224 CHAPTER 15 Financing growth growth). After commercial validation of the product or service offered by the target company, the venture capitalist intervenes and increases produc- tion and the selling and marketing capacity. The company is still medium or little, but the growth capacity of the business idea has improved. It is important to emphasize that the fi nancial resources invested are reduced because the company has already acquired a good part of the market, and selling guarantees the resources needed for the production process. 2. Third stage fi nancing — Figure 15.3 illustrates how third stage fi nancing sup- ports the consolidation of the development reached by the venture-backed company. At this point, it has passed the initial development phase and wants to consolidate and enlarge its market position. The venture capitalist contributes a large amount of money to protect the target company’s market position and to support the management during the design of new growth plans. These types of plans involve the launch of new product, enlargement or diversifi cation of manufacturing and distribution activities, or the acqui- sition of a competitor. Consequently, it becomes necessary to collect new funds dedicated to research and development, marketing, and production. 3. Fourth stage or bridge fi nancing — Figure 15.4 illustrates the maturity stage of a company’s life cycle. By this time the target company has grown con- siderably by enlarging the markets reached and the range of products or Expansion financing Maturity Vulture and distressed financing Time Revenues Early stage financing Development Consolidation FIGURE 15.3 Life cycle time of a company — consolidation stage. 225 services offered. Financing is geared toward going public or for a planned trade sale with venture capitalist support to facilitate the next steps. The venture capital fi nancing can also bridge fi nancial diffi culties and the quo- tation of the company. In this phase the level of risk is very low with occa- sional fi nancial operations that involve large amounts of money. Expansion deals involve not only equity capital but also debt fi nancing when a leveraged buyout (LBO) is realized. Expansion deals only provide minority par- ticipation in the equity of the target company, whereas an LBO requires a major- ity participation. These deals change the property composition of the target company allowing for the differences in participation. 15.3 ADVANTAGES FOR VENTURE-BACKED COMPANIES Venture -backed companies with private equity fi nanced company growth have several advantages: 1. Support in building business — Experienced venture capitalists assist the target company in recruiting managers, developing relationships with cus- tomers, and fi xing business strategy. 15.3 Advantages for venture-backed companies FIGURE 15.4 Life cycle of a company — maturity stage. Expansion financing Maturity Vulture and distressed financing Time Revenues Early stage financing Development Consolidation 226 CHAPTER 15 Financing growth 2. Cash feed — Private equity investors provide the funds necessary to support key business activities. 3. Higher overall return — The support of private equity fi rms allows the original shareholders to obtain a higher return from their investments in the target company, especially when exiting through an IPO. 4. Sponsor in going public — Experienced venture capitalists are key assets in reassuring IPO investors, so their involvement increases the possibility of success in going public. Usually, IPOs realized with private equity inves- tors create higher returns. 5. Spin-off support — Venture capitalists with a wide range of relationships can help when the target company wants to sell its subsidiaries. 6. Venture capitalists improve the target company’s ability to satisfy market demands — Today markets change quickly due to customer needs or tech- nological revolutions, so it is critical to a company’s success to be able to quickly exploit market opportunities. 7. Venture capitalists support the target company upon entry into new mar- kets or industries because they are able to share their management skills and business know-how. 8. Private equity investment is a clear signal a business idea has potential. On the other hand, the lack of interest is a good indicator of an existing problem not easily recognized by the management team or the original shareholders. 9. Original shareholders receive critical support from the private equity investor — The bottom line of the balance sheet will be diligently watched and every possible action placed to maximize the potential return on the investment. 15.4 DISADVANTAGES FOR VENTURE-BACKED COMPANIES To have a clear picture of how private equity investments impact the expan- sion of a target company, a recurring group of potential disadvantages should be considered: 1. Culture changes — The target company’s managers and employees have to work with a new partner who has a high-profi t-oriented culture com- bined with an intense pressure to continue to develop the business. 2. After investing in the target company, private equity fi rms have greater con- trol of the agendas and activities of the original shareholders and managers. 227 3. Timing of exit strategies may not be consistent with the plan of the origi- nal shareholders and management. Many confl icts can arise while manag- ing the right time to exit. 4. Buy back options are usually limited. This means that original shareholders may not be allowed to re-purchase the participation from the venture cap- italist if the deal was unsuccessful. Private equity fi rms are usually reluc- tant to include a buy back option, because it can affect the real potential of the investment return. 5. Private equity investors require a high return from the investment. This means a high level of the value transfers from original to new sharehold- ers. The high return expectations include the value of the money invested as well as the soft support consisting of invested time, networks, experi- ence, and expertise. The original shareholders, before closing the deal with equity investors, have to understand that if the value of their busi- ness will be higher after the deal, then this justifi es the high percentage of value that they must give to the investor. 6. Closing a transaction with private equity fi rms is complex and time- consuming, because this type of deal includes agreements on liabilities and obligations that can take up to a year to close. 7. A typical private equity approach comes with fast decision making. If there are bureaucratic delays, due to the timetables and procedure of the previous shareholders, the investors can decide to abandon a partnership. 8. The willingness of a private equity fi rm to commit additional fi nancial resources in a specifi c investment already part of its portfolio is limited by the continuous focus on its expected returns. This situation can force origi- nal shareholders into adding new funds to the venture-backed company to avoid losing new business initiatives or opportunities due to lack of funds. 15.5 CHARACTERISTICS OF GROWTH Expansion fi nancing deals work best with middle or small size fi rms that want to grow quickly. Small medium fi rms have fl exible production systems that adapt quickly to demand changes. Consequently, fi rms turn to expansion fi nanc- ing to reach another element for their success — dimension. Increasing dimen- sion allows the small medium companies to exploit business opportunities that they otherwise would lose due to the lack or the low availability of effective and alternative tools for internationalization. 15.5 Characteristics of growth 228 CHAPTER 15 Financing growth During this strategic process, soft support given by private equity investors is critical. Their ability to provide fi nancial resources as well as a set of advisory services helps the small medium company to improve its competitive skills. The extensive support provided to these types of companies is also demonstrated in the average duration of the holding period, which is around four years or more when compared with the holding period of buyout operations. The support given for the dimensional growth of the fi rm can be classifi ed in two ways: quantitative and qualitative. Company performance can be quantita- tively compared in terms of revenue and improvement of the margin and num- bers of employees between venture-backed companies and companies that have never needed professional investors. Research demonstrates the high impact of the private equity operation by analyzing the increase in the employment level and turnovers. An expansion deal can lead to qualitative development facilitat- ing the collaboration and joint venture with foreign partners that can result in export business. 15.6 EXTERNAL GROWTH As stated previously, it is possible to realize an expansion investment through internal and external growth. There are three main reasons for external growth: 1. Reinforcing the competitive advantages of the company to strengthen its distinctive skills in the existing activities and businesses — Acquisitions usually involve fi rms operating in the same markets with similar products and services. 2. Expanding competitive advantages to improve and extend the company’s distinctive skills to neighboring sectors — Companies targeted for acquisi- tion usually offer products and services with technological and marketing elements. 3. Exploring the competitive advantages of the company when entering a new sector that requires new skills — This type of target fi rm operates upstream or downstream or in sectors without any correlation. External growth refers to merger and acquisition (M & A) operations with several different objectives; some need a long period of time to be reached, while oth- ers are realizable more quickly. Long-period objectives are classifi ed in three dif- ferent clusters. The fi rst type desires to increase the company’s value and satisfy 229 the interests of the different stakeholders. The second type is connected with a manager who wants to reinforce his personal visibility, and the last type looks for opportunities to collect earnings in a capital account. The short-term objectives, also considered strategic motivations, refer to: Researching and exploiting the scale and scope economies — These compa- nies want to use their experience in marketing or production to improve production capacity through the skills and technologies of the acquired fi rm. Managing interdependence with stakeholders by accelerating growth in the industry where the acquired fi rm already successfully operates to improve their own skills. Improving the proposal system and markets served by acquiring a higher market share and entry into new markets by using the marketing skills of the acquired company and increasing the client base. Entering in new businesses to obtain critical resources from the acquired company or to reduce the risk related to the expansion in new industries. Exploiting and optimizing fi nancial resources through the leverage capacity of the acquired company, stabilization of the cash fl ow, or the acquisition of an underestimated company that can be sold with a good economic return. Appendix 15.1 A business case: REM A15.1.1 Target company REM was founded in the 1930s and operates in the industrial machine sector. It was fam- ily controlled until 2003 when a venture capitalist acquired minority participation. After this investment, the company developed a strategy of acquisitions and a partnership, becoming a global leader of life science and testing equipment. REM operates in more than 50 countries and 70% its total revenues is made in exports. REM’s markets are the electronic, automotive, aerospace, and defense sectors. A15.1.2 Investment structure The operation, closed in 2003, was an expansion capital deal consisting of a minority acqui- sition of about 14% evaluated at €6 million with €40 million as the pre-money value of the target company. Shareholders agreements provided an exit strategy of listing the company or the opportunity to realize a buy back by minority shareholders within a fi xed period of time and with a predetermined method for price determination. 15.6 External growth 230 CHAPTER 15 Financing growth A15.1.3 Critical elements of the investment The main reasons for the deal were the strong competitive market position and the interna- tional exposure of REM, their operation within several markets, and their clear strategy of exter- nal growth in a high potential industry. A15.1.4 Management phase activity Despite tough pressure on the operating margin provoked by the unfavorable exchange rate of the US dollar with the euro, between 2003 and 2007 REM, with the support of a venture capi- talist, realized 6 acquisitions in and out of its domestic market, making it a global player. REM has since started to reorganize its production cycle. A15.1.5 Exiting The founder family terminated the deal in 2008 with re-acquisition of the minority participation owned by the venture capitalist. Appendix 15.2 A business case: MAP A15.2.1 Target company MAP was founded in the 1950s starting with a wholesale food business. Over the years the com- pany expanded toward oil production and fresh food trading. Today, MAP is a wholesale and retail distributor of food and consumer goods including the manufacturing and packaging of food. Its channel is a mix of hypermarket, large stores, and supermarkets with three different brands. A15.2.2 Investment structure The operation was realized at the end of 2003 with the acquisition of a minority stake by two venture capital fi rms of €12,8 million and was a typical expansion capital transaction with an evaluated enterprise value of €106 million. Agreements between the shareholders regarding exit options consisted of a buy back by the majority shareholders or the listing of MAP. A15.2.3 Critical elements of the investment This investment was realized because of MAP’s leadership in a specifi c area of its market, its attractiveness to big foreign players, and high growth trend and good profi t performances. A15.2.4 Management phase activity and exit During the investment, the external growth strategy was unsuccessful so the venture capitalist exited from MAP with a buy back. 231 Appendix 15.3 A business case: FMM A15.3.1 Target company The company was founded in the 1930s because a group of workers started providing facil- ity services to a big transportation fi rm. FMM business consisted of specialized management services for buildings and equipment including maintenance of electrical and lighting services, refrigeration equipment, and catering and canteen services. A15.3.2 Investment structure The investment was realized by two venture capitalists for a total of €20 million, 12% of the equity capital of NewCo, which was built to realize an expansion capital transaction. NewCo involved two business units: facility management and a cleaning and environmental services unit. FMM has subscribed 75% of its equity capital; the remaining stakes were subscribed by other minor private equity operators. This deal structure allowed FMM to collect money to sustain and maintain the strategic growth and control of the two main business units of NewCo. There were two options included in the exit agreement between the shareholders: the listing of NewCo to be realized within a certain period of time or buy back by the minority shareholders. A15.3.3 Critical elements of the investment This deal was done because FMM was a leader in the domestic market with a wide range of diversifi ed services. Venture capitalists were attracted by the high potential growth of the domestic market, the highly skilled management team, the attractive price, and the likelihood of realizing an IPO considering the appeal of the facility management services sector to the fi nancial market. A15.3.4 Management phase activity The contribution of the venture capitalist was important because it allowed the company to fol- low and realize an intense growth strategy of expansion from the facility management industry to the global industrial services sector. FMM has been focused on the integration of new activi- ties as well as the acquisition of a business unit dedicated to healthcare services. A15.3.5 Exiting Early in 2008 shareholders planned to list the company, but due to the negative situation of the fi nancial market, they decided instead to seek out venture capital. They signed an agreement with a venture capitalist to sell 25% of their stake in the company. 15.6 External growth 232 CHAPTER 15 Financing growth Appendix 15.4 A business case: S & S A15.4.1 Target company The company was founded in the 1960s as a typical fi rm led by two families with equity par- ticipations equal to 60 and 40%, respectively. The core business of S & S is the production and distribution of passive security products such as locks for wooden and aluminium frames, padlocks, security locks, and master key systems. Within a few years, it became a leader in its domestic market. S & S expanded its business into the access and safety control systems industry providing both single products and global services. Their main distribution channels include wholesalers, dealers, ironmongers, retails chains, and industrial and banking groups. The revenues are divided between domestic and European markets and the rest of the world at 40, 50, and 10%, respectively. A15.4.2 Investment structure The deal, realized in 2004, consisted of an expansion capital transaction where the venture capitalist acquired a participation of 15% of €13 million and an S & S equity value of €84 mil- lion while the enterprise value was €106 million. The exit agreement between the shareholders and venture capitalists was to list the target company within a certain period of time or a buy back by the minority shareholders with a predefi ned method of price calculation. A15.4.3 Critical elements of the investment This company was targeted because of its strong and competitive market position. S & S was the leader in the domestic security market with huge potential value creation realizable by changing from passive security to safety and security integrated systems. This change created a higher possibility of growth and better profi ts. The venture capitalist was interested in exit- ing from the investment with an IPO. Another interest was the newly started external growth process, initiated by the acquisition of a European company, which was a source of potential manufacturing and commercial synergies. A15.4.4 Management phase activity The performance of S & S during 2004 and 2005 was lower than expected because of the down European and the domestic markets. Another issue faced by S & S was the inability of manage- ment to handle the increasing raw material costs during the turnaround phase. Support pro- vided by the venture capital fi rm was critical in redefi ning and implementing the new strategy from S & S. A15.4.5 Exiting Following the investment in S & S, the venture capitalist had to face emerging problems in the relationship between the two founder families. There were completely opposite points of view on the strategy and its implementation. One view targeted a larger expansion while the other 233 view wanted to keep the old strategic vision of focusing on the passive security industry. Due to these problems, the venture capitalist exited from the deal through a buy back of S & S because he did not agree with the spin-off operation decided on by the founder families. Appendix 15.5 A business case: RDC A15.5.1 Target company This manufacturer of vegetable conserves was founded during the second half of the 1800s. The control and property of RDC was acquired by different owners over the years. In 2003 the controlling group of RDC was declared in default so the temporary receivership divided RDC into two businesses. RDC was purchased by VC, an industrial company that manufactures vegetables, with the support of a venture capitalist, making RDC the leader in the domestic market of fruit juices and one of the most important companies in vegetable products and tomatoes. A15.5.2 Investment structure The deal, concluded at the end of 2004, was realized to support an expansion capital transac- tion. The venture capitalists involved in the investment subscribed 49% of the NewCo with an enterprise value of €113 million and €45 million as debt fi nancing. Even if the private equity fi rms subscribed a minority participation, the agreement between the shareholders was very effective. The exit strategy agreed upon was to list the target company within a certain period of time or a buy back by the minority shareholders with a predefi ned method of price calculation. A15.5.3 Critical elements of the investment Venture capitalists invested in this company because of its well-known brands and market leadership, despite decreasing market shares due to the default. Also attractive was the oppor- tunity to improve RDC through product innovation strategies, extension of the brands, and the possibility of realizing an IPO at the end of the investment. A15.5.4 Management phase activity During the holding period, RDC tried to reorganize the company through functional distribution and completed the strategic merger between RDC and VC. A15.5.5 Exiting During the management period, problems arose due to a confl ict of interests between the shareholders, so, early in 2006, the venture capitalists agreed with VC and placed a put call option on their RDC participation. Luckily, after a few months, they sold their shares. 15.6 External growth [...]... restructuring the production process and building a new plant At the same time they expanded their export business to new developing countries such as North Africa, the Middle East, and China, with an increase in demand that redoubled their price in a short period of time A16.1.5 Exiting The deal was terminated in 2005 when a Russian steel group acquired the entire stake of the venture capitalist and half... venture capital stake and took complete control of the company Appendix 16.3 A business case: RA A16.3.1 Target company RA was founded in the 1970s and operates in the racing accessories industry producing and distributing fireproof cloths, racing seats, helmets, and roll bars It is highly internationalized and services the main motorbike sport teams and drivers who take part in international championships... CHAPTER 15 Financing growth Appendix 15.6 A business case: MED A15.6.1 Target company MED was founded in the 1990s as a publishing company realizing an average yearly growth of 33% until 2004 Today, MED is involved in areas such as information technology, home entertainment, and video games It leads the market in home entertainment and information technology, while it is second in the video game industry... the private equity partner can easily directly monitor and support the firm in an advisory capacity Therefore, it is important to identify the real role of board directors in companies acquired by one or more private equity groups, since it seems that a successful deal concentrates the ownership of the company into the hands of a few shareholders Private equity investors are deeply involved in running... restructuring experience, so they have a strong incentive to maximize the value of the firm In private equity deals tough control is exercised by the general partner over the executive managers when defining and planning the implementation of the portfolio strategy In many cases the venture capitalist sits on the board of companies in which they have invested and their participation increases during significant... business case: FC A15.7.1 Target company The company was founded in the 1980s and manufactured clothes for the fashion industry Over time it built a retail chain in its domestic market In 2005, FC launched an expansion strategy to increase the international arm of its business by opening shops in prominent European cities such as Berlin, Barcelona, and Paris FC operates through two different brands:... A15.8.2 Investment structure During 2008, BALTD founded a NewCo to realize the acquisition of CANCO and its equity capital was subscribed by a pool of private equity investors and a group of managers from both BALTD and CANCO The enterprise value of BALTD was fixed at €120 million for an equity value of €55 million 236 CHAPTER 15 Financing growth A15.8.3 Critical elements of the investment Private equity. .. new magazines focused on the video game industry Agreement with an international publishing company for the production and distribution in the MED domestic market of a foreign information technology magazine Launch of DVD film series with the fulfillment of significant financial performances A15.6.5 Exiting Venture capitalists exited in 2007 by selling the owned participation to another private equity firm... customer service and access to multi-channel features such as SMS and the Internet The main services of MC are divided in several areas such as music, images, games, and infotainment (news, gossip, horoscopes) With their specific brands, MC targets both young and an older audiences A15.9.2 Investment structure The deal was closed during the fourth quarter of 2008 It included one private equity firm that... firm that purchased a minority share of 17% MC, investing €11 million for an equity value of 63 million corresponding to an enterprise value of €58 million The main goal shared between both founder shareholders and venture capitalists is the listing of the company within four years The agreement between the shareholders regarding governance and exit strategy allows the venture capitalist material control . and markets served by acquiring a higher market share and entry into new markets by using the marketing skills of the acquired company and increasing the client base. Entering in new businesses. investment is ongoing. 237 Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals Copyright © 20xx by Elsevier, Inc. All rights reserved.2010 Financing buyouts 16. advantages: 1. Support in building business — Experienced venture capitalists assist the target company in recruiting managers, developing relationships with cus- tomers, and fi xing business strategy.