and Education (Edward Elgar, 2008).

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and foreign bank participation in developing countries. Currently she is conducting research on financial sector outreach and on the impact of remittances on financial development. Prior to joining the World Bank, she worked at the Brookings Institution, the Central Bank of Argentina, the Federal Reserve Board, and the International Monetary Fund. She holds a PhD in economics from the University of California, Berkeley, and a BA from Stanford University. Thomas McKaig is a widely recognized Canadian author with 30 years of international business experience in 40+ countries. He delivers quality business solutions to clients in five languages. He owns Thomas McKaig International, Inc., found at www.tm-int.com. He speaks internationally on quality management and international trade, and is an adjunct professor, teaching Global Business Today in the Executive MBA program at the University of Guelph. His most recent book is Global Business Today (McGraw Hill-Ryerson), with his next international business book due in stores in November 2011. He has served as executive in residence at the University of Tennessee and Universidad de Montevideo and was worldwide strategic marketing adviser to the United States Treasury Department Bureau of the US Mint's Gold Eagle Bullion coin program. Wondimu Mekonnen is a program director of accounting and finance and a lecturer in management accounting at the University of Buckingham. Before joining the University of Buckingham, he lectured at Addis Ababa University for many years and briefly at Grafton College. He also worked for seven and a half years for JSA Services, a firm of chartered accountants based in Watford, UK, in the capacity of accountant and corporate tax accountant, where he gained extensive experience of dealing with small investors and private entrepreneurs.

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Lauren Mills is a senior financial journalist with 17 years' experience working for business publications and national newspapers. She was retail correspondent for the Sunday Telegraph for more than five years and went on to become enterprise editor at the Sunday Express, before joining the Mail on Sunday's financial desk covering a range of sectors that now includes banking, insurance, private equity, mining, pharmaceuticals, and manufacturing. She has also contributed business articles to the Sunday

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Times, the Daily Telegraph, the Daily Mail, the Financial Times, and the Independent on Sunday. Tarun Sabarwal is assistant professor of economics and Oswald Scholar at the University of Kansas. He received his doctorate from the University of California at Berkeley. His research interests include microeconomic theory and financial economics. Dr Sabarwal's work has been published in a number of academic journals, most recently in Economic Theory, in Regional Science and Urban Economics, and in Annals of Finance, among others. He has presented his work at conferences around the world. Sergio Schmukler is lead economist with the Development Research Group of the World Bank. He has also worked continuously for the Office of the Chief Economist for Latin America and for the East Asia and South Asia regions. Besides his work for the World Bank, he has been treasurer of LACEA (Latin American and Caribbean Economic Association) since 2004, was associate editor of the Journal of Development Economics (2001-2004), taught in the Department of Economics, University of Maryland (1999-2003), and worked in the International Monetary Fund Research Department (2004-2005). He gained his PhD at the University of California at Berkeley. William K. Sjostrom, Jr, is a professor of law at the James E. Rogers College of Law at the University of Arizona. He graduated magna cum laude from Notre Dame Law School in 1996, where he was an editor of the Law Review and a Dean's Scholar. Prior to law school, Professor Sjostrom worked as an options trader at the Chicago Board Options Exchange. He received his undergraduate degree in finance with high honors from the University of Illinois in 1991. Before entering academia, Sjostrom worked for four years at the Minneapolis law firm of Fredrikson & Byron, where he focused on public and private securities offerings, venture capital financing, and mergers and acquisitions. Chris Skinner is well known as an authority on the future of banking. He chairs the Financial Services Club, a European networking group, works with the media, and presents extensively at conferences globally, speaking about the future of banking. He has written several books on the subject and keeps a daily blog at

Contributors www.thefinanser.co.uk. Previously, he was vice president of marketing and strategy for Unisys Global Financial Services and strategy director with NCR Financial Services. Skinner is also a cofounder of the website for strategists www.shapingtomorrow.com. Siri Terjesen holds a PhD from Cranfield School of Management (2006), a master's in international business from the Norwegian SchoolofEconomicsandBusinessAdministration (Norges Handelshuyskole), where she was a Fulbright scholar (2002), and a BS in business administration from the University of Richmond, Virginia (1997). She is an assistant professor in the Kelley School of Business at Indiana University and a visiting research fellow in the entrepreneurship, growth, and public policy group at the Max Planck Institute of Economics in Jena, Germany. She has been widely published in leading journals and is a coauthor of Strategic Management: Logic & Action (Wiley, 2008). Jon Tucker is professor offinanceat the Bristol Business School of the University of the West of England and is director of the Centre for Global Finance there. He holds a PhD in European corporate finance (1995) and a BSc in applied economics (1991), both from the University of Plymouth. He has published frequently in leading finance journals and is associate editor of the Journal of Finance and Management in Public Services. He is chief examiner in investment analysis for the Securities and Investment Institute and visiting professor at Universitatea Babes-Bolyai, in Romania. Jos van Bommel is associate professor at CEU Cardenal Herrera University, in Valencia, Spain. He was formerly a lecturer in finance at Oxford University's Said Business School and conducts empirical and theoretical research in various areas of corporate finance. He has completed

several studies on IPOs, but is also interested in private equity, venture capital, and international finance. He also studies the market's microstructure and investigates the strategic behavior of informed and less informed traders to better understand how information is incorporated into market prices. Dr van Bommel holds a university degree in engineering from the University of Eindhoven, an MBA from the IESE Business School, and a PhD in finance from INSEAD. In between his studies he worked in international sales and marketing.

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David Wyss is chief economist at Standard & Poor's. He is responsible for S&P's economic forecasts and publications. Wyss joined Data Resources, Inc., in 1979 as an economist in the European Economic Service in London, which was acquired by McGraw-Hill. He returned to the United States in 1983 as chief financial economist for DRI/McGraw-Hill, became chief economist for Standard & Poor's DRI in 1992, and chief economist for Standard & Poor's in 1999. Wyss holds a BS from the Massachusetts Institute of Technology and a PhD in economics from Harvard University. Pierre Yourougou is associate professor of finance at the Whitman School of Management, Syracuse University. He is also managing director of the Africa Business Program at the Whitman School. His research and teaching interests are in the areas of corporate finance, financial institutions and markets, and emerging markets. Prior to joining Syracuse University in 2006, Professor Yourougou worked for the World Bank, where he held various senior level positions in the corporate finance, financial products development, and public debt management departments. He received his PhD in banking and finance from New York University's Stern School of Business.

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Best Practice Issuing Debt

Optimizing the Capital Structure: Finding the Right Balance between Debt and Equity by Meziane Lasfer EXECUTIVE SUMMARY • Just over 50 years ago Miller and Modigliani (1958) showed that under a certain set of conditions—namely perfect capital markets with no taxes and agency conflicts—a firm's capital structure is irrelevant to its valuation. • Their results are controversial and have raised a large number of questions from academics and practitioners. • This article summarizes the main issues underlying the choice by firms of an appropriate capital structure, taking into account their specific fundamentals as well as macroeconomic factors. • It presents the benefits and costs of borrowing, describes how to assess these to arrive at the basic trade-off between debt and equity, and examines conditions under which debt becomes irrelevant.

TYPES OF FINANCING There are three financing methods that companies can use: debt, equity, and hybrid securities. This categorization is based on the main characteristics of the securities. Debt Financing Debt financing ranges from simple bank debt to commercial paper and corporate bonds. It is a contractual arrangement between a company and an investor, whereby the company pays a predetermined claim (or interest) that is not a function of its operating performance, but which is treated in accounting standards as an expense for tax purposes and is therefore tax-deductible. The debt has afixedlife and has a priority claim on cash flows in both operating periods and bankruptcy. This is because interest is paid before the claims to equity holders, and, if the company defaults on interest payments, it will be declared bankrupt, its assets will be sold, and the amount owed to debt holders will be paid before any payments are made to equity holders. Equity Financing Equity financing includes owners' equity, venture capital (equity capital provided to a private firm in exchange for a share ownership of the firm), common equity, and warrants (the right to buy a share of stock in a company at a fixed price during the life of the warrant). Unlike debt, it is permanent in the company, its claim is residual and does not create a tax advantage from its payments as dividends are paid after

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interest and tax, it does not have priority in bankruptcy, and it provides management control for the owner. Hybrid Securities Hybrid securities are securities that share some characteristics with both debt and equity and include, for example, convertible securities (defined as debt that can be converted into equity at a prespecified date and conversion rate), preferred stock, and option-linked bonds. THE IRRELEVANCE PROPOSITION In 1958 Modigliani and Miller demonstrated that, under a certain set of assumptions, the choice between any of these securities (referred to as capital structure or leverage) is not relevant to a company's valuation. The assumptions include: no taxes, no costs of financial distress, perfect capital markets, no interest rate differentials, no agency costs (rationality), and no transaction costs. These assumptions are, in fact, the main drivers of capital structure and gave rise to the trade-off theory of leverage. THE TRADE-OFF OF DEBT In this so-called Miller-Modigliani framework, firms choose their optimal level of leverage by weighing the following benefits and costs of debt financing. Benefits of Debt There are two main advantages of debt financing: taxation, and added discipline. Taxation: Since the interest on debt is paid

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before taxation, whereas dividends paid to equity holders are usually paid from profit after tax, the cost of debt is substantially less than the cost of equity. This tax-deductibility of interest makes debt financing attractive. Suppose that the debt of a company is $100 million and the interest rate is 10%. Every year the company pays interest of $10 million. Suppose that the corporation tax rate is 30%. If the company does not pay tax, its interest will be $10 million and the cost of debt will be 10%. However, if the company is able to deduct the tax on this $10 million from its corporation tax payment, then the company saves $10 million x 30% = $3 million in tax payments per year, making the effective interest payment only $7 million. If the debt is permanent, every year the company will have a $3 million tax saving, referred to as a tax shield. We can compute the present value (PV) by discounting annual value by the cost of debt, as follows: k x Dx t PV of tax shield - -

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where kd is the cost of debt, D is the amount of debt, and the product of kd and D gives the amount of the interest charge. tc is the corporation tax rate. We simplify the ratio by kd to obtain the present value of the tax shield as the product of the amount of debt and the corporation tax rate. Thus, the value of a company that is financed with debt and equity (such a company is referred to "levered") should be equal to its value if it is financed only with equity plus the present value of the tax shield. We can write this value as: Value of levered firm with debt D = Value of nonlevered firm + D x f.

These arguments suggest that the after-tax cost of debt can be computed as 10% x (1 - 30%) = 7%. Added discipline: In practice, the managers are not the owners of the company. This socalled separation of managers and stockholders raises the possibility that managers may prefer to maximize their own wealth rather that of the stockholders. This is referred to as the agency conflict. In general, debt may make managers more disciplined because debt requires a fixed payment of interest, and defaulting on such payments will lead a company to bankruptcy. Costs of Debt Debt has a number of disadvantages, including a higher probability of bankruptcy, an increase in the agency conflicts between managers and

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bondholders, loss of future financial flexibility, and the cost of information asymmetry. Expected bankruptcy cost. Given that debt holders can declare a company bankrupt if it defaults on its interest payment, companies that have a high level of debt are likely to have a high probability of facing such a default. This probability is also increased when a company is operating in a high business risk environment. Debt financing creates financial risk. Thus, companies that have high business risk should not increase their risk of default by taking on a high financial risk through their use of debt. Evidence indicates that much of the loss of value occurs not in the liquidation process but in the stage of financial distress, when the firm is struggling to pay its bills (including interest), even though it may not go on to be liquidated. Agency costs: These costs arise when a company borrows funds and the managers use the funds to finance alternative, usually more risky, activities than those specified in the borrowing contract to generate higher returns to stockholders. The greater the separation between managers and lenders, the higher the agency costs. Loss of future financing flexibility: When a firm increases its debt substantially, it faces difficulties raising additional debt. Companies that can forecast their future financing needs accurately can plan their financing better and may not raise additional funds randomly. In general, the greater the uncertainty about future financing needs, the higher the costs. Information asymmetry: When companies do not disclose information to the market, their information asymmetry will be high, resulting in a higher cost of debt financing. Redeployable assets of debt: Lenders require some sort of security when they fund a company. This security is referred to as collateral. Lenders accept assets that can be resold or redeployed into other activities, such as property (real estate), as collateral. In general, the lower the value of the redeployable assets of debt, the higher are the costs. FINANCING CHOICES AND A FIRM'S LIFE CYCLE Although companies may prefer to use internal financing to minimize the issuance (transaction) costs, the trend in financing depends critically on the firm's life cycle. Start-ups are small, privately owned companies. They are likely to befinancedby owners' funds and bank borrowings. Their funding needs are high, but their ability to raise external funding is limited because they do not have sufficient assets to offer as

Optimizing the Capital Structure: Balancing Debt and Equity security tofinanceproviders. They will try to seek private equity funding. Their long-term leverage is likely to be low as they are mainly financed with short-term debt. Expanding companies are those that have succeeded in attracting customers and establishing a presence in the market. They are likely to be financed by private equity and/ or venture capital in addition to owners' equity and bank debt. Their level of debt is low and they have more short-term than long-term debt in their capital structure. High-growth companies are likely to be publicly traded, with rapidly growing revenues. They will issue equity in the form of common stock, warrants, and other equity options, and probably convertible debt. They are likely to have a moderate leverage. Mature companies are likely to finance their activities by internal financing, debt, and equity. Their leverage is likely to be relatively high but will depend on the costs and benefits of debt and their fundamental factors, such as business risk and taxation.

CONCLUSION This article discussed the different financing methods companies can use and then argued that their choice depends on the costs and benefits of debtfinancingand the firm's life cycle. For example, whereas start-up companies are likely to be financed with private personal funds, making their leverage low, mature companies tend to have high leverage because they are able to mitigate the costs of debt and gain from the tax benefits. In addition to these factors, in practice firms may choose their financing mix by mimicking comparable firms, or they may adopt the average level of debt of all the companies in their industry. These methods are not highly recommendable as they may result in a suboptimal choice. In other cases they follow a financing hierarchy, where retained earnings are the preferred option, followed by external financing in the form of debt, and then equity. This preference is driven by the transaction and monitoring costs.

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MAKING IT HAPPEN The choice of financing is strategic and involves the following issues: • Both low- and high-debt financing are suboptimal. Companies should aim for the most advantageous level of debt financing, whereby the costs are minimized and the benefits are maximized. • The costs of debt include a greater probability of bankruptcy, an increase in the agency conflicts between managers and bondholders, a loss of future financial flexibility (including the availability of collateral assets), and information asymmetry costs. • The benefits relate mainly to tax shields and the added discipline to mitigate the agency conflicts between stockholders and managers. • This equilibrium applies primarily to mature companies. Start-ups and growth companies are likely to have lower leverage as their borrowing capacity is low. It also applies to companies that normally pay dividends and do not accumulate cash for reinvestment in order to avoid the need to raise external financing. • The recent financial crisis has highlighted another issue in debt financing, namely liquidity. Leverage concepts were developed mainly in times when debt financing was fully available. In the current credit crisis this is no longer the case. Companies therefore now have to pay an extra liquidity cost to raise additional capital. The question is whether this is a temporary situation or a permanent one, in which case debt will become more costly and leverage will be lower than in the past. • Another challenge of debt financing relates to the ethics of the use of excessive debt financing, particularly by financial institutions. Pettifor (2006) was able to foresee the current crisis, tracing debt financing back to early times and arguing that religions are against debt because it results in usury. She provides interesting arguments, challenging the whole structure of debt financing, payment of interest, and interest tax deductibility. Possibly a new structure of debt that is linked to the profitability of assets and incurs no interest will emerge from the current crisis.

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Books: Damodaran, Aswath. Applied Corporate Finance: A User's Manual. 2nd ed. Hoboken, NJ: Wiley, 2006. Pettifor, A n n . The Coming First World Debt Crisis. Basingstoke, UK: Palgrave Macmillan, 2 0 0 6 .

Articles: Graham, John R., and Campbell R. Harvey. "How do CFOs make capital budgeting and capital structure decisions?" Journal of Applied Corporate Finance 15:1 (Spring 2002): 8-23. Online at: dx.doi.org/10.1111/j.l745-6622.2002.tb00337.x Lasfer, Meziane A. "Agency costs, taxes and debt: The UK evidence." European Financial Management 1:3 (November 1995): 265-285. Online at: dx.doi.org/10.1111/j.l468-036X.1995.tb00020.x Modigliani, Franco, and Merton H. Miller. "The cost of capital, corporation finance and the theory of investment." American Economic Review 48:3 (June 1958): 261-297. Online at: www.jstor.org/stable/info/1809766

Websites: About.com article "Debt financing—Pros and cons": entrepreneurs.about.com/od/financing/a/debtfinancing.htm Answers.com article "Debt financing": www.answers.com/topic/debt-ftnancing Washington State University teaching module "Financing sources for ICTs: Debt finance": cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page31.htm

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Issuing Corporate Debt by Steven Lowe EXECUTIVE SUMMARY • The Nobel Prize-winning Modigliani and Miller theorem that capital structure does not matter does not reflect the inefficiencies of the real world. • Taxes, default costs, agency costs, equity dilution issues, credit rationing, and stockholder/ debtholder tensions all impact the economists' perfect market. • Divergent goals between debt and equity holders lead to a number of behaviors, such as decision risk shifting, underinvestment, and asset stripping, which can skew the financing decision. Debt covenants exist to even out the risk/reward structures between debt and equity holders. • Current economic theory suggests that an optimal capital structure that balances the risk of bankruptcy with the tax savings of debt does exist, although it can be a struggle for individual corporations to hit this target amid the constantly changing influences of the modern operating environment.

INTRODUCTION The existence and determination of optimal capital structure is an ongoing topic of research in corporate finance. In a perfect market setting, with no frictions, Modigliani and Miller's seminal research in 1958 suggested that the market value of a firm is independent of its capital structure. In other words, capital structure does not matter. Miller (1991) explained the intuition for this with a simple analogy: "Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as it is. Or he can separate out the cream, and sell it at a considerably higher price than the whole milk would bring." He continued: "The Modigliani-Miller proposition says that if there were no costs of separation (and, of course, no government dairy support program), the cream plus the skim milk would bring the same price as the whole milk." The essence of the argument is that increasing the amount of debt (cream) lowers the value of outstanding equity (skim milk)—selling off safe cash flows to debtholders leaves the firm with more lowervalued equity, keeping the total value of the firm unchanged. Put differently, any gain from using more of what might seem to be cheaper debt is offset by the higher cost of now riskier equity. Hence, given a fixed amount of total capital, the allocation of capital between debt and equity is irrelevant because the weighted average of the two costs of capital to the firm is the same for all possible combinations of the two. Of course, corporations do not operate in a perfect world, and few if any companies are 100% debt financed. Since Modigliani and Miller's Nobel Prize-winning paper, a host

of possible explanations for the relevance of particular financial structures has emerged, centering around the impact of taxes, the costs of default, agency costs, equity dilution, and credit rationing, as well as the differing goals of management and sponsors. Modigliani and Miller have also suggested that firms maintain a reserve borrowing capacity to allow for economic uncertainty. We will look at each of these potential inefficiencies in turn. IMPACT OF TAXES Of the most obvious violations of Modigliani and Miller's assumptions are corporate taxes and the tax deductibility of interest payments. Usually, interest payments made to debtholders are deducted from corporate profits before they are taxed. Consequently, the corporate tax saved acts as a subsidy on interest payments. For example, if the tax rate is 34%, then for every dollar paid in interest payments 34 cents of corporate taxes are avoided by the company (although those receiving the interest must pay tax on their interest income). In contrast, if income is paid out as dividends to stockholders, that income is taxed twice, once at the corporate level via corporate taxes, and again as an income tax on the equity holder. Hence, any corporation seeking to minimize its taxes and maximize the revenues available to investors should finance itself entirely with debt. In a 1977 article, "Determinants of corporate borrowing," Myers showed that considering corporate taxes in isolation does not reflect real world economic interactions. Transferring interest payments to individual bondholders to

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Financing and Raising Capital

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avoid corporate taxes does not make investors any better off if they then have to pay higher personal taxes on that interest income than the corporation and investors would have owed had the corporation not used debt. Miller argued that because tax rates on capital gains have often been lower than tax rates on individuals' dividend and interest income, the firm might lower the total tax bill paid by the corporation and investor combined by not issuing debt at all. Moreover, taxes owed on capital gains can be deferred until the realization of those gains, further lowering the effective tax rate on capital gains. Because of this interaction, there is an optimal level of debt (less than the 100% suggested above) for corporations as a whole.

DEFAULT COSTS

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Costs associated with financial distress and, more obviously, bankruptcy also keep firms from issuing large levels of debt compared to their level of underlying equity finance. These costs can take two forms, being either explicit or implicit. Explicit default costs include the payments made to lawyers, accountants, and other professional advisers in the case of bankruptcy and liquidation, or filing for Chapter 11 protection. These costs can represent a significant portion of total corporate assets, which are lost to investors in the case of bankruptcy. Corporations also need to consider the indirect costs of financial distress that occur as a company moves closer to default and bankruptcy. These can include higher costs from suppliers which fear that the company might not pay its future bills, and the loss of customers who want stable and longterm relationships with their suppliers and counterparties. Clearly, investors would prefer that firms stay out of default or financial distress so that these costs, both explicit and implicit, are not incurred. However, as a corporation takes on more and more debt, the probability of bankruptcy increases. Hence, the marginal benefit of further increases in debt declines as debt increases. At the same time, the marginal cost increases, so that afirmthat is optimizing its overall value will focus on this trade-off when choosing how much debt and how much equity to use for financing. These costs are one of the factors that restrain firms from maintaining very high levels of debt, and are why different industries, with different earnings volatility, can support different levels of debt.

8

AGENCY COSTS

The decision to issue corporate debt arises from the conflict between competing sources of finance offered by the debt and equity markets. There are large differences between a firm that is 100% owner managed and one in which the equity is owned by external stockholders or a mix of the managers and outside stockholders. With external stockholders, the managers act as agent for the ultimate owners. Although these agents should run the firm to maximize its value, they may not be perfect agents for the equity owners as they may make some decisions to further their own interests ahead of the ultimate owners. Agents could award themselves excess pay or benefits, or indulge in empire-building to increase their own reputations. They may even favor the security of the debtholders rather than the returns of the stockholders. The impact of these agency costs can affect the distribution of financing for a corporate.

CREDIT RATIONING

Traditional economics argues from the standpoint that markets are efficient (as we have seen with Modigliani and Miller's contribution). In 1981 Joseph Stiglitz and Andrew Weiss suggested that markets are only efficient under exceptional circumstances. To reduce potential losses, lenders without perfect knowledge of their counterparties have an incentive not only to charge higher rates to high-risk lenders, but also to ration the provision of credit to them as well. The concern for the lender is that, as it raises the rate of interest charged for its loans, only those firms which are most desperate for finance will take the loans, and these are precisely the corporations that are most likely to go into bankruptcy. If bankruptcy occurs, the corporation is able to walk away from its debt and the lending institution underwrites the cost of failure. This suggests that if a firm is able to obtain a large amount of loan financing, it has a large incentive to undertake higher-risk projects because the risk is asymmetric. Typically, credit rationing will most often happen with smaller and younger corporations, which are more likely to be owned by their founders, rather than to firms that have a track record or some existing external investors. It is with these owner-managed firms that the risk of imperfect knowledge creates most tension between equity and debt holders. Not only is it likely that the manager/owner of a firm has superior information on his business, but he can also adjust his managerial or investment strategy after concluding a debt contract.

Issuing Corporate Debt Only corporations with riskier projects would be ready to take high interest rate loans, so raising the interest rate without credit rationing would increase the proportion of risky borrowers and reduce the overall profitability of the lender.

the bondholders would be better off with the investment, equity holders will be unwilling to pay for them. Alternatively, as corporate default approaches, equity stockholders will be willing to invest all their current investment in a very risky project with high potential returns. If the project fails, the bondholders will lose more, but the stockholders can be no worse off because EQUITY DILUTION Myers and Majluf (1984) produced research their claims were worthless anyway. If, however, suggesting that owner-managers use external the project succeeds, the stockholders will be the financing (debt or equity) only when there is major beneficiaries. insufficient internal financing (i.e. their own Finally, and perhaps most obviously, stockmoney) available for new projects. Indeed, they holders could just pay out all of the firm's go as far as to suggest that managers prefer to assets as dividends to themselves, leaving issue debt over equity. The idea behind this an empty shell for the bondholders to claim theory is that managers often believe they have a when the firm is then unable to repay its debt. better idea of the true worth of their corporation In an effort to prevent this, most debt issues than potential outside bond or equity investors. or bank lending will have covenants attached Since potential investors cannot adequately to prevent the equity holders stripping assets, value stock, it would generally be sold at a price and hence security, away from the corporation below the price the managers think appropriate. that takes on the debt financing. These covenants Rather than sell stock too cheaply, therefore, exist to restrict stockholders' freedom of managers who need externalfinancingwill prefer action, and to try to even out the risk/reward to issue debt. It can be argued that in issuing structures between debt and equity holders. equity to outside investors, owner-managers However, bond contracts cannot prevent all might think that the firm is overvalued and that eventualities. the current owners are taking advantage of this All of these strategies—risk shifting, underovervaluation. This reinforces the view that debt investment, paying out large dividends—are is likely to be preferred over equity in smaller, more likely the more indebted is the firm. private companies. Stockholders may adopt policies that benefit themselves at the expense of the bondholders, DIFFERING GOALS OF FINANCIAL and the incentive to do this is strongest when it SPONSORS is not clear that the firm will have sufficient cash The idea of bondholder and stockholder conflict is flow to cover its debt payments. widely accepted as a key determinant of financial Potential lenders know this and limit the debt policy. Bondholders and stockholders often have competing aims and attitudes to risk-taking they extend accordingly. Similarly, corporate behavior. Even in highly profitable corporations, managers who want to attract lenders and debt stockholders bear most of the investment funding have to judge how much debt is suitable costs but share the benefits with bondholders. for a company in a particular industry and state Consequently, bondholders typically value a of growth. Youngfirmsin high-growth industries, risk-averse strategy as that will increase the for example, tend to use less debt, and firms in chances of getting all their investment back. stable industries with large quantities of fixed Stockholders, on the other hand, are willing assets tend to use more debt. to take on riskier projects. If the risky projects succeed, they will get all the profit themselves, CONCLUSION whereas if the projects fail the risk is shared with Current economic theory, based on many of the ideas discussed above, suggests that an optimal the bondholders. Another area where these divergent goals capital structure exists that balances the risk of are clearly demonstrated is with the problem bankruptcy with the tax savings of debt. Once of underinvestment in times of financial established, this capital structure should provide difficulty. Stockholders have little incentive greater returns to stockholders than they would to invest in new projects as corporate default receive from an all-equity firm. However, the approaches, because the funds they contribute complexities of the competitive environment to the enterprise will benefit bondholders and and the huge diversity of corporations and their other creditors in the event of default; this is competitive environments all affect an individual the so-called debt overhang problem. Even if corporation's optimal capital structure. 9

Financing and Raising Capital .2

MAKING IT HAPPEN

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Debt/Equity ratio (D/E) In these figures I have plotted stock price versus D/E.5 Figure 3 shows the stock price maximized for the optimal D/E ratio according to theory. If investors do indeed value the flexibility we describe, the stock price might be higher if the company pursued a capital structure that moved about in the shallow portion of the curve, resulting in the "Optimal practice" in Figure 3. This scheme

results in a stock price that is maximized with less than the "Optimal theory" D/E ratio. The heavy dotted curve for stock price intentionally has a slightly higher maximum stock price—a speculation on our part. We caution that many theorists would not agree with this conclusion. On the other hand, a number of practitioners as well as investors might find the assertion reasonable.

Figure 3. Flexible capital structure and value

Stock price

Shift in "optimal" D/E if investors value flexibility

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Optimal theory

Debt/Equity ratio (D/E)

21

Financing and Raising Capital CONCLUSION, IDEAS, AND ACTIONS

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Theory is important. Common sense is powerful. Strategy benefits from theory and common sense. The time horizon for strategy depends on a variety of factors, including the dynamics of the social, political, economic, and technology environments. Tactics should be consistent with short-term success and long-term opportunities. Here are some suggestions that might fare well in dynamic environments and prepare you to survive on a favorable basis in periods of high economic uncertainty and market turmoil. • Estimate your current optimal capital structure. • Many (all) economies enjoy/suffer the effects of cycles. When times are good, and as the tide moves to flood, pay down some debt. Move to the left on the shallow portion of the capital structure curve, rather than remain in the region of theoretical optimal debt. Increasing good unused debt capacity not only helps in survival, but also may allow for harvesting opportunities when the falling tides have carried others to peril. • Operate in the shallow part of the WCOC curve. Leave a reasonable chunk of unused debt capacity, enough to allow rapid financing of unusual opportunities. • Compare the current D/E to the target D/E and the shallow curve range for the D/E. If it lies within the shallow curve range, you don't need major adjustments now. Continue to track and anticipate how the company will "walk about" in the shallow curve range. • If the company is outside the shallow curve range, decide on the strategy to move to the target range. The choice of how to move to a more optimal debt/equity ratio hinges on a number of factors, including the expected internally generated cash flows, the expected internal generation of equity, the principal repayment/refunding schedule, cash flow relative to capital investments, dividend policies, and external market conditions. • Compare the business risk of actions you anticipate taking with your current business. Recognize and react to a change in the business risk of the company. If the business risk of the company increases/decreases as a result of good investment choices that are of higher risk, adjust financial risk by decreasing/increasing the target debt/equity ratio. • If you currently have significant unused good debt capacity, recognize that this good debt capacity is of potential interest to a company 22

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seeking acquisitions. The buying company can use your unused good capacity as a way offinancingthe acquisition, or to move the combined company capital structure to a more favorable range. Changing from the use of bad debt capacity might involve one or several different actions, including the acquisition of a company that has unused good capacity. Do not buy a company for this reason alone! However, recognize this potential effect in acquisition strategies. Evaluate whether control issues are important or even dominant; control is often a concern for private or closely held companies. We assert that, for public companies, efforts by management to protect management's position and issues of control should rarely if ever determine the correct course of action. Decide on a strategy for capital structure that is consistent with the corporate strategy. Communicate your capital structure target and strategy to markets. Separately from the choice of D/E and the strategy, effective communication reduces the uncertainty in investors' minds. Here is a sample statement: • "Given our intended investments, likely market conditions, and the tax environment, our target D/E is about 25%. To allow us to take advantage of favorable opportunities during different phases of economic cycles, we will typically maintain a working D/E capital structure, in the 15% to 25% range." • "This strategy allows us to employ good debt capacity to obtain funds quickly to pursue attractive opportunities, regardless of economic conditions and capital market circumstances" "We feel that investors value a flexible financing policy that allows their company to maintain choice of action and to avoid ever being forced to take particular actions." Behave consistently with your strategy. Demonstrated behavior builds and sustains credibility. Increased credibility reduces investor uncertainty and enhances stock prices. Remember that an increase/decrease in the corporate tax rate increases/decreases the value of using debt. Changes in tax rates should prompt a review and adjustment of capital structure.

SUMMARY The prudent use of debt in financing if interest is tax-deductible offers the prospect of increasing firm value.

Capital Structure: A Strategy that Makes Sense Issues of control also influence the use of debt versus equity.6 For publicly owned companies, managers might, inappropriately, use too much debt as a means of perpetuating management's control or to promote management's interests. Making D/E choices to perpetuate control is defensible (although perhaps not wise) to maintain control of private and/or family-owned firms. Perfect capital markets with the taxdeductibility of interest argue for an optimal debt/ equity ratio. The presence of imperfect capital markets, seasonal and cyclical business cycles, a change in the nature and risks of investments, and human behavior suggest a strategy for the management of capital structure. Finance the company in the shallow segment of the weighted cost of capital curve. Leave some unused good debt capacity to allow the company to pursue opportunities even if capital market conditions are unfavorable, or to use as an emergency reserve. The emergency reserve concept rests on the common sense perspective

that a company should never be forced into a course of action—but should be able to choose to follow a course of action. Operate with a debt/equity ratio that is lower than the optimal ratio. This posture provides flexibility, allows practical management in raising capital, and keeps the company away from the steeply increasing WCOC that occurs above the optimal D/E. This position of creditworthiness allows one to raise a chunk of capital from debt to fund an opportunity independent of the conditions in capital markets. Investing the raised capital in good investments will generate cash flow and increase the equity base, with a resultant decrease in the D/E ratio, moving it back to the left. Good projects that are managed well restore good debt capacity and will allow one to repeat the process in future periods. In summary: capital structure makes a difference in an environment in which interest is tax-deductible.

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MORE INFO Articles: Groth, John C , and Ronald C. Anderson. "Capital structure: Perspectives for managers." Management Decision 35:7 (1997): 5 5 2 - 5 6 1 . Online at: dx.doi.org/10.1108/00251749710170529 Israel, Ronan. "Capital structure and the market for corporate control: The defensive role of debt financing." Journal of Finance 46:4 (September 1991): 1391-1409. Online at: www.jstor.org/stable/2328863 Miller, Merton H. "The Modigliani-Miller propositions after thirty years." Journal of Applied Corporate Finance 2 : 1 (Spring 1989): 6 - 1 8 . Online at: d x . d o i . o r g / 1 0 . I l l l / j . l 7 4 5 - 6 6 2 2 . 1 9 8 9 . t b 0 0 5 4 8 . x Modigliani, Franco, and Merton H. Miller. "The cost of capital, corporation finance, and the theory of investment." American Economic Review 48:3 (June 1958): 2 6 1 - 2 9 7 . Online at: www.jstor.org/stable/1809766 Prezas, Alexandres P. "Effects of debt on the degrees of operating and financial leverage." Financial Management 16:2 (Summer 1987): 3 9 - 4 4 . Online at: www.jstor.org/stable/3666002 Prezas, Alexandres P. "Interactions of the firm's real and financial decisions." Applied Economics 20:4 (April 1988): 5 5 1 - 5 6 0 . Online at: dx.doi.org/10.1080/00036848800000064

NOTES 1 Since in perfect capital markets one has no costs and bankruptcy has no undesirable consequences. 2 See Groth, John C. "Accounting and economicsCritical perspectives." qfinance.com. Online at: tinyurl.com/3yp58zv 3 We want the market to understand that the delay in repayment of principal is part of altering the capital structure—to avoid any perception that the company is unable to make the payments of principal. This delay approach is only to avoid debt issuance costs for fresh debt.

4 Depending on circumstances, the structuring of the rights offering can almost certainly ensure that some shareholders not in the control group do not exercise their rights. 5 In many presentations and discussions the plot/ discussion is total firm value versus D/E. 6 Managers and boards of directors that make capital structure decisions to protect their position or influence their rewards generate agency costs borne by stockholders and, in some circumstances, also by creditors.

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EXECUTIVE SUMMARY

• Capital structure reflects the financing strategy and potentially influences the value of a company. • The potential value to shareholders of capital structure depends on the tax environment. • Understanding the logic of capital structure and the origin of potential value is of import to leaders, strategists, and managers. • The greater the business risk, the lower the optimal debt/equity (D/E) ratio. • Tax strategy and management should consider capital structure. The higher the expected tax rate, the more important are capital structure decisions and management.

INTRODUCTION Capital has three forms: human, tangible, and financial. In this article, we focus on how financing choices influence the cost of financial capital and company value. Capital structure focuses on the sources of financial capital. The choice of structure affects firm value in some economies.1 The seminal works of Nobel laureate Franco Modigliani conceived important relationships and issues in capital structure. Subsequently, researchers have nourished the development of capital structure theory and the related literature, and they have influenced practice. Many companies follow the prescriptions of capital structure theory, and create value for stockholders and society.2 We do not have the "perfect" capital markets described by economists, and key factors influence the choice of capital structure. For example, investors are concerned with the potential for, and cost of, bankruptcy. If a company disappoints investors by using too little or too much debt, its stock price will suffer. Understanding exactly how the use of some debt may add to company value is essential to understanding capital structure. First, we will clarify the meaning of capital structure. Then we will address other issues. CAPITAL STRUCTURE The decision on capital structure is the choice of how to finance a company. Capital structure represents the proportion of each source of

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financing relative to total financing. Types of financing fall into broad categories: equity, representing ownership; debt; and preferred financing. Interestingly, in some economies the concept of equity or ownership was unfamiliar until recently, as historically individuals did not enjoy the privilege of ownership. Capital structure is about dividing up expected economic returns (not accounting returns) and risk, in exchange for providing capital. Those divisions are specific. For example, a pecking order exists amongst the different creditors. The "covenants" of debt arrangements, as well as precedent in practice and legal arrangements, address these relationships. For example, in practice "normal" trade credit is often not formalized, and the company routinely pays trade creditors.3 In the context of capital structure and an "ongoing enterprise," equity ownership is last in line with a claim on what others have not claimed of the returns. Equity holders also bear the risks which the creditors and preferred shareholders (if present) have not accepted. In the event of financial distress or bankruptcy, in most economies very specific rules apply to dividing up the carcass.4 In Figure 1, the balance sheet depicts the "assets" and the source of financing, and, consequently, the claim on the assets. For simplicity, we will focus on financing with a combination of debt and equity, ignoring preferred shares as a source of capital. In fact, many firms do not have preferred shares.

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The choice of assets, how well we manage the assets, and the nature and success of our providing product/services to markets, taxes, and other factors determine the business risk of the company. The business risk influences the cost of equity capital. For a firm without debt, or an "unlevered" firm, the cost of equity equals the risk-free rate of interest plus a premium for business risk. Collectively, the business risk factors will determine the expected level and risk of cash flows that originate in the asset side of the company. These expected cash flows that come from the asset side of the company must service any debt. After debt service and the payment of taxes, the net remaining cash flows provide the expected returns to equity holders. The higher the business risk of a company— and hence, the greater the uncertainty in cash flows from the asset side of the business—the less financial risk a company should have, and the lower the optimal D/E ratio. Consequently, the more uncertain the environment, and the greater the sensitivity of the business side of the company to the economic environment, the more important it is that one select a capital structure with care. Companies with high sensitivity to the cyclical effects of the economy should consider a more conservative capital structure, and have a strategy to manage the structure across economic cycles. For the purposes of discussion, Figure 1 shows four alternative financing arrangements. In financing alternative A, only equity holders provide capital. In finance jargon, situation A represents an unlevered firm. Each equity holder has a claim on the after-tax benefits of owning and operating the assets, as well as on the assets themselves. The proportion of total shares owned determines the claims of each. In some instances, different classes of equity exist, with the rights of each class defined accordingly. Alternatives B and C represent different ways of financing the same assets, with C having a

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higher debt/equity ratio than B. Assuming that the nature of liabilities (discussed shortly) for B and C are the same, C, which has the higher debt/equity ratio, has greater financial risk. We will explain alternative D later in the chapter. Relative Position and Risk Capital structure does not involve sharing, but dividing and ordering. Deciding to use debt and/or preferred ownership entails dividing expected returns and risk, and ordering claims— both for "normal" times, as well as in the event of bankruptcy. Think of a line of people, an uncertain future, and expected benefits that may stem from the operation or sale of a company's assets, or benefits that might arise from the financing of the company. A metaphor helps in understanding the issues and relationships. Imagine an apple orchard. Uncertainty exists about future crops in terms of the size, and quality, of the apples. Variance in quality means not all apples in a crop have equal value. Let's see how the ordered line works. Governments are first in line, taking the most certain and best apples for taxes. Some taxes are ardent claims, which are due independent of the sufficiency of the crop. Equity holders bear this tax responsibility. However, tax circumstances also affect creditors and other providers of capital. Fundamental Principle: The Division of Risk and Expected Return A position first in line gives first access to the orchard, and the right to take the best apples. Others enter the orchard according to their order in the line, each taking the apples they are allowed—if apples are available. The average quality of the remaining apples declines with the successive removal of the best of the remaining crop, as those in line are careful and claim the best apples to which they are entitled. Remove the best, and the quality of what remains must be lower—and the risk that insufficient or no apples remain increases. After the tax authorities, creditors are next in line, with multiple creditors each careful to specify and protect their position in the line. Sometimes creditors limit the number and/ or magnitude of other credit claims in line. Preferred stockholders (if the company has any) have a position in line ahead of common stockholders, but behind creditors. A company may have different classes of stockholders, with the classes also ordered. Equity holders are last in line, expecting to

Capital Structure: Perspectives get the lower-quality (higher-risk) apples that are left, and having a claim on all that are left. Equity holders, last in line, have the most risk, but also the possibility of unlimited returns. Equity holders bear the risk that others have not accepted, and they get what is left over. Different classes of equity holders may exist, with these classes differentiated and "labeled," for example, class A. The classification scheme specifies the positions, potential rights, and claims of each class. With distress or bankruptcy, the provisions of the various sources of financing specify the relative position and claims of each party, but with one usual modification: tax liabilities, attorneys, and related costs often take first from the carcass. After that, an ordered picking over the corpse follows. Motivation for Using Debt A logical question surfaces: why would equity holders allow others to go ahead of them in the line? There are two main reasons for this: garnering incremental value; and/or issues of control. Increased Value Potential increases in value stem from "leveraging effects" (stockholders) and tax effects (total firm value). Capital structure theory generally focuses on the value that may originate in tax effects that result from the use of debt. This article focuses on capital structure, but we will first briefly comment on the classic financial leverage reasons for using debt. Equally Clever Creditors and Stockholders Have Implications The presence of astute creditors and stockholders will result in no bargains or favors in terms of dividing up expected returns and risks. Creditors will not give stockholders a bargain just to be nice. Absent control issues, capital structure is only important if interest on debt is tax-deductible, and dividend payments are not deductible.

sufficient pretax income to allow the deduction of the interest before calculating taxes. The net effects are: • Lenders expect payment of 10%, whether the company has taxable income or not. • If the company realizes the tax deduction, the after-tax cost = 10% (1 - 0.3) = 7%. • The expected benefit of the tax deduction goes to stockholders. • The stockholders have increased financial risk that stems from the borrowing—and letting creditors precede them in line. • Stockholders are astute. Increased risk increases the cost of equity capital. • However, if the expected value of the tax savings is attractive to stockholders relative to the added risk of borrowing, stockholders are happy, and the share price increases. • The right choice of capital structure will result in a reduction of the weighted cost of capital—even though the cost of both equity and debt capital increase with debt, as Table 1 illustrates, and we discuss below. Importantly, the tax deduction and its benefit is an expected benefit, as the uncertain pretax income (EBIT or NOI in several economies) must be large enough to allow the interest deduction.

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Tax Rate and Implications Notice that the higher the tax rate, the greater the potential impact of the deductibility of interest on the after-tax cost of debt. For example, with the same 10% borrowing rate but a 40% tax rate, the after-tax cost is 10% (1 - 0.4) = 6%. We take care not to confuse issues. We don't benefit from higher tax rates. However, the higher the tax rate we endure, the more important becomes the choice of capital structure. To reiterate, the tax benefits of using debt do not alter the promised cash flows in the form of interest or principle to creditors. Any tax benefits therefore precipitate to stockholders, and that is core to understanding how capital structure can create value.5

Asymmetry of Effects The use of some debt in place of some equity will lever up (down) the expected returns to stockholders. If interest is tax-deductible, the potential good or bad leveraging effects are asymmetric. If the company has returns on its assets that exceed the cost of debt, a positive leveraging effect accrues to stockholders. If stockholders view these returns as attractive, Example A company borrows money at afixedrate of 10%. given the financial risk of the added debt, the The tax rate is 30%. The company expects to have stock value increases. TAX-DEDUCTIBLE INTEREST In some economies, interest is tax-deductible. The expected deductibility of interest payments provides opportunity for value. The expected benefit of this deduction flows to stockholders, which is best illustrated with an example.

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If the EBIT for tax accounting is insufficient to allow the deduction of interest, stockholders must now bear the full cost of debt rather than benefit from a lower after-tax cost.6 This shift in tax impact results in a greater and adverse leveraging effect on returns to stockholders, as equity investors must now cover the full cost of debt, rather than the after-tax cost of debt. Using the original example above, the cost of debt rises from the after-tax 7% to the full 10%. The inability to realize the interest deduction results in an asymmetric effect on expected returns to stockholders.

BEHAVIOR OF WEIGHTED COST OF CAPITAL

An example showing the behavior of the component costs of capital and the weighted cost of capital (WCOC) appears in Table 1. For simplification, we consider only equity and debt sources of capital. One might employ one or more models, or different forms of models, as well as alternative econometric procedures to estimate the costs of the components of capital for different levels of leverage.7

Entries reflect the raising of money from debt and equity in different proportions. The more debt that is used as a proportion of the total, the less equity (and fewer shares). Costs are after-tax costs to the company. The cost of debt represents the weighted cost of debt, reflecting the fact that first-in-line creditors have lower risk, and the borrowing cost is lower. Creditors that follow in line have greater risk, and demand a higher rate. For all entries in this table, the company is getting the same amount of money. The values show the effects of getting this money in different proportions from debt and equity, which is the capital structure decision. Choices of capital structure seek to increase the value of the firm. Hence, in Table 1 and all discussion in this chapter and the chapter "Capital structure: A strategy that makes sense" (pp. 17-23), debt and equity refer to the market values of debt and equity. Hence, the D/E ratio we calculate uses the market values of the debt and equity. Note in Table 1 that the weighted cost of capital (WCOC) at first decreases, reaching a

Table 1. Calculation of weighted cost of capital (WCOC) Source of capital

Relative proportion

Cost of component

Weighted cost of component

0%

5.40%

0.00%

Equity

100%

13.00%

13.00%

Debt

10%

5.40%

0.54%

Equity

90%

13.40%

12.10%

Debt

20%

6.10%

1.22%

Equity

80%

13.90%

11.12%

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Capital Structure: Perspectives minimum when about 30% of capital comes from debt and 70% from equity. Observe also that this decrease occurs even though the weighted cost of debt increases with the use of an increased proportion of debt capital. Recognize that successive increments of debt cost more, as successive creditors in the line of claimants demand higher expected returns to compensate for their higher risk. With an increase in the use of debt, the cost of equity increases as well. Equity holders recognize the greater financial risk attendant with a higher D/E ratio, and demand increased expected returns. Seemingly, the WCOC could not decline if the cost of components increased. The reason for the decline stems entirely from the expected taxdeductibility of debt, and equity holders think the value of the tax benefit is attractive compared to the added risk. As the D/E ratio increases, the amount of equity decreases because we are raising the same amount of capital everywhere in Table 1. If we raise more from debt, less comes from equity. The use of some debt rather than all equity amplifies the effect on a per-share basis, as the company needs fewer shares for the same amount of capital. The result is that with an increasing D/E the expected tax benefits increase, and these are spread over fewer shares. In the example in Table 1, note that obtaining more than 30% of capital from debt results in an increase in the WCOC. Above 30% debt, stockholders do not think that the incremental tax benefits of more debt are attractive enough to compensate them for the incremental financial risk, and the uncertainty of realizing the tax benefits. Hence, the demanded rate of increase in the cost of equity and debt overpowers the effects on value of the expected incremental tax benefits of employing more debt. Summary Given a particular business risk of a company, determined by the asset side of the business and how well the company employs its assets, an optimal capital structure exists—optimal, as it lowers the WCOC of the company. For example, in Table 1, using about 30% from debt and 70% from equity will result in the lowest weighted cost of capital.8 Note in the table that the cost of components increases in a nonlinear manner as the use of debt increases. This behavior is related to several factors, including: the risk of realizing the expected tax benefit of debt; potential distress caused by excess debt, and its effects on operations as well as opportunities and investments; and possible bankruptcy with attendant loss.

OTHER ISSUES

The Nature of Liabilities and Optimal D/E The nature of the liabilities influences the choice of capital structure. Let alternative D in Figure 1 represent the same capital structure as in alternative C. Suppose that certain characteristics of the liabilities for C and D differ. To illustrate, assume that the weighted maturity of liabilities in D is less than that in C, and/or that C represents borrowing at a fixed rate while some debt in D has a variable rate of interest. Despite the same D/E ratio, the financial risk of D is greater than that of C because D is bearing interest-rate risk if the debt has a variable rate of interest, and D has more risk as it faces refunding of debt sooner. Less flexibility in the timing of refunding the debt is a potentially important issue, as capital market conditions vary over time. The developments and difficulty for firms of obtaining "replacement" credit in the 2008 crisis illustrate this refunding risk. Logically, the nature of the liabilities therefore affects the optimal D/E ratio. For A, B, C, and D, the business risk is still the same. The use of liabilities with greater risk (in this scenario, maturity and interest rate risk) results in a lower optimal D/E, despite the same business risk on the asset side of the company. Thus, if the structure shown for C is optimal, the structure shown for D is incorrect. D should have a lower optimal D/E ratio than C, as the nature and structure of liabilities for D results in higher risk on the financing side of the company. CONCLUSION The tax deductibility of interest provides the opportunity to add to company value by employing the correct amount of debt relative to equity. The underlying relationships that cause this potential increment in value rest on the logical behavior of informed investors who agree to divide risks and expected returns. The deductibility of interest has expected economic benefits that flow to equity holders. Consequently, the use of debt is logical if interest is tax deductible and we expect to realize the benefit of that deduction. The higher the corporate tax rate we must endure, the greater the value of issuing debt. The choice of how to finance the company, and its resulting debt/equity ratio, is the capital structure decision. Issues relating to the strategy and management of capital structure are discussed in the article "Capital structure: A strategy that makes sense" (pp. 17-23).

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• In capital structure decisions, the examination focuses on the market value of debt and equity. • Changes in the tax rate will influence the optimal capital structure. • The greater the business risk, the lower the optimal D/E ratio. • The choice of capital structure will influence the cost of the individual sources of capital, and, in turn, the weighted cost of capital. • "Real world" considerations argue for a target capital structure, and a strategy to pursue that structure. The chapter, "Capital Structure: A Strategy that Makes Sense," examines these issues and offers guidance on a strategy.

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MORE INFO Articles: Groth, John C, and Ronald C. Anderson. "Capital structure: Perspectives for managers." Management Decision 35:7 (1997): 552-561. Online at: dx.doi.org/10.1108/00251749710170529 Miller, Merton H. "The Modigliani-Miller propositions after thirty years." Journal of Applied Corporate Finance 2:1 (Spring 1989): 6-18. Online at:

dx.doi.org/10.1111/j.l745-6622.1989.tb00548.x Website: Weighted average cost of capital: en.wikipedia.org/wiki/Weighted_average_cost_of_capital

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1 Issues of control can influence choice of capital structure, for example, with current managers not willing to issue equity as the issuance would dilute management's "personal" control percentage, or alter the distribution of shares in float. 2 Actions that lower the cost of capital result in benefits to individuals in economies and societies. In contrast, in 2008 we have witnessed the adverse and spreading effects that result from interruptions in the availability and/or cost of capital in economies. 3 If suppliers perceive unnecessary risk or the likelihood of financial distress, suppliers may demand trade notes payable. Trade notes payable formalize trade credit, and seek to clearly identify the obligation. Hence, requiring formalization of obligation with trade notes payable clarifies as well as "perfects" the supplier's interest, and relative claimant position. This formalization can alter the risks to the suppliers of receipt of payment, both during ongoing operations as well as in the case of bankruptcy. Normally, the

30

existence of trade notes payable on a balance sheet signals concerns by trade creditors of the financial viability of the company. 4 Multiple classes of equity may exist, with specified relative claimant positions during normal operations as well as in bankruptcy. 5 In imperfect markets with multiple periods, and with certain tax rules, the risk of promised cash flows to creditors may be reduced by the tax-deductibility of interest in previous periods or by carry-back tax effects. These issues are beyond the scope of this article. 6 In some environments, differences exist in accounting for taxes, and accounting for financial reporting. 7 The most common approaches include several different model forms based on the capital asset pricing model, multi-factor models, discounted cash flow models, riskpremium models, and other pricing models. 8 This is an approximation. Estimating the WCOC curve and finding the minimum point is not a precise science.

Capital Structure: Implications by John C. Groth

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• Reducing the weighted cost of capital increases the net economic returns, and adds to company value. • Place the company in a position that it can choose what it wants to do, rather than have circumstances force it to take a course of action. • The use of too little debt (L) results in a lower stock price, and too much debt (M) also lowers the stock price. • The more uncertain an environment, the greater the importance of the choice of and the strategy for managing capital structure. • If a company's business risk is very sensitive to economic cycles, a company should manage its debt/equity (D/E) ratio across the cycle. • Knowledge of capital structure theory and practice is important in stock repurchase programs, mergers and acquisitions, divestitures, leveraged buyouts, and strategies aimed at defeating takeover.

INTRODUCTION A tax environment that allows for the deduction of interest charges, but not the deduction of dividends, results in an optimal capital structure for a company. The optimal structure results in a lower weighted cost of capital (WCOC) for reasons examined in the article "Capital structure: Perspectives" (pp. 25-30). This article examines the implications of capital structure, and some of the key factors that influence capital structure. KEY IMPLICATION: WCOC AND VALUE Recognizing the behavior of the WCOC when

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there are changes in the D/E ratio, we now review how the correct capital structure ultimately adds benefits in terms of economic margins and resultant value. Figure 1 illustrates the origin of value, and the significance of lowering the WCOC that results from selecting the optimal D/E ratio for a company. Recall that value arises from earning a net economic return that exceeds the cost of capital. For example, the net present value of a project represents the dollar value of having earned economic returns in excess of the cost of capital while the capital is in a project.

Figure 1. WCOC and net economic returns as D/E ratio varies Return on equity (%) Net economic return (NER) - Optimal

Weighted cost of capital (WCOC)

Cost of equity capital, no debt Risk-free interest rate (RF)

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In Figure 1, with no debt the economic returns company. The greater the business risk of are labeled NER @ D/E = o. Moving down the the company, the higher the cost of equity, WCOC curve in the diagram increases the net and the lower the optimal debt/equity ratio. economic returns, with attendant increases in Changes in business risk stem from one or value. The WCOC is for projects that do not alter more of the following: the business risk of the firm. • Changes in market conditions: For example, Figure 2 graphically illustrates the impact of an increase in competition, trends in capital structure on stock price, keeping in mind consumer preferences, greater uncertainty that as we go from no debt to an increasing D/E we about the costs of inputs, political risk, and are reducing the number of shares. The use of too other forces over which a company normally little debt (L) results in a lower stock price, and too has no or little control; much debt (M) also lowers the stock price. • Changes in how things are done: for example, Moving from L to the optimal level is quite easy. management of the operating cycle, decisions Borrow money and buy back some shares. Moving on working capital, cost control, efficiency of from M back to the optimal level is, in theory, operations, effectiveness of product design, equally easy, but in practice may face challenges marketing. depending on market conditions. Capital structure • Changes in what is done: for example, the strategy is discussed in the article "Capital structure: markets pursued, and the investments made A strategy that makes sense" (pp. 17-23). to support those choices. Figure 2. Capital structure and stock price Stock price L = Too little debt M = Too much debt

D/E Optimal D/E The Core Implication Reducing the weighted cost of capital increases the net economic returns, and adds to company value. Remember that the relationship between WCOC and value is non-linear, making the choice and management of D/E particularly important.1

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OTHER IMPLICATIONS Capital structure has numerous additional implications, including the following.

Investments and Optimal Structure The interrelationships between capital structure, assets, and a dynamic environment have implications in terms of risk, value, choice, strategy, and actions. For example, if a company changes the nature or structure of its assets by investing in projects of greater risk than its current risk, and/or if external changes and trends in markets alter the business risk of the company, then the optimal capital structure changes.2

Business Risk Change and Capital Structure • Recall that business risk is the risk associated with the asset side and operations of the

Effects of Financial Risk on Business Risk In imperfect markets, excess financial risk resulting from the financing of the firm may

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Capital Structure: Implications affect the business risk of the company.3 This crossover or feedback effect alters the risk on the operating side of the company. Developments in the economy, and the automotive industry in the fall of 2008 are an examples. A company offers a 100,000-mile warranty on its cars, but customers feel that high financial risk might result in the company going bankrupt. Hence, the high perceived financial risk of the company by customers affects purchase decisions, and the perceived value of the warranty in their purchase decision. In reality, the asset side and finance side of a company are not independent. Cyclical Business The choice of capital structure has an impact on alternatives, decisions, and strategy—especially across economic cycles. In a cyclical business, the patterns and magnitudes of expected cash generation from the business, or "asset side," of the company are subject to the influence of the economy, an influence over which a company has no control. In this scenario, the business risk of the company changes as it lives through the ebbs and flows in the economy. The sensitivity of companies to a cyclical economy varies. A company may adjust its asset structure and operations in anticipation of, or in response to swings in the economy. However, other than adding liquidity in anticipation of a deteriorating economy, major changes in other assets are often costly, or not practical.4 Some companies may also try to insulate the adverse effects of the cycle on the business risk of company with other strategies, such as in-house finance companies to support credit sales.5 A change in the business risk (BR) alters the optimal capital structure of the company. An increase (decrease) in BR decreases (increases) the optimal D/E. A significant sensitivity to the business cycle has important implications.6 A company will survive (or perish), or have opportunities (or miss opportunities), according to its strategy and financial position at a point in time. Place the company in a position that it can choose what it wants to do-rather than have circumstances force it to take a course of action.7 The implication is that a company that generates cash flow in a cyclical pattern should reduce its debt during periods of high cash generation, moving its D/E to the lower D/E limit of the target capital structure, consistent with the discussion in the article "Capital structure: A strategy that makes sense" (pp. 17-23).

Stock Repurchase Knowledge of capital structure theory and practice is important in stock repurchase programs. If the company does not issue new common stock—for example, issuing stock for an acquisition, or as a result of the exercise of options—the repurchase of a company's own stock is a reduction in equity that will reduce the D/E ratio of the company. To maintain the desired target D/E ratio, a repurchase of stock will require a corresponding reduction in the company's debt. Acquisitions A company making an acquisition should consider the implications in terms of optimal capital structure. To the extent the business risk of the target and acquiring companies differ, the optimal D/E ratios for the target and acquiring companies differ. One may adjust to the desired post-acquisition target D/E, coincident with the acquisition and attendant financing arrangements. Additional issues are important, including the following. Independent of any operational or "synergistic effects" that may result from a merger, a pure financial merger benefit may exist. Lewellen (1971) offered astute arguments addressing this issue. Essentially, one can demonstrate that the mere combination of firms may offer financial benefit. The combined cash flows of the two companies may result in lower risks to creditors, with this reduction stemming from a co-insurance effect. Capital structure opportunities may also exist if the target company does not have an optimal capital structure. These particular benefits differ from the pure financial rationale, and their realization is not dependent on the acquisition. If the current management of the target company has ignored the prescriptions of capital structure theory, the acquiring company may benefit by adjusting the capital structure concurrently with the acquisition. In a merger, "good" or "bad" debt capacity in the target or acquiring firms has practical implications.8 Returning to Figure 2, we can consider two scenarios: • Assume the target company has too little debt, shown by the D/E of L. The target company has unused good-debt capacity, and also a share price that is lower than the optimal level. The acquiring company can use this unused good-debt capacity to help finance the acquisition, and, at the same time, realize the increment in share price represented by the change from the D/E of L

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to the optimal D/E. • Assume the target company has too much debt, shown by the D/E of M. Unused gooddebt capacity does not exist in the target company. However, if the acquiring company "refinances" the acquisition and, in effect, moves the acquired company to the optimal D/E, the acquiring company realizes the value represented by the share-price gain that would result from the company moving from M D/E back to the optimal D/E. Again, the gains for these scenarios have nothing to do with acquisition itself, but result from correcting the mistakes made by management in the capital structure of the target company. Divestments Capital structure in the divesting of a portion of the company is important. Separate from the appropriateness of the divestment, casting off the new company with the optimal D/E ratio will maximize the value realized. Tax Issues Assuming interest is tax-deductible, uncertainty about future tax rates and other changes in taxes do influence capital structure decisions. If one knew the effective dates of new tax rates, or thought tax rates would increase (decrease) in the future, one would consider altering the target D/E ratio. Recall that the higher the tax rate, the lower the after-tax cost of debt—if the company has sufficient pretax income to allow the interest deduction. Implications for capital structure would exist if dividends also became deductible. If the tax-rate effect was the same for dividends or interest deductions, under some circumstances an optimal D/E would no longer exist, as debt offers no advantage over equity. If interest and dividend payments were both deductible, but the tax rate applicable to these deductions varied, an

optimal D/E would remain.9 In many tax environments, a company may carry back or forward certain tax variables, and realize tax effects in previous or future periods. This results in timing the realization of tax benefits, and thus affects the present value of the tax treatment. In addition, tax issues can be very important in an acquisition, especially if certain tax options will expire at a point in time. In some tax environments and circumstances, an acquisition with attendant changes in capital structure might allow realization of a tax benefit, or at least preserve it for a future period. Other Implications Strategies aimed at defeating a potential takeover have, some assert, included exceeding the optimal amount of debt to make the company an unattractive target. Following this practice is inappropriate, and generally not aligned with shareholder interests. However, the observation reflects that a management might understand and employ capital structure theory to promote management's rather than shareholder interests. In a leveraged buyout (LBO), equity participants often intentionally ignore the guidelines of capital structure in an attempt to maximize personal wealth. For example, in an LBO those with an equity position attempt to maximize personal return on equity. Consequently, over the shorter term, they allow the company to greatly exceed the optimal D/E ratio, as they seek to maximize the future value of equity interest, rather than a current share price. With this approach, the plan is that, over time, the company can pay down debt, and attain an optimal D/E ratio. Then those with the equity interest take the company public with a stock issue, and the pricing of the equity issue reflects the now-optimal D/E ratio.

MAKING IT HAPPEN

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The implications of capital structure theory are many. We have shared some of the most important. In summary: • Recognize that changes in what you do, and how you do it (markets pursued, capital investments) influence the capital structure decision, and the management of capital structure. • Changing the business risk of a company changes its optimal capital structure. • Changing the capital structure of a company will change its risk, and its value. • Reducing unnecessary business risk 10 allows one to derive greater benefits from capital structure since one will enjoy a higher optimal debt/equity ratio. • The interrelationships between capital structure, assets, and a dynamic environment have implications in terms of risk, value, choice, strategy, and actions.

34

Capital Structure: Implications The nature of liabilities in terms of maturity, variable versus fixed interest rate, principal repayment schedules, restrictive covenant of debt, etc., influence the optimal capital structure. Reduce uncertainty in investors' minds by adopting and disclosing an optimal target D/E ratio. Provide a simple explanation of the logic for the company's target D/E ratio, and the strategy the company will follow. The article "Capital structure: A strategy that makes sense" (pp. 17-23) focuses on issues in capital structure, and strategy. If a company's business risk is very sensitive to economic cycles, a company should manage and adjust its D/E across the cycle. Reducing the D/E ratio during periods of robust economic activity and high cash generation restores debt capacity to sustain and support the pursuit of opportunities during downturns in the economy.

CONCLUSION The fact that interest is tax-deductible in many economies is an argument for the use of some debt in financing a company. The right combination of debt and equity results in a capital structure that reduces the weighted cost of capital. The lower weighted cost of capital results in a higher net economic margin—the difference between the economic return on a project and the weighted cost of capital. The expected benefit of the tax deduction flows to shareholders, who bear the added financial risk associated with the debt. As long as shareholders view the expected value of the tax benefits as attractive compared to the added financial risk, then they welcome the use of debt. A dynamic environment complicates decisions.

Understanding core issues allows one to make/manage prudent actions in a dynamic environment. In particular, we should recognize that although a company should have a target capital structure, its management must remain sensitive to internal changes as well as changes in the markets and economies, and pursue a strategy that "makes sense." For example, if a company alters its business risk, it should adjust its debt/equity ratio. Similarly, if management perceives greater/less risk in the external environment, it should decrease/increase the debt/equity ratio. In the end, we see the need for a keen awareness of circumstance and future possibility, coupled with an understanding of fundamental concepts better equip us to make judgments—and then take actions that add value.

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MORE INFO Articles: Israel, Ronan. "Capital structure and the market for corporate control: The defensive role of debt financing." Journal of Finance 46:4 (September 1991): 1391-1409. Online at: www.jstor.org/stable/2328863 Lewellen, Wilbur G. "A pure financial rationale for the conglomerate merger." Journal of Finance 26:2 (May 1971): 521-537. Online at: www.jstor.org/stable/2326063 Prezas, Alexandras P. "Effects of debt on the degrees of operating and financial leverage." Financial Management 16:2 (Summer 1987): 39-44. Online at: www.jstor.org/stable/3666002 Prezas, Alexandras P. "Interactions of the firm's real and financial decisions." Applied Economics 20:4 (April 1988): 551-560. Online at: dx.doi.org/10.1080/00036848800000064 Website: Basic Modigliani-Miller theorem: en.wikipedia.org/wiki/Modigliani-Miller_theorem

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36

and selling appliances sounds like the correct strategy. If one wants to be in consumer credit or speculate on interest rates, then do that elsewhere. 6 Theorists might argue that capital markets anticipate potential changes in the economy, and recognize that some companies are more sensitive to economy-wide swings than are other companies. Consequently, some argue these "variances in business risk" across time are recognized, and already captured in the market-derived estimates of an optimal D/E and attendant WCOC. 7 See Groth.1 8 A discussion of good and bad capacity appears in the article "Capital structure: A strategy that makes sense" (pp. 17-23). 9 The issues and arguments concerning these issues are beyond the scope of this article. For example, whether a company would or would not pay a cash dividend would influence the decisions. Issues to do with control might also be an argument for debt rather than equity. For example, if a company issues equity, those with control dilute their ownership unless they invest at least proportionately in the new equity issue. 10 See Groth.1

Credit Ratings by David Wyss

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• A credit rating is an opinion from a credit rating agency about the creditworthiness of an issuer or the credit quality of a particular debt instrument. • Primarily, the rating opinion considers how likely the issuer of the debt instrument is to meet its stated obligations, and whether investors will receive the payments they were promised. • A failure to meet such payments may be considered a default.

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INTRODUCTION There are three major international rating agencies in the United States: Standard & Poor's Ratings Services (a unit of The McGraw-Hill Companies), Moody's Investors Service, and Fitch Ratings (a unit of Fimalac SA). In addition, there are many regional and niche rating agencies that tend to specialize in a geographical region or industry. The major agencies state that their opinions of the credit quality of securities are based on established, consistently applied, and transparent ratings criteria. Although the agencies use different criteria, definitions, and rating scales, they each state a view on the probability that an entity or security will default. Some rating agencies also assess the potential for recovery—how likely the investors are to recoup their investment in the event of default. Issuers of most fixed-income securities issued in world financial markets request and receive a credit rating from a rating agency. Although credit rating evaluations are not always required, they may increase the marketability of a debt instrument by providing investors with an independent opinion about the instrument's relative credit quality.

agencies have a strong track record, as reported in their default and transition studies. Over the long run, securities with a higher credit rating have consistently had lower default rates than securities with lower ratings. Ratings are just opinions, however, and there have been certain periods when highly rated securities in a specific sector ultimately performed worse than other securities rated in the same category. Accordingly, ratings do not remove the need for the investor to understand what he or she is buying. The Standard & Poor's rating scale is a simple and easy-to-understand shorthand for its credit opinions. A more detailed analysis is typically available from Standard & Poor's, including the rationale behind the rating opinion. Investors are encouraged to read the detailed analysis carefully to understand why an agency assigned a particular rating. Having a rating may be useful even if a corporation elects to raise money privately rather than through a public bond issue. Obtaining a rating may make it easier for a company to seek funding from a private lender or bank. Although not every company needs a credit rating, most medium-sized or larger firms find it useful.

WHY DO CORPORATIONS REQUEST A CREDIT RATING? A credit rating opinion is often required by investors before they purchase securities. Many investors want to see an established opinion about the credit quality of a security that is not from the issuer or underwriter. In addition, some funds have made it a requirement for their investment guidelines or as part of what they have promised their investors. Issuers who are not well known or who are trying to sell into international markets may benefit from a rating from a recognized rating agency. The rating provides market participants with an opinion on the credit quality of a particular investment. Ratings from the major credit rating

HOW A RATING IS ASSIGNED Credit rating agencies assign ratings to issuers, including corporations and governments, of debt securities, as well as to individual issues such as bonds, notes, commercial paper, and structured finance instruments. The agencies rate an issuer by analyzing the borrower's ability and willingness to repay its obligations in accordance with their terms. The agency's analysts consider a broad range of business and financial risks that may interfere with prompt and full payment. Most rating agencies use a mix of quantitative and qualitative analysis. Typically, analysts who consider qualitative factors contact management at the firm being rated to obtain additional information that may help them to arrive at

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AFRICA One ofthe most significant and interesting global economic developments of the past few years is the emergence of Africa as a competitive region for business. Africa is the fastest reformer in terms of easing business entry.6 It is now easier for private foreign firms to do business in Africa, d u e t o recently simplified business regulations, _, j 1 , u ,,. °, , strengthened property rights, eased tax b u r d e n s , increased access t o credit, a n d other economic reforms. African countries are diverse with respect to their politics and economics. The risks of doing business may vary in their nature and intensityfromcountry to country. These risks may

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CASE STUDY Bujagali Hydropower Project, Uganda The Bujagali Project is a private power generation project. The 250 MW run-of-the-river hydroelectric power plant is currently under construction on the Victoria-Nile on Dumbbell Island, Jinja, Uganda. The project achieved its financial closing in December 2007, and is expected to be commissioned in 2011. Bujagali is the first independent power project (IPP) in Uganda, and the largest mobilization of private financing for a power project in Africa. It was named "Africa Power Deal of the Year 2007" by Project Finance magazine. Bujagali is a good example of how various international financial institutions can work together with private sector project sponsors to address their financing and risk mitigation concerns, and meet the client country's economic objectives. Rationale for P P P According to the World Bank, the severe shortage of electricity in Uganda contributed to a decline in GDP growth to around 5% in 2005/06. Bujagali is an essential part of Uganda's energy-sector strategy to provide a sustainable and affordable source of electricity. The government of Uganda lacks, however, the necessary technical expertise and financing to complete the project on its own. Private sector participation was sought to fill the gap. Project Partners The Bujagali project is a public-private partnership between the private sector project sponsors represented by Bujagali Energy Ltd (BEL), the government of Uganda, including the Ministry of Energy and Mineral Development (MEMD) and Uganda Electricity Transmission Company Ltd (UETCL), multilateral and bilateral development financial institutions,7 and commercial lenders, including Absa Capital (South Africa) and Standard Chartered Bank (UK). BEL, a special-purpose company (SPC), is incorporated in Uganda, and is privately owned by Industrial Promotion Services (Kenya) Ltd (IPS (K)), the industrial development arm ofthe Aga Khan Fund for Economic Development (AKFED) and SG Bujagali Holdings Ltd (Mauritius), an affiliate of US-based Sithe Global Power LLC. The sponsors were selected through international competitive bidding procedures. r_q {J *~7 —t ^ j

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Project Description The Bujagali project is developed, financed, constructed, and maintained by BEL on a BOOT basis. BEL also manages the construction of the Interconnection Project on behalf of UECTL, which will own and operate the project. The Interconnection Project involves the construction of about 100 kilometers of high-voltage electrical transmission line to interconnect the power generation facility (the Bujagali project) to the national electric grid. Structured as IPP, BEL will sell the electricity to UETCL, Uganda's national transmission company, under a 30-year power purchase agreement (PPA). 76

Public-Private Partnerships in Emerging Markets Financing Finance for the project is structured as an integrated package for both the power plant and transmission components. The total cost for the integrated projects, about $800 million, is being mobilized on a limited-recourse basis, through equity and debt in the ratio of 22:78. The government of Uganda provided an in-kind equity contribution of $20 million. The equity financing is shared by the sponsors, IPS (K) and SG Bujagali Holdings Ltd, on a pro rata basis. The equity structure of BEL is complex. Figure 1 provides a simplified description. The debt is being financed by loans from the group of lenders, the World Bank group providing a far more substantial amount of $360 million ($130 million loan from IFC, $115 million partialrisk guarantee from International Development Association to commercial lenders, and $115 investment guarantee from Multilateral Investment Guarantee (MIGA) to cover the equity position of SG Bujagali Holding Ltd). The project financing plan is described in Figure 2. Contractual Arrangements and Risk-Sharing Mechanism Contractual agreements define the transactions and allocation of the commercial, technical, and political risks among the partners. The contractual structure of the Bujagali project is consistent with industry practice for limited-recourse project finance transactions (see Figure 3). The project implementation agreement, also called the concession agreement, signed between the government of Uganda and BEL on December 13, 2005, defines the terms of the concession the government grants to BEL to design, finance, own, operate, and maintain the project. Under the 30-year PPA, BEL agrees to sell exclusively to UETCL all the production, and UETCL agrees to purchase the contracted capacity (i.e., 250 MW), with the government guaranteeing the UETCL's payment obligations. In addition to the implantation agreement and PPA, BEL signed a fixed-price, date certain, turnkey engineering, procurement, and construction (EPC) contract with Salini Costruttori SpA (Italy), and Alsthom Power Hydraulique (France), and an operation and maintenance (O&M) agreement with affiliates of Sithe Global. The EPC contract requires the power plant to be commissioned within 44 months. The EPC contractors were selected through competitive bidding, in accordance with the EIB procurement rules. The O&M agreement reflects BEL's commitments under the PPA. own, operate, and maintain the project. Under the 30-year PPA, BEL agrees to sell exclusively to UETCL all the production, and UETCL agrees to purchase the contracted capacity (i.e., 250 MW), with the government guaranteeing the UETCL's payment obligations. In addition to the implantation agreement and PPA, BEL signed a fixed price, date certain, turnkey engineering, procurement, and construction (EPC) contract with Salini Costruttori SpA (Italy), and Alsthom Power Hydraulique (France), and an operation and maintenance (O&M) agreement with affiliates of Sithe Global. The EPC contract requires the power plant to be commissioned within 44 months. The EPC contractors were selected through competitive bidding, in accordance with the EIB procurement rules. The O&M agreement reflects BEL's commitments under the PPA. The contractual structure ensured that the project-related risks, including completion and operation, were borne by the project sponsors and commercial lenders. However, these risks were mitigated by contracts and various insurance arrangements. The risks related to supply/input (hydrology risk), market, political, and natural forces were borne by the government of Uganda under the government guarantee and implementation agreements. The participation of the IFC and the guarantees provided by the World Bank group (IDA and MIGA) are critical in mitigating the completion risk, and to provide Uganda with access to long-maturity commercial loans in favorable terms.

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CONCLUSION sector, shifting risks and securing financing are PPP can offer a win-win situation for both the important benefits. For the private sector, the public and the private sectors. Globalization environment represents an opportunity to add /•} , , , . . , value to the organization, and act in a socially \2 b _. ' . , ,. ^ J, Tj has led to the emergence ofc new economies. .,, , responsible manner. PPP involves complicated • — i With scarce resources, the public sector in many a r r a n g e m e n t s ^ ^ r e q u i r e a g r e a t d e a l of economies needs pnvate sector partners. PPP is expertise and flexibility. The essence of PPP is > a unique opportunity for the two diverse sectors risk allocation—preparation, and proper risk ^ to learn how to work together. For the public management and pricing are a must. (")

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MAKING IT HAPPEN

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• Work to build trust among partners. • Put together a solid risk management process, with clear accountability and understanding of the risks faced, how they are allocated, and how risk is to be priced. • Be as specific as possible about your role and responsibilities.

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• Conduct a readiness analysis of your organization. • Know exactly what you want and expect. • Know what the various partners want and expect.

• Familiarize yourself with the nature and operations of international financial institutions and agencies, such as the World Bank, its affiliated agencies (IFC, IDA, MIGA), and other cooperating organizations. • Make sure you do a feasibility study and conduct due diligence. * ^ ° s ' o w ' Learning about PPP is important. Existing relationships could serve as an easier first step. • Decide on what valuation techniques would be appropriate (for example, internal rate of return, net present value, adjusted present value, and real options). • Analyze all possible scenarios. • Review and revize as appropriate. • Work towards a sustainable relationship, but have an exit strategy.

MORE INFO Books: Akintoye, Akintola, Matthias Beck, and Cliff Hardcastle. Public-Private Partnerships: Managing Risks and Opportunities. Maiden, MA: Blackwell Science, 2003. Grimsey, Darrin, and Mervyn Lewis. Public Private Partnerships: The Worldwide Revolution in Infrastructure Provision and Project Finance. Northampton, MA: Edward Elgar, 2007. Mobius, J. Mark. Mobius on Emerging Markets. New York: Irwin Professional, 1996. Osborne, Stephen P. (ed). Public-Private Partnerships: Theory and Practice in International Perspective. London: Routledge, 2000. Yescombe, E. R. Public-Private Partnerships: Principles of Policy and Finance. Oxford: Elsevier, 2007. Article: Michel, Frangois. "A primer on public-private partnerships." Public Financial Management Blog (February 22, 2008). Online at: blog-pfm.imf.org/pfmblog/2008/02/a-primer-on-pub.html Reports: Economist Intelligence Unit. "Operating risk in emerging markets." London: Economist Intelligence Unit, 2006. Online at: graphics.eiu.com/files/ad_pdfs/eiu_Operating_Risk_wp.pdf Kennedy, Robert E. "Project valuation in emerging markets." Boston, MA: Harvard Business School, May 14, 2002. Available from: hbsp.harvard.edu

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www.doingbusiness.org/documents/ DoingBusiness2007_FullReport.pdf 6 Bujagali Hydropower Project: www.bujagali-energy. com; www.worldbank.org/bujagali 7 The institutions include the African Development Bank (ADB), European Investment Bank (EIB), the World Bank Group, Agence Frangaise de Developpement (AFD), Proparco, Netherlands Development Finance Company (FMO), Kreditanstalt fur Wiederaufbau (KfW), and Deutsche Investitions und Entwicklungsgesellschaft (DEG).

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Sources of Venture Capital by Lawrence Brotzge

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EXECUTIVE SUMMARY

• Sources of capital depend on whether it is an early-stage company or a rapidly expanding business that is seeking significant financing. • Angel investors rather than venture capital funds usually provide seed capital for new companies. • Use your network to get connected with sources of venture funding, and know your audience before you meet with them. • Venture capitalists look for high rates of return and have a relatively short time horizon. • These investors will assist the entrepreneurs with many aspects of their business besides capital.

INTRODUCTION There are many sources of venture capital. They include: • friends and family; • individual angel investors or angel investor groups; • early-stage venture capital funds (VCs); • expansion-stage and later-stage VC funds; • community-based venture funds; these are often run by development agencies, which are usually funded or subsidized by local government funds designed to stimulate business growth. This article answers a number of questions about obtaining venture capital. When is it appropriate to seek venture funding rather than bank financing? How do you go about finding these funding sources? How do they differ, and what drives their investment decisions? Entrepreneurs and their management team need to understand the role of these investors, what expectations they will have for return on their investment, and over what time frame they will expect to earn those returns. EARLY-STAGE COMPANIES Companies are usually started by a single entrepreneur or a small group of entrepreneurs. These founders frequently work for no pay, a situation that is referred to as "sweat equity."1 The initial cash needed is likely to be provided by the founders, but may be supplemented by money from friends and family members who have a variety of reasons to want to be a part of what the founders are doing. This type of funding is sometimes referred to as "seed capital."2 The founders may also seek bankfinancing,but if the bank is willing to extend credit it will probably be based on their personal assets or borrowing capacity. Banks rarely lend to companies that do

not have a track record of revenues and profits. Venture capitalists generally expect to see that the founders have put in a combination of sweat equity and personal cash, and they prefer to see that they have raised some money from friends and family. After exhausting these sources, entrepreneurs may think it is time to approach VCs to raise the funds they need to grow their business. In fact, although VCs did invest smaller amounts in the 1970s and 1980s, they are now much larger funds and tend only to invest when companies need multiple millions. As this transition was taking place, angel investors began to fill the gap between friends and family and VCs. ANGEL INVESTORS Typically, angel investors are thought of as wealthy financiers who want to fund startup companies that have a change-the-world idea or invention. They do usually have some wealth, but it is not necessarily the case that they are extremely rich. Successful business men and women may be sought out by entrepreneurs for their particular expertise. These individuals may not have previously thought of themselves as angels, but they may become interested in the business and impressed by the entrepreneurs and decide to invest. On the other hand there are those who regularly look for such opportunities. Angels generally invest in companies in their local area so they can keep an eye on their money. Beginning in the mid-1990s, angel investors began to realize that there were some disadvantages to being a lone investor. For example, it is unlikely that one or even a couple of people possess all the knowledge necessary to make wise investments. 83

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They may have knowledge of many aspects of the be funded by the VC specialists. But for many new business they are considering, but they are not businesses there is an overlap between angels and likely to understand everything about the business "early-stage" VCs, and it is not uncommon that and how to structure the investment. Additionally, the two groups will coinvest. a single investor would have to put a fairly large What constitutes expansion- and later-stage sum in a single company to have any real say in the companies? Expansion-stage companies have business. A group of angels is more likely to have a customers and proven revenue, and there are breadth of knowledge and, by pooling their funds, good reasons to believe that they are positioned an impact on the company. Angel investment to grow very rapidly, at rates of 30-100% groups have been forming over the past 10 to 15 annually. And later-stage companies already years, and there are now several hundred such have substantial revenues, so the next round groups in the United States and Canada. of financing is meant to grow the company to A 2008 study of US angel investing3 showed a critical mass and attract public financing, or that in 2007 some US$26 billion was invested in result in a merger or acquisition by another over 57,000 entrepreneurial ventures and that company. In both situations it is likely that this the number of active investors totaled almost will provide liquidity and at least a partial exit for 260,000. It can readily be seen that individual founders and investors. Many young companies angel investors still make up the lion's share of never get to the point of seeking expansion or investors, which creates a challenge for those later-stage VC funding, not because they fail, but rather because they determine that an earlier entrepreneurs trying to connect with them. Finding angels requires networking. Ask attorneys merger or acquisition makes more sense for both and accountants, especially those who frequently founders and investors. work with and specialize in startup companies. If your business is technical in nature, you might WHAT VENTURE CAPITALISTS contact universities, and you should certainly try to LOOKFOR make contact with current and retired executives It makes little difference if it is an angel investor or an early-stage VC, they expect to see a who come from industries related to yours. business plan with a detailed description of the business model, marketing plans, competition, VENTURE FUNDS Some VCs focus on investing in particular etc. This includes financial statements showing industry sectors, or geographies, or stages past results and a forecast for the next three of a company's life. Some may restrict their to five years. Considerable emphasis will be investments to local businesses. Some will fund placed on the cash flow forecast, as cash flow early-stage companies, but others may only is a primary concern with any relatively new entertain investments in what are known as business. Investors will want to know how their investment will be put to use—often referred expansion-stage and later-stage companies. The definition of an early-stage business can to as "use of proceeds." They tend to look vary widely and is not easily denned in terms of unfavorably on large portions of their funds revenues. If, for example, it is a service business being used for accrued and unpaid expenses, or software company, it may not require a lot of particularly founders' salaries, or to pay down investment for the company to achieve positive accounts payable. The prospective investors will cash flows. At the other extreme, a life sciences perform considerable due diligence, which will business (biotech, pharmaceutical, and medical include such areas as product reviews; speaking devices), which involves substantial research and with customers, vendors and distributors; and regulatory approval, may be years from any real examining any patent filings and pending legal revenues and will need significant funding along matters. Primary among their assessments will the way. As a general rule, before a company is be evaluating the management team. ready for VC funding a number of events will The review performed by expansion-stage and have taken place, such as completion of proof later-stage VCs does not differ much from that of concept, development of prototype products, outlined above; however, their investigations beta testing of the product or service, and, finally, will look more closely at areas such as market generation of revenues. However, certain types conditions. Since at this point the business has of businesses—most notably life sciences or a proven market for its product or services, it other large technical projects—require such large is far easier to assess future growth projections amounts of capital that they are well beyond the than when the company was just entering the capacity of angels. These businesses tend only to market. Thus, a reasonably accurate assessment

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Sources of Venture Capital can be made of how fast the business can be scaled up and its ultimate potential. VCs will also reevaluate the company's management. Often the skills needed to launch a business differ from those required to grow it. All venture investors have one question in common: When will they see a return on their investment? In other words, when will there be a liquidity event—a sale of the company or a public offering of the stock? This is called the exit strategy.4 Venture capital is not generally meant to be long-term in nature. Most funding assumes that there will be an exit in three to seven years. RETURN ON INVESTMENT SOUGHT BY VENTURE CAPITALISTS The earlier in a business's life cycle the investment is made, the greater the risk. Thus, the higher the potential return on investment the venture capitalist will seek. Because there is a risk of total loss on at least some their investments, VCs must

be able to see the potential for significant returns on each new investment. This means either quick returns or, if the time frame will be longer, large multiples of their investment. So company founders should not be surprised to learn that venture capitalists would like the opportunity to earn 10 or even 25 times their investment. That means that most venture investors have little interest in businesses that do not have excellent growth and profit prospects. The terms of the investment will include the financial structure and the "pre-money value,"5 which is the value placed on the business before the new investors put their cash into the company. Thus, pre-money value is the amount assigned to all investors who have invested in the equity of the company thus far. This determines what percentage the new investor will own. If the premoney value is $3 million and $1 million is newly invested by VCs, they own 25% of the company.

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CASE STUDY Example of the Actual Results of an Early-Stage VC The investors put in US$120 million between 1998 and 2002, which is a typical funding period. This was invested in 31 companies and—although the fund has not yet exited all of these companiesreported results to date, plus a reasonable projection of ultimate exits, show these results: Number of companies

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The internal rate of return (IRR) to the investors will be about 23% on an annualized basis. This table illustrates how results vary by investment, indicates the degree of risk, and demonstrates why the VC must have the potential (often unrealized) to earn very large returns on each investment. In this case, without the three deals that produced very large returns, the overall results would not have been very attractive.

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There are also many considerations as to what security the venture investors will own. They usually require a form of a security that is "senior" to the equity held by founders and small investors. This provides legal protection and authority, even though they may be minority investors (in terms of their ownership share of the company). The instrument often used for this purpose is preferred stock, with a variety of provisions attached that allow some level of control over major business decisions. For the venture investors to have an opportunity to earn handsome returns on their investment, they focus not only on the pre-money valuation, but also on how many future rounds of fundraising the company might need as it grows. Even if future investments are made on the basis of an increased valuation, the additional capital will dilute prior investors' ownership stake. So

while the need for additional funding may be a good indication that the company is growing and needs more working capital to expand, that must translate to a much higher ultimate liquidation value if each investor group is to see healthy returns on the capital they put atrisk.Historically, venture capital internal rates of return (IRR)6 have averaged between 20% and 30%. THE ROLE OF VENTURE CAPITALISTS AFTER THEY INVEST Venture investors are not passivefinanciers;rather, they foster growth in companies by becoming actively involved with the management team, and in developing strategic and operational plans, marketing plans, etc. They will hold one or more positions on the company's board of directors. VCs see themselves as entrepreneursfirstand financiers second.

MAKING IT HAPPEN Companies will encounter lots of competition when seeking venture funding. So be sure to take the right steps to increase your company's chances of success: • Where should I be looking for investors? Be certain to look for help from local organizations that foster new business development in your area, such as local development agencies and funds established to encourage innovation and new technologies, and universities. • How do I get connected to the right funding sources? Talk to all your contacts, ask lots of questions, and remember that it is far better to arrive at a source via a referral. • How do I prepare to meet with prospective investors? Consider getting someone to coach your management team, prepare a first-class, focused business plan, understand your cash flow, and prepare realistic financial projections. • What should I know about my audience? They will be assessing the management team as much as the business. VCs do not invest in businesses that do not have significant growth potential, but you must be realistic and prepared to defend your numbers. They will also be interested in knowing that there are multiple exit strategies. • How do I sell our management team? Show the investors that you are the right people to run the business, and address areas where you need to add missing skills. Remember that founders may not be the best people to run the company, and consider supplementing the team with an advisory board, or ask the VC to assist in identifying advisers.

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Book: Van Osnabrugge, Mark, and Robert J. Robinson. Angel Investing: Matching Startup Funds with Startup Companies—A Guide for Entrepreneurs, Individual Investors, and Venture Capitalists. San Francisco, CA: Jossey-Bass, 2000.

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Websites: Angel Capital Association (North America's professional alliance of angel groups): www.angelcapitalassociation.org Center for Venture Research, Whittemore School of Business and Economics, University of New Hampshire: wsbe.unh.edu/cvr Kauffman Foundation: www.kauffman.org

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www.bizplanit.com/vplan/exit/basics.html 5 See "The pre-money value of a pre-revenue startup" at www.matr.net/article-25906.html 6 For a basic explanation of IRR and a downloadable spreadsheet example, see www.solutionmatrix.com/ internal-rate-of-return.html

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Assessing Opportunities for Growth in Small and Medium Enterprises by Frank Hoy

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• The growth stage of a small or medium-size enterprise (SME) typically requires more resources than the company commands. • In order to grow in their competitive environments, SMEs should proactively engage in identifying opportunities. • The management team should have criteria and procedures for assessing opportunities, as only the most promising and suitable should be pursued. • Exploiting opportunities includes obtaining resources to implement the business's growth strategy. • The long-term health and survival of SMEs depends on their ability to recognize, evaluate, and pursue growth opportunities in competitive environments.

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INTRODUCTION Many companies experience rapid growth at some stage of their life cycle. For some, this may happen soon after they are launched. Others have multiple spurts, followed by a leveling-off period or even a decline. A consistent characteristic of the growth stage is that demands exceed existing resources. Consequently, business owners must be creative in acquiring and managing the resources needed to seize growth opportunities. Successful entrepreneurs are astute at, first, identifying opportunities and, second, taking action to pursue those opportunities. The idea behind starting a business may have been spontaneous. It may come from prior experience or personal preference. It may have resulted from loss of employment. Although bankers, investors, and educators often emphasize the need for planning in advance of opening an enterprise, the evidence is that most venture creators did not prepare a business plan before they started. For a small or medium-size enterprise (SME) that has been operating for some time, however, a planning process is essential to any assessment of whether to take up a growth opportunity. IDENTIFICATION OF OPPORTUNITIES Opportunity recognition is at the core of an entrepreneurial venture. The founder of a company with growth potential will identify and seek to satisfy unmet customer needs. Creativity, new technologies, and new marketing approaches are all characteristics of growing enterprises. A key word in this stage isflexibility.The leaders of the company arefindingnew markets, sometimes on the international scene. Growth may come

not only from sales of products and services, but also through acquisition. The growing firm gains recognition for its brand name and builds customer loyalty. Robert Ronstadt coined the term "corridor principle" to explain how small and medium business owners identify opportunities that a prospective entrepreneur does not recognize.1 At the time an individual opens his or her first enterprise, it is as if the budding entrepreneur is inside a room consisting of his or her life experiences and observations. Starting the business is the equivalent of opening a door, stepping out, and discovering a corridor. Up and down the corridor are other doors, each representing a new opportunity. If the first door—i.e., starting the business—is not opened, none of the other doors will be seen. Launching the business allows the owner to enter new networks, obtain access to information, and otherwise make discoveries that would never have happened without going into business. From the strategic management literature, we learn about "environmental scanning" as a technique for being alert to new events, trends, and changes that may result from legislation and regulation, competitor initiatives and reactions, customer tastes, technological developments, and many other occurrences. Some business executives look at environmental disruptions as threats, but those disruptions are invariably viewed as opportunities for entrepreneurial small and medium business owners. Rita McGrath and Ian MacMillan proposed formalizing the scanning procedure by devising a register in 89

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which opportunities could be categorized as one or other of the following:2 • redesign of products or services • redifferentiation of products or services • resegmenting of the market • reconfiguring of the market • development of breakthrough competencies

• the competence of the management team; • the prospects for wealth creation and the feasibility of harvesting that wealth.

EXPLOITATION OF OPPORTUNITIES There are numerous triggers that may enable a small firm to seize a growth opportunity: • the firm finds an unexploited market niche, and the newly tapped demand launches the ASSESSMENT OF OPPORTUNITIES growth stage Enterprises that have been functioning for a period of time have strategies that were either • the firm overcomes the "liability of newness" formulated or which emerged. The first test of factor as customers, suppliers, and creditors whether to seize an opportunity is to evaluate conclude that it will survive and they increase whether it is consistent with thefirm'sstrategy, as the level of business which they are willing to the risk and cost of failure can be high if there is a conduct mismatch. On the other hand, if the business is in • the management team travels up the learning decline, an opportunity that requires a change in curve, becoming more competent, perhaps strategy may be the key to renewal and growth. even redefining the nature of the business Before pursuing the opportunity, firm man- • the founder faces a crisis and is forced to agers should ascertain the conditions that reinvent the business produced it. Will they persist? Is there a market • a change of leadership brings in new ideas of sufficient size to make the opportunity and perspectives attractive? And what resources are required to • the business acquires and exploits skills it did succeed in exploiting the opportunity? not previously have Failure to consider this last question can lead • alliances are formed with partners that to disaster. Many small and medium enterprises may help the firm to enter new markets or do not have the resource base to embark on highintroduce new products growth trajectories. Such growth may demand • managers recognize that the company has significant capital infusions. Smaller firms may entered a gradual decline that must be not have access to traditional sources of capital. reversed if the business is to survive They may not have collateral or credit lines for Because growth opportunities typically exceed borrowing and are not likely to be publicly traded, the capacity of the small or medium enterprise, so they can't seek equity investment. Financing at creative approaches may be needed to obtain the this stage requires creativity. It is not unusual for finance that will build such capacity. Immediate business owners in the early growth stages to rely sources of equity or debt are most likely to be first on their own resources—personal savings, the owners themselves and other management home mortgages, pension funds, etc.—followed team members. This is typically followed by by funding from family and friends. A family family members who are willing to accept risk member with a steady income and solid credit in support of their relatives. The willingness of record may be the cosigner on a bank loan. For banks to provide financing is usually a function some companies, financing may not be available of the credit history of the firm and economic at all. In such situations, "bootstrapping" may conditions. In the case of SMEs, banks often be the appropriate course of action. This term is look to the assets of the owner rather than the derived from the notion of pulling oneself up by revenue-generating ability of the firm. the bootstraps, i.e., being self-reliant. It involves Numerous alternative organizations engage finding ways of achieving goals when capital is in lending practices, however. Credit unions limited, minimizing the need for outside financing, have become aggressive in business lending. For maximizing the impact of the entrepreneur's minority and disadvantaged populations, avariety investment, and/or optimizing cash flow.3 of microlenders provide financial assistance. For Some additional criteria that SMEs use to those firms whose growth phase has true valuecreating potential, wealthy individuals known screen opportunities include: as business angels may be a source of funds. • the competitive environment and profit Angel investors often bring the added benefit of potential of the industry; business management expertise, and may serve • general and local economic conditions; in formal or informal advisery capacities with an • the ability of the firm to achieve a sustainable enterprise to which they provide money. competitive advantage;

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Assessing Opportunities for Growth in SMEs CASE STUDY Spira—Six Billion Customers? Andrew B. Krafsur, CEO of Spira Footwear, Inc., contends that everyone on the planet is a potential customer for his company's shoes. Formed in January 1999, Spira was initially funded through loans from the founder and his wife. In the spring of 2001, the company sold common stock through a private placement, obtaining proceeds of US$1,155,000. Spira introduced its shoes to the market in December 2001. The critical competitive component that Spira offered was a patented "WaveSpring" technology. According to the company website, "WaveSpring technology stores and disburses energy with every step."4 The spring involved is laterally stable, lightweight, and compact. It can fit in both the heel and forepart of the shoe. In July of 2007, Spira issued a private placement memorandum seeking a total of US$4,000,000 from accredited investors—i.e., individuals with net worth of at least US$1,000,000 or an annual income of at least US$200,000. The funds were to be used to reduce debt, to increase inventory, and for market expansion, including in international markets. Over the next year negotiations with the primary targeted investment group proved slower than expected. Less than US$1,000,000 was raised, leading the executive team to seek other sources of financing. An additional half million dollars was raised from the owning family of a department store chain, and an angel investor committed a US$1,000,000 loan that could be later converted to equity. Despite the reduced ability to raise funds and due directly to the economic downturn, Spira's executives and board of directors chose to concentrate strategic efforts on marketing. They anticipated that reduced spending by consumers might cause competitors to cut costs by scaling back on promotional activities and inventory. To the leadership team at Spira, this represented an opportunity. The company entered into an alliance with the Walt Disney Company, sponsored athletes of high visibility to the running community, and pushed forward with with new product development. One early measure of success was a leap in ranking for Spira in search engine listings.

CONCLUSION Creativity and an ability to identify opportunities are seen as characteristics of entrepreneurs at the time they start their companies. Enterprises that prosper and grow must continue to identify and pursue opportunities. In an existing small or medium business, structuring the process for recognizing and exploiting opportunities prevents the management team from slipping into routines that worked in the past but may not keep the firm competitive in the future. Enterprise managers

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must be able to: 1 identify opportunities; 2 assess whether those opportunities are appropriate for their firms; 3 devise strategies to exploit the opportunities. These steps require more planning than entrepreneurs generally engage in at the time they create their ventures. And the management team should always keep in mind that implementing the plans will be different from formulating them.

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MAKING IT HAPPEN The growth of an enterprise is often accompanied by increased bureaucratization. When a company is founded and in the start-up stage, the owner is involved with everything. As the firm grows, even small businesses develop policies, procedures, and guidelines. As these rules develop, t h e management team must be diligent to prevent them from stifling further growth. Such diligence should lead to an organizational culture that encourages the assessment and pursuit of opportunities. Actions that can be taken to promote this include: • familiarizing new employees with the history and traditions of the enterprise, especially introducing t h e m to the sacrifices that were made and the initiatives taken; • investing in continuing education for all employees, not j u s t on specific j o b requirements, but also on improving communication and other interpersonal skills; • providing information about industry conditions and forecasts, technological developments, and other topics; • engaging in team-building efforts, particularly those that hone opportunity identification and assessment skills. • Devising a system that reinforces experimentation and innovation.

MORE INFO Books:

Bhide, Amar V. The Origin and Evolution of New Businesses. New York: Oxford University Press, 2000. Harvard Business Review on Entrepreneurship. Boston, MA: Harvard Business School Press, 1999. Hitt, Michael A., et al. (eds). Strategic Entrepreneurship: Creating a New Mindset. Oxford: Blackwell, 2002. Websites: Capital Formation Institute: www.cfi-institute.org National Association of Seed and Venture Funds (NASVF; US): www.nasvf.org US Small Business Administration: www.sba.gov

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1 Ronstadt, Robert. "The corridor principle." Journal of

Actions that can be taken to maintain small investors' confidence to continue investing include the following: • Make managers shareholders, and let the small investors know about it. • Protect your company against any possible financial risk by holding a well-diversified portfolio of various shares.

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• Keep the existing shareholders happy, well treated, and looked after. They will bring in more investors.

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• Turn your workers into shareholders. Workers with a financial stake in a company work more efficiently when the company's success results in a rise in the share price. • Create a stable and conducive environment that encourages people to save and prosper.

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MORE INFO Books:

Lindahl, David. Trump University Commercial Real Estate 101: How Small Investors Can Get Started and Make It Big. Hoboken, NJ: Wiley, 2008. Stowe, John D., Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey. Equity Asset Valuation. Hoboken, NJ: Wiley, 2007. Articles: Brush, Michael. "A revolution for small investors." MSN Money (April 30, 2008). Online at: tinyurl.com/cjhbq9 Hanson, Tim. "Secret advantages for small investors." The Motley Fool (January 9, 2006). Online at: tinyurl.com/cdjlo5 Lease, Ronald C, Wilbur G. Lewellen, and Gary G. Schlarbaum. "The individual investor: Attributes and attitudes." Journal of Finance 29:2 (May 1974): 413-433. Online at: www.afajof.org/journal/jstabstract.asp7ref=8798 Lian, Tan Kin. "Protecting the small investors." The Online Citizen (September 22, 2008). Online at: tinyurl.com/2erwxth Luo, Jar-Der. "The savings behavior of small investors: A case study of Taiwan." Economic Development and Cultural Change 46:4 (July 1998): 771-788. Online at: dx.doi.org/10.1086/452373 Malmendier, Ulrike, and Devin M. Shanthikumar. "Are small investors naive about incentives?" Journal of Financial Economics 85:2 (August 2007): 457-489. Online at: tinyurl.com/2vphlj6 [PDF]. Papworth, Jill. "Investors should lose Abbey habit." Guardian (London) (January 22, 2005). Online at: tinyurl.com/36luklk Snowdon, Ros. "HBOS cash call sets poser for small investors." Yorkshire Post (April 30, 2008). Online at: tinyurl.com/32tfqb3 Treanor, Jill. "Small investors threaten to derail B&B fundraising." Guardian (London) (June 28, 2008). Online at: tinyurl.com/359b45k Varian, Hal R. "Economic scene; despite the recovery in stocks, some of the forces behind the internet bust are still lurking." New York Times (July 3, 2003). Online at: tinyurl.com/agkjuj Wilson, Graeme. "Halifax in a fix." Sun (London) (September 17, 2008). Online at: tinyurl.com/32zjhty

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Table 1 lists the world's 20 largest pension funds as ranked by Pensions & Investments. Insurance companies and banks are also important types of institutional investor that constitute the traditional asset managers.

Paralleling the growth of traditional institutions is the universe of nontraditional institutional investors. Among them, a sovereign wealth fund (SWF) is a state-owned investment fund composed of financial assets such as stocks,

Table 1. The world's top 20 pension funds based on total assets. (Source: Pensions & Investments; Watson Wyatt, 2006) Rank

u

z

Country

Fund

Assets (US$ million)

1

Government Pension Investment

Japan

870,587

2

Government Pension

Norway

235,849

3

ABP

Netherlands

226,974

4

Notional Pension

Korea

214,184

5

California Public Employees

US

195,978

6

Pension Fund Association

Japan

183,352

7

Federal Retirement Thrift

US

167,165

8

Local Government Officials

Japan

137,153

9

California State Teachers

US

133,988

10

New York State Common

US

131,861

11

GEPF

South Africa

124,167

12

Postal Savings Fund

Taiwan

117,265

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Florida State Board

US

114,935

14

General Motors

US

114,271

PL,

15

New York City Retirement

US

105,860

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ranked by Institutional Investor in 2007. A private equity fund is a pooled investment vehicle which invests its money in equity securities of companies that have not "gone public" (i.e. are not listed on a public exchange). Private equity funds are typically limited partnerships with a fixed term of ten years (often with annual

extensions). At inception, institutional investors such as pension funds and endowments (limited partners) commit a certain amount of capital to private equity funds, which are run by the general partners. Table 4 is a list of the ten largest private equity firms in the world as ranked by Private Equity International in 2008.

Table 4. The world's ten largest private equity firms. (Ranking by Private Equity International, 2008) Firm

Rank

u

Headquarters

Capital raised 2003-2008

1

The Carlyle Group

Washington, DC

$52 billion

2

Goldman Sachs Principal Investment Area

New York, NY

$49.05 billion

3

Texas Pacific Group

Fort Worth, TX

$48.75 billion

4

Kohlberg Kravis Roberts

New York, NY

$39.67 billion

5

CVC Capital Partners

London, UK

$36.84 billion

6

Apollo Management

New York, NY

$32.82 billion

7

Bain Capital

Boston, MA

$31.71 billion

8

Permira

London, UK

$25.43 billion

9

Apax Partners

London, UK

$25.23 billion

10

The Blackstone Group

New York, NY

$23.3 billion

t—I

118

The Role of Institutional Investors in Corporate Financing THE ROLE OF INSTITUTIONAL INVESTORS IN CORPORATE FINANCING

Institutional investors supply capital for firms seeking to raise finance from both publicly traded securities markets and from the private domain.

Institutional Investors as Holders of Publicly Traded Securities Given their large portfolio size, institutional investors naturally become dominant holders of publicly traded securities. According to the 13F filings that institutional investors are required to lodge with the Securities and Exchange Commission (SEC), institutional investors hold over 68% of the total market value of US common stocks. According to the "Flow of Funds" data provided by the Federal Reserve, institutional investors hold approximately 86% of corporate bonds in the US corporate bond markets. Therefore, their investment behavior will have a significant influence on the pricing of these securities. For corporate managers who raise money from capital markets, it is important to understand the demand structure of institutional investors for publicly traded securities. Despite their apparent heterogeneity, institutional investors share common characteristics because of the legal environment that they face as fiduciaries, and because of the demand for liquidity resulting from the large sizes of their portfolios and the need to reduce transaction costs. As a group, institutional investors exhibit preferences for certain stock characteristics in their equity portfolio. In particular, they tend to prefer stocks with larger market capitalization, higher turnover ratios, and higher levels of price. In other words, institutional investors are willing to pay a higher premium for stocks with these characteristics.1 Because most institutional investors benchmark their performance against certain indices, they naturally exhibit preferences for stocks in popular equity indexes. In the US market, when stocks are included into the S&P500 Index, the most prevalent equity index, the prices of those stocks tend to experience a 2-3% increase over a short period of time. Firms with access to the corporate bond market tend to issue bonds as a means of debt financing. Based on the credit quality of the issue, corporate bonds can be classified into investment-grade and noninvestment-grade

(high-yield or junk bonds, which are rated Ba and below by Moody's, or BB and below by Standard & Poor's). For corporate bond issuers, it is important to recognize the tendency of different classes of corporate bonds to attract different types of institutional investor—namely the clientele effect—in corporate bond markets. Institutional investors generally place restrictions on investing in noninvestment-grade bonds. For example, the National Association of Insurance Commissioners (NAIC) imposes on insurance companies an upper limit of 20% of their assets for investment in high-yield bonds. Pension funds often impose limits on the value of a portfolio that can be invested in high-yield bonds. US investment-grade bond mutual funds place a limit of 5% of assets for investments in junk bonds and must sell any security if it falls below a B rating. However, there are institutional investors that specialize in junk bonds such as hedge funds with strategies in distressed assets and high-yield bond mutual funds. A recent study shows that when a bond receives a downgrade from investment to speculative grade there is a persistent price decline of 2%, whereas similar downgrades that do not cross the junk bond threshold do not experience such persistent price drops. This result suggests the importance of investor clientele for the pricing of corporate bonds.2

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Institutional Investors as Fund Intermediaries for Private Firms For entrepreneurial firms at the early stage of their life cycle, private equity funds comprise an important source of financing. Two primary categories of private equity funds are venture capital funds and leveraged buyout funds. In particular, venture capital funds provide equity capital for firms that are not yet profitable and lack tangible assets. Typically, such venture capital funds are active investors and play a primary role in shaping the top management team of the companies in which they invest. Unlike venture capital funds that invest in young, fast-growing private companies, leveraged buyout funds invest in established companies and facilitate the process of purchasing an entire company or a controlling part of the stock of a company involving large amounts of debt—a 'leveraged buyout." During the past two decades, jT\ both types of private equity funds have played an ^~. increasingly important role in corporate financing. 1—1

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Financing and Raising Capital .2

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CASE STUDY Hedge Funds and the Turmoil of the Convertible Bonds Market Convertible bonds, which give holders an option to exchange the bonds for a specified number of shares of common stocks, are an importance source of capital for many firms. Among various reasons, managers favor convertible bonds because they are less costly than a direct share issuance, and because firms to which straight debt and equity are not available can still raise money in the convertible bond market. SEC Rule 144A, effective in 1990, allows firms to issue securities to qualified institutional buyers (QIBs) without having to register these securities. This regulation significantly accelerates the capital-raising process from more than one month in the public market to one or two days in the 144A market from announcement to closing. As a result, nearly all convertible bonds in recent years have been issued via the 144A market. According to the SDC Global New Issues database, convertible bond issuance amounted to $50.2 billion in 2006, increasing more than sixfold from $7.8 billion in 1992. It is generally believed that hedge funds that conduct convertible arbitrage are the major players in the convertible bond markets, purchasing more than 70% of convertible bonds in the primary market. In late 2004 and early 2005, large institutional investors in convertible hedge funds, unimpressed with the performance of hedge funds in 2004, started to withdraw capital from those funds. To meet investor redemptions, hedge funds sold convertible bonds, causing their prices to fall relative to their fundamental values, which in turn lowered the returns on convertible hedge funds. From January to May of 2005, the Credit Suisse/Tremont Convertible Arbitrage Hedge Fund Index decreased by 7.2%.3 The lower returns on convertible hedge funds triggered further investor redemptions and more selling of convertible bonds, forming a vicious cycle. The price of convertible bonds dropped significantly below fundamental values. The maximum discount of convertible bonds was 2.7% in May 2005." A gradual price recovery took place in 2006.

CONCLUSION The dramatic expansion of institutional investors in global capital markets demonstrates the changing savings pattern of households in the global economy. As such, corporate managers who wish to raise funds to finance the growth of their firms must understand such institutionalization in the global fund markets, In equity markets, institutional investors tend to prefer liquid stocks with larger market capitalization, higher turnover, and higher price levels. Because the performance of institutional investors is typically benchmarked against

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certain indexes, stocks in popular equity indexes are particularly favored by institutional investors and are thus priced at a higher valuation ratio, In bond markets that are mainly populated by institutional investors, there is a clear clientele effect. Banks, insurance companies, pension funds, and investment-grade bond mutual funds place severe restrictions on the holdings of highyield bonds, whereas hedge funds and high-yield bond mutual funds provide capital for highyield issuers. Lastly, private equity funds are an important source of capital for entrepreneurial firms.

MAKING IT HAPPEN Institutional investors have dominated global capital markets. As a result, the assets under their management constitute an important source of capital for corporate managers. • To attract institutional investors in equity markets, liquidity of shares is a major consideration. In particular, larger market capitalization, higher turnover, and higher price levels are important in attracting institutional holdings. Index membership is a strong sweetener. • In bond markets, investment-grade bonds have a broader institutional investor base, whereas the issuance of high-yield bonds relies on capital providers such as specialized bond mutual funds and hedge funds. • For entrepreneurial firms that seek both capital and strategic support, private equity funds appear to be increasingly important.

120

The Role of Institutional Investors in Corporate Financing MORE INFO

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Books: Davis, E. Philip, and Benn Steil. Institutional Investors. Cambridge, MA: MIT Press, 2004. Jaeger, Robert A. All About Hedge Funds: The Easy Way to Get Started. New York: McGraw-Hill, 2003. Pozen, Robert C. The Mutual Fund Business. 2nd ed. Boston, MA: Houghton Mifflin, 2002. Pratt's Guide to Private Equity & Venture Capital Sources. New York: Thomson Reuters, 2008.

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Websites: Dow Jones LP Source Galantes: www.dowjones.com/privatemarkets/gal.asp Institutional Investor: www.institutionalinvestor.com Investment Company Institute (ICI): www.ici.org Pensions & Investments: www.pionline.com Preqin: www.preqin.com Private Equity International (PEI): www.peimedia.com Sovereign Wealth Fund Institute: www.swfinstitute.org Watson Wyatt: www.watsonwyatt.com

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NOTES 1 Gompers, P. A., and A. Metrick. "Institutional investors and equity prices." Quarterly Journal of Economics 116 (2001): 229-259. 2 Da, Z., and P. Gao. "Clientele change, persistent liquidity shock, and bond return reversal after rating downgrades." Working paper, University of Notre

,0 Dame, IN. Online at: ssrn.com/abstract= 1280834 3 Based on the author's calculations. 4 Mitchell, M., Pedersen, L. H., and T. Pulvino. "Slow moving capital." American Economic Review 97:2 (2007): 215-220.

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Understanding and Accessing Private Equity for Small and Medium Enterprises by Arne-G. Hostrup

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EXECUTIVE SUMMARY • Private equity is an important component of funding for small and medium enterprises (SMEs). • The goal of securing a company's long-term financing and becoming independent of banks' continuously changing lending behavior is one that preoccupies many enterprises, from foundation to sale. • Very few companies are familiar with the market structure, processes, framework, and conditions of private equity. • There are a number of reservations about this type of financing.

DEFINITION OF PRIVATE EQUITY Private equity is the generic term for all forms of financing through external equity capital in the broader sense. The generic term is often subdivided into: • Venture capital (VC) is made available by business angels (who provide so-called informal venture capital, or IVC) and venture capital companies, usually management companies with a venture capital fund under administration. VC is made use of in a company's early stages—from foundation, market entry, and growth, right down to bridge financing prior to an initial public offering (IPO). • Private equity in a narrower sense is made use of in, for example, expansion, internationalization, MBO/MBI, general reorganization of debt capital financing structures, and turnarounds. The unequivocal characteristic of private equity in the SME sector is that the investor makes the invested capital available without provision of security and thus participates fully in the entrepreneurial risk of a business. Capital is normally made available over the medium to long term (3-10 years) in the form of liable equity. The forms of investment range from acquisition of a stake under the provisions of company law, with payment of the amount invested into the company's capital reserve, to a completely dormant partnership with no direct relationship under the provisions of company law. A combination of both options is often seen, with the investor becoming a shareholder of the company and making part of his investment as a nonrepayable payment into the capital reserve and another part as a repayable

and continuously interest-bearing dormant partnership investment. As regards the extent of the stakes acquired under company law, the range varies from minority and majority holdings to complete takeovers by the private equity investor. The investor's objective is to sell the acquired shares at a later point in time within the framework of a so-called exit, thereby making as much profit as possible. The exit can take place within the framework of an IPO, a trade sale, or a buyback by the previous shareholders. Professional private equity investors usually expect a rate of return of more than 30% per annum. The expectations of business angels may differ. MARKET STRUCTURE AND PARTICIPANTS As a basic principle, the private equity market can be subdivided into the informal/formal and private/governmental areas. In general, the entire field of business angel financing is regarded as the informal private equity market. Business angels are wealthy private investors who use their own capital to acquire stakes in other companies. The formal private equity market is the entire "regulated area," i.e. usually private equity funds or their management companies. Depending on the investment motive or situation of the company, the market subdivides further, with investors specializing in the following sectors: • seed-financing (business angels); • early-stage businesses; • later-stage businesses; • medium-sized businesses; • buy-outs; • corporate venture capital. Within these sectors there are investors who 123

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confine themselves to a certain technology or geographic region. Usually, there is an umbrella organization that unites the private equity firms in any major country and, in some cases, major regions. As a rule, umbrella organizations are a good place to find individual investors and to research their respective special interests (see More Info section).

INVESTMENT PROCESS

established companies tend to shy away from "publishing" a request for financing in this way and often make use of a corporate finance consultant. The extent of support provided by such a consultant ranges from the simple establishment of contact with investors to comprehensive support for the entire process. For instance, many CF consultants offer support when it comes to compilation of the business plan, then present a list of suitable investors and take charge of directly addressing such investors. Support during the due diligence process and contract negotiations is also customary. Consultants are mainly remunerated on the basis of a fixed daily rate (€700-2,000) and a performance-related fee in the event that a private equity investment materializes. The usual commission ranges from 1 to 4% of the investment. The amount varies depending on the agreed fixed remuneration and the support services provided.

Business Plan A substantive business plan is the basic requirement for any involvement of private equity investors. Within the framework of the business plan, the company's strategy and objectives are usually articulated for at least the next five years. In addition, the firm seeking equity capital must highlight all business and financial aspects of a project. At an international level, the following structure is commonly found in business plans: Due Diligence • executive summary • product or service After an investor has voiced interest, he or she • market and competition begins with the due diligence process. The entire • marketing and sales company is "put to the test." Its history, current • business model, business system and market and competition, and strategy for the organization future are closely examined. Some investors • entrepreneurial team, management, prefer to undertake parts of the due diligence personnel themselves, but as a rule the task is passed to • implementation schedule external consultants. The due diligence process is often divided into the following parts: • opportunities and risks • financial planning and financing • Legal: Fulfillment of the duty to provide • appendix. information or limitation of liability risks; The business plan is the basis for an investor's identification and valuation of legal risks. decision to invest and usually becomes an • Product/technique: Assessment of products/ integral part of a participation agreement. services at the development stage, technical Moreover, the plan is a helpful controlling feasibility, market acceptance, etc. instrument for management over the following • Strategic/business: Description and, if years. The business plan should therefore be possible, quantification of potential on the compiled with care. market and resource side. • Commercial: Assessment of the future Selecting and Addressing Investors development of the market in which the How do I find and select the right investor for my business operates. company? And how do I address this person or • Financial: Assessment of the company's past fund? Generally, there are three ways in which commercial situation and its future earnings an SME can identify potential investors: potential. • Tax: Identification of tax-related risks and a • research on the internet, followed by a direct tax-optimized design for the transaction. approach with submission of the business • Environmental: Disclosure of any plan environment-related liabilities that may • presentations at investor conferences impose a heavy cost burden following • hiring a corporate finance (CF) consultant. conclusion of the deal. For smaller or younger companies, direct addressing or presentation at conferences is a In most cases analysis focuses on the financial common method. In particular, this applies to and strategic/business areas. Depending on the the entire venture capital segment. Larger or company's age and history, legal due diligence

124

Understanding and Accessing Private Equity for SMEs may also become a focal point. The objective is to provide a background for decisions that are in accordance with the investment, based on the performed corporate analysis. Due diligence requires careful preparation by the management of the business to ensure that information and data requested by the investor or his agent are properly and fully presented. An important factor in preparation and organization of materials for the due diligence process is the selection of a team, and thereby the establishment of responsibilities for the collection and processing of data and making available contact persons for interviews. Before the start of the due diligence process, the company that is going to be scrutinized should create a "data room" in which all required information is gathered so that it can be accessed and inspected bythe examiners. This can range from a simple folder or CD to a professionally designed online platform (these are offered by specialized service providers). With an online platform all the required data are input in electronic form so that they can be checked by external examiners with authorization to access the information. Clearly, the younger a company is, the fewer materials there may be available for examination. In the case of a foundation project, this material is often confined to the business plan. Practice has shown that the due diligence process can often become protracted, or that there may even be a breakdown of the entire contract negotiations, for the following reasons: • incomplete documents; • contact persons not available for interviews; • unconvincing budget planning (e.g. unrealistic assumptions, inconsistent planning, poor or incomplete data sources); • legal disputes with uncertain outcomes in respect of liability, or warranty and patent risks as well as risks related to the legal protection of registered designs; • environmental risks; • tax-related risks; • insufficient recoverability/value of inventories and accounts receivable; • management is unable to convince an investor of its ability to realize the business objectives beyond a limited extent. Company Valuation Valuation of the company is almost always the most critical issue in contract negotiations, and intended projects frequently fail at this particular point as the parties involved are unable to reach

agreement on the price. Company valuation can be based on various internationally recognized procedures, such as: • discounted cash flow; • multiples like price-earnings ratio or pricecash flow ratio; • asset value procedure; • exit value procedure. Which procedure is used depends on many factors, such as the preferences of the investor, the country in which the company's registered office is located, and the age of the company. When determining a company value that is appropriate for both sides, the following should be borne in mind: • there is no such thing as a correct value; • although valuation procedures are objectively comprehensible, the range of results they give can be extremely wide; • company valuation is always a reflection of opinions, which can differ widely—especially with young companies. However, a valuation can indicate a plausible value; • in the final analysis, it is offer and demand that determine the value of a company. In conclusion, the general rule is that there is a value, and there is a price. Contracts Participation agreements are very extensive contracts, often consisting of several hundred pages. Therefore, a lawyer should always be consulted. As a general rule, in the case of participation in a limited liability company, such an agreement has the following components: • participation agreement; • partnership agreement; • articles of association; • contract on the establishment of a silent partnership; • advisory committee statute; • management board regulations; • managing director employment contract. How individual agreements are allocated among the above-mentioned documents may vary from one investor to another. For instance, certain agreements may be incorporated in the participation agreement by one investor, while another investor may place the same agreements within the partnership agreement. Participation agreements include a large number of clauses that often raise problems for companies which are seeking private equity for the first time. For instance, investors have comprehensive rights

125

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