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Mergers, Acquisitions & Investment Banking for Mid-Market Business Owners
Knowledge Base - Funding
Corporate Funding & Finance Overview - This area of funding and finance outlines the financial decisions corporations make and the tools and analysis used to make these decisions. The primary goal of corporate funding and finance is to enhance while reducing the firm's financial risks. Equivalently, the goal is to maximize the corporation's return on capital. The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions are long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other hand, the short term decisions can be grouped under the heading "working capital management". This subject deals with the short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the terms on credit extended to customers).
 
The Financing Decision - Achieving the goals of corporate finance requires that any corporate investment be financed appropriately. Cost of money and cash flows (and hence the riskiness of the firm) will be affected, the financing mix can directly and materially impact the valuation of the business. Management must therefore identify the "optimal mix" of financing the capital structures that result in maximum business value. The sources of financing will, generically, comprise some combination of and equity component . Financing a project through debt results in a liability that must be serviced and hence there are cash flow implications regardless of the project's success. Equity financing is less risky in the sense of cash flow commitments, but results in a dilution of ownership and earnings. The cost of equity is also typically higher than the cost of debt, and so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk. Management must also attempt to match the financing mix to the asset being financed as closely as possible, in terms of both timing and cash flows. One of the main theories of how firms make their financing decisions is the Pecking Order Theory, which suggests that firms avoid external financing while they have internal financing available and avoid new equity financing while they can engage in new debt financing at reasonably low interest rates. Another major theory is the Trade Off Theory in which firms are assumed to trade-off the Tax Benefits of debt with the Bankruptcy Costs of debt when making their decisions. One last theory about this decision is the Market timing hypothesis which states that firms look for the cheaper type of financing regardless of their current levels of internal resources, debt and equity.
 
Financial Plan - In general usage, a financial plan can be a budget, a plan for spending and saving future income. This plan allocates future income to various types of expenses, such as rent or utilities, and also reserves some income for short-term and long-term savings. A financial plan can also be an investment plan, which allocates savings to various assets or projects expected to produce future income, such as a new business or product line, shares in an existing business, or real estate. In business, a financial plan can refer to the three primary financial statements (balance sheet, income statement, and cash flow statement) created within a business plan. Financial forecast or forward looking financial plan can also refer to an annual projection of income and expenses for a company, division or department. A financial plan can also be an estimation of cash needs and a decision on how to raise the cash, such as through borrowing or issuing additional shares in a company. While a financial plan refers to estimating future income, expenses and assets, a financing plan or finance plan usually refers to the means by which cash will be acquired to cover future expenses, for instance through earning, borrowing or using saved cash. Financial planning is the task of determining how a business will afford to achieve its strategic goals and objectives. Usually, a company creates a Financial Plan immediately after the vision and objectives have been set. The Financial Plan describes each of the activities, resources, equipment and materials that are needed to achieve these objectives, as well as the time frames involved. Performing financial planning is critical to the success of any organization. It provides the business plan with rigor, by confirming that the objectives set are achievable from a financial point of view. It also helps the CEO to set financial targets for the organization, and reward staff for meeting objectives within the budget set. Rest assured that any party lending money or investing in the company will requre a high-quality Financial Plan. The lender or investor will hold management accountable for producing results in line with the Financial Plan. 
 
Asset Based Lending - In the simplest meaning, asset-based lending is any kind of lending secured by an asset. This means, if the loan is not repayed, the asset is taken. In this sense, a mortgage is an example of an asset-backed loan. Pledging real estate, CD's or other tangible assets with market value as security decreases the lenders risks and usually results in a lower interest rate.  However, Asset Based Lending can be used to describe lending to business and large corporations using assets not normally used in other loans. Pledging accounts receivables as security is a common practice of companies seeking to arrange for a line of credit.  Banks, conventional lenders and companies specializing in factoring accounts receivables are skilled at assessing the value and risks of a companies accounts receivables and extending corresponding credit limits. Exotic transactions are becoming more common; like lending against the value of a trademark or intellectual property. For example, a software development company producing electronic games took out a line of credit secured by its successful, trade marked, proprietary electronic game product.  If the company fails to repay, the bank then owns the intellectual property and trademark, and can sell the rights to repay the outstanding loan. Higher than normal interest rates are generally charged by the banks to offset their business risks.  This type of lending is usually done when the normal routes of raising funds, such as the capital markets (selling stocks or bonds to investors) or normal unsecured or mortgage secured bank lending is not possible. The use of exotic lending is employed by companies that are in dire financial status. It is usually accompanied by high interest rates, and can be very lucrative for the lender. For example, a bank made more money from asset-based lending business then it did the rest of its corporate business (both lending and fee based services). In fact, many financial services argue that normal lending to corporations can no longer be profitable in and of itself, because the interest rates involved are too low. This is because for most of the second half of the twentieth century, it has been possible for corporations to not borrow from banks but instead borrow from individual investors in the form of bonds. Thus, competition has made rates so low that many feel they do not adequately reflect the risk (see: risk-based pricing). Most financial services companies now only lend as part of a package of services. An asset based business line of credit is usually designed for the same purpose as a normal business line of credit - to allow the company to bridge itself between the timing of cash flows of payments it receives and expenses. The primary timing issue involves what are known as accounts receivables - the delay between selling something to a customer and receiving payment for it. A non asset based line of credit will have a credit limit set on account opening by the accounts receivables size, to ensure that it is used for the correct purpose. An asset based line of credit however, will generally have a revolving credit limit that fluctuates based on the actual accounts receivables balances that the company has on an ongoing basis. This requires the lender to monitor and audit the company to evaluate the accounts receivables size, but also allows for larger limit lines of credits, and can allow companies to borrow what they would normally would not be able to. Generally, terms stipulating seizure of collateral in the event of default allow the lender to profitably collect the money owed to the company should the company default on its obligations to the lender. Factoring of receivables is a subset of asset-based lending and is often used in conjunction with a standard ABL facility which uses inventory or other assets as collateral. The lender mitigates its risk by controlling who the company does business with to make sure that the company's customers can actually pay. Lines of credits to even riskier companies may require that the company deposit all of its funds into a "blocked" account. The lender then approves any withdrawals from that account by the company and controls when the company pays down the line of credit balance.
 
Angel Investors - An angel investor or angel (known as a business angel in Europe), is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or ownership equity. A small but increasing number of angel investors are organizing themselves into angel networks or angel groups to share research and pool their investment capital. Angels typically invest their own funds, unlike venture capitalists, who manage the pooled money of others in a professionally-managed fund. Although typically thought of as individuals, the actual entity that provides the funding may be a trust, business, investment fund, etc. Angel capital fills the gap in start-up financing between "friends and family" (sometimes humorously called friends, family, and fools) who provide seed funding, and venture capital. Although it is usually difficult to raise more than a few hundred thousand dollars from friends and family, most traditional venture capital funds are usually not able to consider investments under U.S. $12 million. Thus, angel investment is a common second round of financing for high-growth start-ups, and accounts in total for almost as much money invested annually as all venture capital funds combined, but into more than ten times as many companies (U.S. $25.6 billion vs. $26.1 billion in the US in 2006, into 51,000 companies vs. 3,522 companies. Of the 51,000 U.S. companies that received angel funding in 2006, the average raise was about US$500,000. Healthcare services, and medical devices and equipment accounted for the largest share of angel investments, with 21 percent of total angel investments in 2006, followed by software (18 percent) and biotech (18 percent). The remaining investments were approximately equally weighted across high-tech sectors.

Profile of An Angel Investor - Angel investments bear extremely high risk, and thus require a very high return on investment. Because a large percentage of angel investments are lost completely when early stage companies fail, professional angel investors seek investments that have the potential to return at least 10 or more times their original investment within 5 years, through a defined exit strategy, such as plans for an initial public offering or an acquisition. Current 'best practices' suggest that angels might do better setting their sights even higher, looking for companies that will have at least the potential to provide a 20x-30x return over a five- to seven-year holding period. After taking into account the need to cover failed investments and the multi-year holding time for even the successful ones, however, the actual effective internal rate of return for a typical successful portfolio of angel investments might, in reality, be as 'low' as 20-30%. While the investor's need for high rates of return on any given investment can thus make angel financing an expensive source of funds, cheaper sources of capital, such as bank financing, are usually not available for most early-stage ventures. Thus, in addition to funds, angel investors can often provide valuable management advice and important contacts. According to the Center for Venture Research, there were 234,000 active angel investors in the U.S. in 2006.

Venture Capital - Venture capital is a type of private equity capital typically provided by professional, outside investors to new, growth businesses. Generally made as cash in exchange for shares in the investee company, venture capital investments are usually high risk, but offer the potential for above-average returns. A venture capitalist (VC) is a person who makes such investments. A venture capital fund is a pooled investment vehicle (often a limited partnership) that primarily invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. Venture capital can also include managerial and technical expertise. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies, or ventures, with limited operating history, which cannot raise funds through a debt issue. The downside for entrepreneurs is that venture capitalists usually get a say in company decisions, in addition to a portion of the equity. Generally, venture capital is closely associated with technologically innovative ventures and mostly in the United States. Due to structural restrictions imposed on American banks in the 1930's there was no private merchant banking industry in the United States, a situation that was quite unique in developed nations. As late as the 1980's, Lester Thorough, a noted economist, decried the inability of the USA's financial regulation framework to support any merchant bank other than one that is run by the United States Congress in the form of federally funded projects. These, he argued, were massive in scale, but also politically motivated, too focused on defense, housing and such specialized technologies as space exploration, agriculture, and aerospace. US investment banks were confined to handling large M&A transactions, the issue of equity and debt securities, and, often, the breakup of industrial concerns to access their pension fund surplus or sell off infrastructural capital for big gains. VC compensation in a typical venture capital fund, the general partners receive an annual management fee equal to 2% of the committed capital to the fund and 20% of the net profits (also known as "carried interest") of the fund; a so-called "two and 20" arrangement, comparable to the compensation arrangements for many hedge funds. Strong Limited Partner interest in top-tier venture firms has led to a general trend toward terms more favorable to the venture partnership, and many groups now have carried interest of 25-30% on their funds. Because a fund may run out of capital prior to the end of its life, larger VC's usually have several overlapping funds at the same time; this lets the larger firm keep specialists in all stages of the development of firms almost constantly engaged. Smaller firms tend to thrive or fail with their initial industry contacts; by the time the fund cashes out, an entirely new generation of technologies and people is ascending, whom the general partners may not know well, and so it is prudent to reassess and shift industries or personnel rather than attempt to simply invest more in the industry or people the partners already know.
 
Raising Substantial Venture Capital - Venture capital is not generally suitable for all entrepreneurs. Venture capitalists are typically very selective in deciding what to invest in.  As a rule of thumb, a fund may invest in as few as one in four hundred opportunities presented to it. Funds are most interested in ventures with exceptionally high growth potential, as only such opportunities are likely capable of providing the financial returns and successful exit event within the required time frame (typically 3-7 years) that venture capitalists expect. This need for high returns makes venture funding an expensive capital source for companies, and most suitable for businesses having large up-front capital requirements which cannot be financed by cheaper alternatives such as debt. That is most commonly the case for intangible assets such as software, and other intellectual property, whose value is unproven. In turn this explains why venture capital is most prevalent in the fast-growing technology and life sciences or biotechnology fields. If a company does have the qualities venture capitalists seek such as a solid business plan, a good management team, investment and passion from the founders, a good potential to exit the investment before the end of their funding cycle, and target minimum returns in excess of 40% per year, it will find it easier to raise venture capital. Investment Bankers - Investment banks help companies and governments (or their agencies) raise money by issuing and selling securities in the capital markets (both equity and debt). Almost all investment banks also offer strategic advisory services for mergers, acquisitions, divestiture or other financial services for clients, such as the trading of derivatives, fixed income, foreign exchange, commodity, and equity securities. The primary function of an investment bank is buying and selling products both on behalf of the bank's clients and also for the bank itself. Banks undertake risk through proprietary trading, done by a special set of traders who do not interface with clients and through Principal Risk, risk undertaken by a trader after he or she buys or sells a product to a client and does not hedge his or her total exposure. Banks seek to maximize profitability for a given amount of risk on their balance sheet.
 
Private Equity - Private equity is a broad term which commonly refers to any type of non-public Ownership Equity securities that are not on a public exchange. Since they are not listed on a public exchange, any investor wishing to sell private equity securities must find a buyer in the absence of a public marketplace. There are many transfer restrictions on private securities. Private equity firms generally receive a return on their investment through one of three ways: an IPO, a sale or merger of the company they control, or a recapitalization. Unlisted securities may be sold directly to investors by the company (called a private offering) or to a private equity fund, which pools contributions from smaller investors to create a capital pool. Considerations for investing in private equity funds relative to other forms of investment include:
  • Substantial entry costs, with most private equity funds requiring significant initial investment (usually upwards of $1,000,000) plus further investment for the first few years of the fund.
  • Investments in limited partnership interests (which are the dominant legal form of private equity investments) are referred to as "illiquid" investments which should earn a premium over traditional securities, such as stocks and bonds. Once invested, it is very difficult to gain access to your money as it is locked-up in long-term investments which can last for as long as twelve years. Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales be made.
  • If the private equity firm can not find good investment opportunities, they will not draw on your commitment. Given the risks associated with private equity investments, you can lose all your money if the private-equity fund invests in failing companies. The risk of loss of capital is typically higher in venture capital funds, which back young companies in the earliest phases of their development, and lower in mezzanine capital funds, which provide interim investments to companies which have already proven their viability but have yet to raise money from public markets.
  • Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers significantly outperforming the public markets.
Leverage Buy Out - A leveraged buyout (or LBO, or highly-leveraged transaction , or "bootstrap" transaction) occurs when a financial sponsor gains control of a majority of a target company's equity through the use of borrowed money or debt. A leveraged buyout is a strategy involving the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired, in addition to the assets of the acquiring company, are used as collateral for the loans. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital. In an LBO, there is most often a ratio of 70% debt to 30% equity, although debt can reach as high as 90% to 95% of the target company's total capitalization. The equity component of the purchase price is typically provided by a pool of private equity capital. Typically, the loan capital is borrowed through a combination of prepayable bank facilities and/or public or privately placed bonds, which may be classified as high-yield debt, also called junk bonds. Often, the debt will appear on the acquired company's balance sheet and the acquired company's free cash flow will be used to repay the debt. In the industry's infancy in the late 1960's the acquisitions were called "bootstrap" transactions, and were characterized by Victor Posner's hostile takeover of Sharon Steel Corporation in 1969. If a bank is unwilling to lend, the management will commonly look to private equity investors to fund the majority of buyout. A high proportion of management buyouts are financed in this way. The private equity investors will invest money in return for a proportion of the shares in the company, though they may also grant a loan to the management. The exact financial structuring will depend on the backer's desire to balance the risk with its return, with debt being less risky but less profitable than capital investment. Although the management may not have resources to buy the company, private equity houses will require that the managers each make as large an investment as they can afford in order to ensure that the management is locked in by an overwhelming vested interest in the success of the company. It is common for the management to re-mortgage their houses in order to acquire a small percentage of the company. Private equity backers are likely to have somewhat different goals than management. They generally aim to maximize their return and make an exit after 3-5 years while minimizing to themselves, whereas the management rarely look beyond their careers at the company and will take a long-term view. While certain aims do coincide - in particular the primary aim of profitability - certain tensions can arise. The backers will invariably impose the same warranties on the management in relation to the company that the sellers will have refused to give the management. This "warranty gap" means that the management will bear all the risk of any defects in the company that affects its value. As a condition of their investment, the backers will also impose numerous terms on the management concerning the way that the company is run. The purpose is to ensure that the management runs the company in a way that will maximize the returns during the term of the backers' investment, whereas the management might have hoped to build the company for long-term gains. Because the two aims are not always incompatible, the management may feel restricted.
 
Management Buyouts - A special case of such acquisition is a management buyout (MBO), which occurs when a company's managers buy or acquire a large part of the company. The goal of an MBO may be to strengthen the managers' interest in the success of the company. In most cases, the management will then take the company private. MBO's have assumed an important role in corporate restructurings beside mergers and acquisitions. Key considerations in an MBO are fairness to shareholders, price, the future business plan, and legal and tax issues. One recent criticism of MBO's is that they create a conflict of interest - an incentive is created for managers to mismanage (or not manage as efficiently) a company, thereby depressing its stock price, and profiting handsomely by implementing effective management after the successful MBO, A management buyout (MBO) is a form of acquisition where a company's existing managers acquire a large part or all of the company. Management buyouts are similar in all major legal aspects to any other acquisition of a company. The particular nature of the MBO lies in the position of the buyers as managers of the company and the practical consequences that follow from that. In particular, the due diligence process is likely to be limited as the buyers already have full knowledge of the company available to them. The seller is also unlikely to give any but the most basic warranties to the management, on the basis that the management knows more about the company than the sellers do and therefore the sellers should not have to warrant the state of the company. In many cases the company will already be a private company, but if it is public then the management will take it private. Some concerns about management buyouts are that the asymmetric information possessed by management may offer them unfair advantage relative to current owners. The impending possibility of an MBO may lead to principal-agent problems, moral hazard, and perhaps even the subtle downward manipulation of the stock price prior to sale via adverse information disclosure - including accelerated and aggressive loss recognition, public launching of questionable projects and adverse earning surprises. Naturally, such corporate governance concerns also exist whenever current senior management is able to benefit personally from the sale of their company or its assets. This would include, for example, large parting bonuses for CEO's after a takeover or management buyout. Since corporate valuation is often subject to considerable uncertainty and ambiguity, and since it can be heavily influenced by asymmetric or inside information, some question the validity of MBO's and consider them to potentially represent a form of insider trading. The mere possibility of an MBO or a substantial parting bonus on sale may create perverse incentives that can reduce the efficiency of a wide range of firms - even if they remain as public companies. This represents a substantial potential negative externality. The Purpose of an MBO - The purpose of such a buyout from the managers' point of view may be to save their jobs, either if the business has been scheduled for closure or if an outside purchaser would bring in its own management team. They may also want to maximize the financial benefits they receive from the success they bring to the company by taking the profits for themselves. This is often a way to ward off aggressive buyers.

MBO Debt Financing - The management of a company will not usually have the money available to buy the company outright themselves. They would first seek to borrow from a bank, provided the bank was willing to accept the risk. Management buyouts are frequently seen as too risky for a bank to finance the purchase through a loan. Along with the typical interest payment associated with debt, mezzanine capital will often include an equity stake in the form of warrants attached (or equity co-investments) to the debt obligation or a debt conversion feature identical to that of a convertible bond. Mezzanine capital is a more expensive financing source for a company than secured debt or senior debt. It is more expensive because of the increased credit risk, i.e. in the event of default, mezzanine debt is less likely to be repaid in full. It is only secured by the equity of the company, and not the company's tangible assets (e.g., property, cash or accounts receivable). In compensation for the increased risk, mezzanine debt holders will require a higher interest payment or an equity stake in the company. However, it is a cheaper source of financing than equity as the current equity holders achieves less dilution.

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