199 13.6.1 Key steps to the venture capital method The key steps to the venture capital method are Step 1: Terminal value calculation Step 2: Future value of the investment Step 3: Percentage of shares to subscribe Step 4: Amount of shares to issue Step 5: Value of newly issued shares Step 1: Terminal value calculation — The expected holding period and the calculation of the terminal value are addressed. The terminal value is usually calculated with comparables, typically P/E and DCF approaches. For example : If the expected holding period is 4 years and the expected net income at y Ϫ 4 is 6 million, a terminal value calculated through a P/E comparable of 5 would be 30 million. Step 2: Future value of the investment — Calculation of the future value of the investment taking into account the expected holding period and the expected IRR, which is defi ned from the constraints of the investor. For example : If the investment is 2 million, the holding period is 4 years, and the expected IRR is 55%, the future value is 11,54 million. Step 3: Percentage of shares to subscribe — Calculation of the shares the investor has to buy to acquire the expected IRR. The number of shares is found by dividing the future value of the investment by the terminal value of the fi rm. For example : If the future value of the investment is 11,54 million and the terminal value is 30 million, the percentage of shares for the investor is 38,46%. Step 4: Amount of shares to issue — Calculation of the number of new shares that the venture-backed company has to issue to ensure a particu- lar percentage of capital to the investor. This calculation consists of a simple proportion: % share new new old new shares old * % share % share ϭ ϩ ϭ Ϫ1 where new and old represent the number of new and old shares. For example : If the percentage of shares the investor must have is 38,46% and existing shares are 300.000, the number of new shares available to issue is 187.488. 13.6 Venture capital method 187 488 300 000 38 46 13846 . .,% ,% ϭ Ϫ * 200 CHAPTER 13 Techniques of equity value defi nition Step 5: Value newly issued shares — Calculation of the price of newly issued shares for the investor is executed dividing the amount of the investment by the number of new shares. For example : If the investment is 2 million and the number of new shares is 187.488, the price per new share is €10,67. The implied pre money valuation is 10,67 so the value of 300.000 shares equals €3,201 million and the post money value of all 487.488 shares equals €5,201 million. It is important to point out that venture capitalists presume there will be dilution of their participations. To mitigate the effect of this dilution, the reten- tion ratio is used to quantify the decreasing participation realized between the closing and exiting of the deal. In the previous example, if 20 to 30% more capi- tal is subscribed, then the participation of 38,46% will become 24,36% of the fi nal equity capital and the retention ratio equals 64%. Therefore, to ensure an equivalent participation to the fi rst investor, the actual percentage of the partici- pation will be 60%; that is the ratio between the percentage of 38,36% and the retention ratio. The formula of retention ratio is Retention ratio /( )/( )ϭϩ ϩαβ γ11 where: α is the percentage of equity capital subscribed by the investor at fi rst issuing; β is the percentage of equity capital subscribed at second moment; γ is the percentage of equity capital subscribed at third moment (see Figure 13.4 ). 5 Value of new issued shares 4 Number of new shares to issue 3 Percentage of shares 2 Future value of the investment 1 Terminal value calculation Investment/number of new shares (existing shares ∗ percentage)/(1 – percentage) Future value of the investment/terminal value Investment (1 ϩ expected IRR) ^(expected time) P/E or DCF approaches Formulas applied Steps FIGURE 13.4 Venture capital method steps. 20113.6 Venture capital method 2003 2004 2005 2006 2007 Sales 197,004.00 240,306.00 283,251.00 297,358.00 312,203.00 Operating costs 184,138.00 223,889.00 263,005.00 275,977.00 289,768.00 EBITDA 12,866.00 16,417.00 20,246.00 21,381.00 22,435.00 Depreciation Ϫ5,492.00 Ϫ7,289.00 Ϫ8,583.00 Ϫ8,538.00 Ϫ7,651.00 EBIT 7,374.00 9,128.00 11,663.00 12,843.00 14,784.00 Other income ϪϪϪϪϪ Interest expenses Ϫ1,428.00 Ϫ1,724.00 Ϫ1,474.00 Ϫ1,184.00 Ϫ817 EBT 5,946.00 7,404.00 10,189.00 11,659.00 13,967.00 Ta xe s Ϫ2,238.00 Ϫ2,763.00 Ϫ3,519.00 Ϫ3,891.00 Ϫ4,482.00 NET INCOME 3,708.00 4,641.00 6,670.00 7,768.00 9,485.00 FIGURE 13.5 Profi ts and losses statement (€/000). Appendix 13.1 A business case: MAP MAP S.p.A. is an Italian retail distributing company operating in the food sector. It has local branches in central and southern Italy with more than 650 shops with an average size of 650 m 2 . Growth is expected to be quite strong, and the real estate policy is not to buy shops but to rent them due to their strong negotiation of rental installments. In 2002, MAP needed a private equity investor to support the expansion strategy, but the existing shareholders did not want to lose control. No acquisition of competitors was planned in the short-medium run, and the general forecast of selling food was expected to be positive in the central and southern part of Italy. The forecasts (see Figure 13.5 ) were based on the following assumptions that came from the business plan realized with the supervision of the private equity investor. The unlevered approach is adopted to calculate cash fl ow for the fi rm. The main infor- mation came from the balance sheet regarding data on assets and liabilities. The company did not have surplus assets or minorities within the equity, and the net fi nancial position was 20 million coming from a cash position of 20 million (see Figure 13.6 ). The main comparables on the market came not only from Italy (where only the company Eat & Food can be considered a comparable, even if it is not listed) but from all over Europe. See Figure 13.7 for the data. Considering the capital structure of MAP, the book value of the debt was 30.000 and the book value of equity was 3.000. The risk free rate was 3% (calculated as 5-year 2003 Italian Government bonds) and the return on market investment was estimated at a level of 10% with an expected holding period of 5 years. 202 CHAPTER 13 Techniques of equity value defi nition 2003 2004 2005 2006 2007 (ϩ) EBIT (Ϫ) Income taxes (ϩ) Depreciation (Ϫ) Increase net working capital (Ϫ) Capex 14,784 Ϫ4,482 7,651 Ϫ6,677 0 11,276 12,843 Ϫ3,891 8,538 Ϫ6,021 0 11,469 11,663 Ϫ3,519 8,583 Ϫ3,121 Ϫ6,800 6,806 9,128 Ϫ2,763 7,289 5,870 Ϫ16,650 2,874 7,374 Ϫ2,238 5,492 Ϫ14,779 Ϫ15,785 Ϫ19,936CASH FLOW FIGURE 13.6 Cash fl ow unlevered statements (€/000). Beta EV/sales EV/EBITDA D/E Manger & Boire 0.92 1.20 16.00 6.70 The Kroeger Company 0.88 1 18 7.2 Safeway, Inc 0.72 0.9 14 4.5 Tesco 0.62 1.3 20 3.4 Mangiare & Bere not listed 1.4 17 8.1 FIGURE 13.7 Comparables. A13.1.1 Sample valuation using comparables It was decided not to use the data from the comparables because there were too many differ- ences between these business and MAP such as the average size of the shops, the geographi- cal area covered, and the status of company (public or private). For this reason, the average value of the ratios EV/S and EV/EBITDA were calculated: Based on the averaged values, two values were identifi ed, as shown in Figure 13.8 . The German company Essen & Trinken was used even though it was not an Italian company, because it has a market very similar to MAP in terms of population and average salary, but the average size of its shops is smaller, only 350 m 2 and it is quoted on the stock market. Assuming that Essen & Trinken is the most comparable competitor to MAP, its valuation is cal- culated by applying the EV/EBITDA equal to 18, thus obtaining 231.588. After these calculations it was possible to defi ne an enterprise value for MAP of 218.722 to 231.588, but considering the MAP’s private status, it would be appropriate to apply a discount of 15 to 20% leading to a new value of 174.978 to 185.270. 20313.6 Venture capital method EV/sales EV/EBITDA Average MAP Implied Value €/000 1.16 € 228,525 Manger & Boire (FR) 1.2 16 Essen & Trinken (DH) 118 Eat & Drink (UK) 0.9 14 Food & Drink (USA) 1.3 20 Mangiare & Bere (ITA) 1.4 17 17 € 218,722 FIGURE 13.8 Average of comparables and MAP’s implied value (€/000). A13.1.2 Sample valuation using the net present value method The key point of this method is identifying the WACC by calculating the cost of debt. Based on this, the book value of the debt was 30.000 and the interest forecasted for 2003 was 1.428 and the cost of the debt equaled 4,76%, which was obtained by using the ratio between the two values. The second step is to identify the cost of capital necessary to fi nd the correct β . Because MAP was a private company, the only way to consider the average of the β of the comparables, excluding the effect of the capital structure and then re-levering the β according to MAP’s cap- ital structure, was to follow the formula from Section 13.3.4. The average β of the comparables equaled 0,785, the tax rate was 33%, and the average D/E ratio of the comparables equaled 5,98, so the β unlevered equaled 0,1568. The MAP’s β levered was calculated applying the relevant formula as per Section 13.3.4. The D/E ratio of MAP equaled 10 and the tax rate was 33%, so a re-levered β equaled 1,207. Using this β , the desired risk premium equaled 10% and the free risk rate was 3%, so the MAP’s cost of equity capital was 11,45%. The next step was to identify the weight of the debt and equity of MAP, which were 91 and 9%, respectively. Then the averaged value of the cost of debt and equity capital was calculated obtaining a WACC equal to 3.94%. Using the cash fl ow shown in Figure 13.6 we obtain: Present value of the cash fl ows for the years 2003 to 2007 equal to 8.662,18. Terminal value discounted to year 2002 equals 235.909,42. The NPV of MAP was calculated adding the terminal value and the present value of the cash fl ow. This result was deducted by the net fi nancial position, 20.000, so the NPV equaled 224.571,60. In this sample, there were no surplus assets or minorities. 204 CHAPTER 13 Techniques of equity value defi nition Appendix 13.2 Business case Rainbow: Sample valuation using the venture capital method Rainbow is a company active in the biotechnology industry and the two entrepreneurs, who are also the two founder engineers of the company, have developed a new product and regis- tered the patent. They have already reached an agreement with a big European partner who is a leader in pharmaceutical product distribution for a future launch of their innovative product. They asked Iris Partners, a private equity investor specializing in start-up fi nancing, to fi nance their initiative, focused on implementing the plant needed to start the new busi- ness, with an investment of 4,5 million. Iris ’ strategy for this type of investment requires an IRR of 45% to be realized within 5 years, so the future value of the investment equals 28.843.803,28 as per the formula included in Section 13.6. Based on the business plan redacted by the entrepreneurs, the terminal value of the com- pany was 42 million, calculated by the formula in Section 13.6 using a terminal year net income of 3,5 million and a comparable P/E of 12. Iris Partners considered the correct percentage of new share to be issued and subscribed 68,68% calculated with a total of 100.000 old shares; the total new shares to be issued is 219.241,20 with a price of 20,53. The valuation of Rainbow before the investment was 2.052.534, after the investment it was valued at 6.552.533,94. The difference between these two values is equal to the invest- ment of 4,5 million realized by Iris Partners. 205 Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals Copyright © 20xx by Elsevier, Inc. All rights reserved.2010 Financing seed and start up 14 14.1 GENERAL OVERVIEW OF EARLY STAGE FINANCING Each entrepreneurial project is developed through several phases according to the life cycle time of a company. It is easy to identify the development phase by the problems that occur at different points in the fi rm’s structure. During this phase the venture capitalist is considered more than a simple supplier of risk capital and he ends up as a fi nancial intermediary able to support and improve the growth of venture-backed companies. How and why the venture capitalist decides to invest in a business idea that has to be defi ned and planned before the company even exists are reviewed in this chapter. To understand the investment activity in risk capital, it is necessary to ana- lyze the key management process realized by the investor. This analysis focuses on critical topics related to the relationship between the entrepreneur and the venture capitalist and all the building steps necessary to organize the complex structure owned by the venture capitalist initiative. The classical approach to the venture capitalist investment, realized in the emerging entrepreneurial initia- tive, leads to the study of fi nancing and managerial resources and their impor- tance. The resources are destined to be used for highly innovative projects with good potential. These are matched with minority participation to reach capital gains because of the revaluation of the stakes and the opportunity to differenti- ate the risk. It is therefore important to emphasize that venture capitalists Operate with a pre-established and limited period of time, usually between 3 and 5 years CHAPTER 206 CHAPTER 14 Financing seed and start up Acquire only minority participation because of the entrepreneurial risk and diffi culty selling the control participation Point out, from the fi rst time with the target company, the importance of the return on the investment; his investment is in part remunerated during the holding period, by dividends and advisory fees, paid by the target company 14.1.1 Seed fi nancing Figure 14.1 identifi es the different stages during the life cycle of a company. This chapter focuses on the fi rst phase — early stage fi nancing. It is possible to further subdivide this phase into two parts, risk and return profi le. Each part has specifi c objectives. Seed fi nancing is defi ned as a participation in favor of using a special purpose vehicle (SPV) specifi cally meant for developing a research project. It is impor- tant to underline the difference between seed and start-up fi nancing. In the start-up fi nancing phase there is no company to fi nance, but there is a person or team of researchers who want to invest in and develop a project that hopefully will produce a successful business idea. Industry sectors typically targeted for seed fi nancing include information technology, pharmaceutical, chemical, telecommunication, and biomedical. Time Revenues Early stage financing Vulture and distressed financing Expansion financing FIGURE 14.1 Life cycle of a company. 207 Regarding the risk profi le, two things must be considered. First, entrepreneurs in need of seed fi nancing have no existing fi rm, and are usually a team of researchers ready to join a capital investor to obtain funds necessary to found a company that will lead and develop their business idea. Secondly, the venture capitalist has to consider the management and its risk profi le related to a good performance of the fi nanced project. Risks that affect investors include: 1. Sudden death — In the beginning the project is owned just by the researchers. The fi rst thing they do is share their valuable know-how with the founders. Usually the fi rst promoter of the business idea obtains the copyright. 2. Support structure for the researchers — To facilitate research, the private equity investor has to provide an adequate infrastructure: Incubator — A group of instruments and infrastructures necessary to ensure the correct development of the project. Joint venture between several centers of research — The return will be shared if the project becomes a successful business (bilateral agreement). The incubator structure is very expensive when compared with the bilateral agreement. It does not allow the private equity investor to invest in different industries, but if the project is successful the investor does not have to share his earnings. Bilateral agreements permit the investor to operate in different indus- tries at the same time, but they impose the division of the investment return if the business idea is profi table. Considering the industries involved, seed fi nanc- ing is similar to charity. Most researchers can collect the money they need with a fundraising campaign. As mentioned in Chapter 9, during the screening of potential projects to be fi nanced, the private equity investor applies the famous golden rule: start with one thousand projects valuated, go through one hundred projects fi nanced, and just ten projects will be successful. There are two tools used to manage investment return: diversify because of the large amount of resources divided between different business initiatives and mitigate the potential risk on the capital invested by having sub-products guaran- teed by the project. There can be potential ethical problems with the second tool. 14.1.2 Start-up fi nancing This type of participation fi nances an already existing company that needs pri- vate equity resources to start the business. The risk is based on launching a com- pany built on a well-founded business idea and not on the gamble of discovering a new business idea. 14.1 General overview of early stage fi nancing 208 CHAPTER 14 Financing seed and start up At this point in the business, risk depends on two variables: the total amount of the net fi nancial requirement and the time necessary to reach the breakeven point of the activity fi nanced. The risk is not strongly connected with the entre- preneur or the validity of his business idea, which are preconditions for the participation. What is really important is the growth of the industry in terms of capital intensity required and the forecasted trend of the turnover. The high level of risk is due to the investment realized at the time (t 0 ) when it is uncertain if the business will reach the breakeven point. The performance profi le of a start-up initiative, in terms of IRR, is connected with the ability and capacity to re-sell the participation on the fi nancial market. The track record and credibility of the private equity investor are key factors in the success of the exit strategy when obtaining the desired return from the investment realized. The main investor’s goal (a good and successful exit from the investment) can be facilitated by drawing up agreements with other private equity funds regarding their availability and commitment to buy the participation after a predefi ned period of time. Another solution is to sign a buy back agreement with the entrepreneur or other shareholders who agree to repurchase the venture cap- italist’s participation in the company after a predefi ned period of time. 14.2 OPERATION PHASES DURING EARLY STAGE FINANCING Different stages of a company’s development need different types of capital investment. From the origination to the implementation up to the exit strategy, each phase needs different capital and know-how. During the start-up phase, the venture capitalist has an intense and complex interaction with the entrepre- neur to verify the necessary fi nancial and managerial support. During the seed fi nancing phase the technical validity of the product or service is still unproven, so the venture capitalist offers limited fi nancial resources to support the devel- opment of the business idea and the preparation of the commercial feasibility plan. Consequently, there is huge risk faced by the investor. Start -up fi nancing provides the funds needed to start production with- out commercial validity of the product or service offered. During this stage, the entrepreneur risk is huge, but there is also risk connected to the fi nancial resources provided. This is usually more important than the risks invested dur- ing the seed phase. First stage fi nancing is linked to the improvement of production capacity after it is completed but the commercial validity of the business idea is still not totally verifi ed. This requires a large amount of fi nancial resources, but is less risky and managerial support is still limited. [...]... private equity operator After three years, an increase in the risk capital was realized with the involvement of two new private equity firms, and in 2005 two other investors financed the new issued risk capital A14.4.3 Exiting Private equity investors exited in 2006 with an IPO in the Zurich based public equity market specializing in biotechnological companies 14.6 Private investor motivation and criteria... success and the business idea represented a big opportunity to create an innovative fluffs treatment A14.8.4 Exiting The investment is ongoing, but in 2008 an industrial partner, operating in the pollution control industry, was involved in the risk capital of FLUFF This page intentionally left blank CHAPTER Financing growth 15 15.1 GENERAL OVERVIEW OF FINANCING GROWTH The investment activity of venture capitalists... the minimum and maximum investment entrance The minimum investment includes fixed costs during the screening of all business projects such as due diligence and monitoring and managerial 14.5 Supporting innovation development 211 advisory costs The maximum investment considers the physical financial funds owned by the venture capitalist and the need to maintain an equilibrium between the portfolio of investments... Project financing was realized in 2006 with €11 million due to the collaboration of three private equity firms INBIOT, before the 2006 investment, had been the target of private equity investments valuing €100 million A14.2.3 Critical elements of the investment Private equity investors saw high potential for the business idea and the IPO opportunity as an exit strategy A14.2.4 Exiting Private equity investors... invests risk capital wants to be reimbursed, but he wants first to share the eventual success of the business The bank is solely interested in reimbursement Two types of organization structures are used in venture capital operations during the seed or start-up initiative: Business Angels and corporate venture capitalists A Business Angel is a private and informal investor who decides to bring risk capital. .. the development of the business idea, a more effective reporting system, improving the planning and control process, and hiring highly skilled managers 14.6 Private investor motivation and criteria 215 A14.1.5 Exiting After two years the private equity investor sold its minority participation of 41% to another venture capitalist who specialized in supporting companies during the next stages of their... industrial groups The private and venture capital system is a financial tool with potential to accomplish the competitiveness, innovation, and growth objectives implemented 1 The investment is ongoing 210 CHAPTER 14 Financing seed and start up by the Lisbon protocol The venture capitalist is motivated by the potential quality and long-term growth of industrial leverages operating in innovative industries as... Exiting The private equity investor exited in 2007 with an IPO Appendix 14.7 A business case: SPINORG A14.7.1 Target company SPINORG, founded in 2003, was created through a spin-off realized by scientific researchers coming from the domestic national center of research The company operates in the spin electronic industry researching and developing innovative materials It is financed by scientists and. .. services and by selling its innovative machines A14.7.2 Investment structure The investment was realized at the start-up phase A14.7.3 Exiting The private equity investor exited in 2004 through a buy back Appendix 14.8 A business case: FLUFF A14.8.1 Target company FLUFF, founded in 2006, operates in the innovative and high-tech industry that processes, recovers, and disposes residual produced during motor... elements of the investment Private equity invested in COMPEURO because its business idea had high potential and an IPO opportunity as an exit strategy 14.3.4 Exiting The private equity investor exited from the investment in 2005 with an IPO Appendix 14.4 A business case: NORWEN A14.4.1 Target company The company, founded in 1999, researches and develops medicines and was spun off by an international . EBIT (Ϫ) Income taxes (ϩ) Depreciation (Ϫ) Increase net working capital (Ϫ) Capex 14, 784 Ϫ4, 482 7,651 Ϫ6,677 0 11,276 12 ,84 3 Ϫ3 ,89 1 8, 5 38 Ϫ6,021 0 11,469 11,663 Ϫ3,519 8, 583 Ϫ3,121 Ϫ6 ,80 0 6 ,80 6 9,1 28 Ϫ2,763 7, 289 5 ,87 0 Ϫ16,650 2 ,87 4 7,374 Ϫ2,2 38 5,492 Ϫ14,779 Ϫ15, 785 Ϫ19,936CASH. shares the investor must have is 38, 46% and existing shares are 300.000, the number of new shares available to issue is 187 . 488 . 13.6 Venture capital method 187 488 300 000 38 46 1 384 6 . .,% ,% ϭ Ϫ * . structures are used in venture capital operations dur- ing the seed or start-up initiative: Business Angels and corporate venture capital- ists. A Business Angel is a private and informal investor who