Can you tell your PEs from your VCs? Part 4

 

 

 

 

 

 

In the first three parts of this series, I have covered:

  • The different types of Venture Capital and Private Equity firms
  • Their investment Criteria
  • How to approach them
  • What they are looking for, and
  • Six reasons why business plans are rejected

In this the fourth and final part of the series, I am going to discuss the Characteristics of the Financial Plan and Six Ways Investors make Money out of their Investee Companies.

Characteristics of the Financial Plan

As mentioned in my previous post, investors are seeking a three to five year plan and this should be done on a monthly basis.  Try to make sure that you have clear input, working and out put areas.  The statements will need to have a fully integrated Profit and Loss Account, Cash Flow and Balance Sheet.

Your assumptions areas should be clearly labeled, I try to use green cells as input areas.  The assumptions should be easy to manipulate and should focus on the key business drivers.  If you don’t know what these are to start with, don’t worry, this will soon become apparent as you move through the modelling process.  It is important that you can use this for testing different outlooks or “Scenarios”.  This will also help you to find out which drivers your business is most sensitive to and this should enable you to re-consider some of your strategic planning.

The investors will use the data to model their sources and uses and structuring assumptions.  This involves building in the financing structure and its costs in order to model their returns scenarios.  As each investor does this in a different way, I do not recommend attempting to do this work for them.  Don’t forget though that the business will need to be able to sustain any financing structure and meet any minimum ratios or covenants set by providers of finance, including banks.

How do Investors Create Value and Make Money?

This is not rocket science.  The investor has an in-price on the date of investment, the business generates value during the period of ownership and the investor gets a return of capital on sale.  The sum of these, the first being negative (and the interim period may also have some negative cash flows) and, hopefully, a positive end result.  Lets see how this might be achieved in a little more detail.

1. Valuation Multiple Arbitrage

In simple terms, the investor buys at a lower multiple of profits than it sells at.  The Earnings Before Interest, Tax, Depreciation and Amortisation is the profit line most investors focus on.  This is the line in the profit and loss account which is independent of the balance sheet structure (Interest, Depreciation and Amortisation) and independent of tax.  This is also known at EBITDA.

If the investor buys a company at 5x EBITDA and sells at 8x EBITDA, it will make a profit equal to 3x EBITDA.

The ability to do this depends not only on the attractiveness of the company but also market conditions.  Depending where in the business cycle the purchase and sale events take place, this can either work for or work against the investor.  As a result, investors are very cautious about opportunities where this is the cited method of creating value.

2. Making the Business More Profitable

If you cannot improve the multiple, improve the other variable, EBITDA.

How can this be achieved.  You can look at your financial model and work it out for your self.  Here are some examples.

  • Increase revenues by selling more
  • Increase revenues by putting up prices
  • Increase prices to increase gross margins
  • Reduce cost of sales to increase gross margins
  • Reduce fixed costs
  • Reduce variable costs
  • Reduce central costs

These are all actions within the control of the management and are therefore more attractive to investors.  This is a good reason why investors put so much store in the quality of the management team and its ability to deliver.

3. Cash Flow

This is a critical part of any deal and, if you are in any doubt, cash and profit are very different things.  If you are not sure why check out my blog post on this here.

One of the ways that investors reduce their in cost is to reduce the direct cost to themselves, the Equity Cheque, by raising some of the purchase price from a third party, normally a bank in the form of debt.  Historically, Private Equity houses have been able to raise 3x-4x EBITDA in debt from banks.  Today, if they can get it, the range is more likely to be 1x-2x.  This is certainly true for deals under £100m. For the much larger deals these ratios might be a little higher in todays market.

During their ownership of the business, they need the company to generate cash to pay the interest on this debt and to repay the capital.  In an ideal situation, over a three to five year period, the business will generate enough cash to pay all the debt back.  If this happens there is extra value left at the sale of the company which will accrue to the shareholders of the company.  How this is divided does depend on the financial structuring of the deal.  DO NOT ASSUME that it will be shared equally.

How do you improve cash flow?

  • Increase the profitability of the company
  • Improve the efficiency of the business’s working capital – again see my previous blog post here to understand how this works.  Essentially, you need to understand what is a source of cash and what is a use of cash.
  • Control capital and operational expenditure
  • Sell surplus business assets (property is a good example)
  • Dispose of loss making parts of the business, the earlier this is done in the process the better as it reduces a drain on cash flow.

4. Deal Structuring

One of the ways that investors make money is by structuring the terms of the deal in their favour.  Think about the shareholding structure as a pie and the % of share ownership as slices of the pie.  When the company is sold the proceeds are divided between the shareholders depending on their ownership percentage.  Right?  Yes but only if there is one class of shares.

Investors will typically introduce preference shares, different classes of shares with different rights, convertible debt, interest yield costs and redemption premia to name but a few.  This means that the ranking of the return of capital to the parties can be slanted in their favour and typically they will try to ensure that they get their original capital back ahead of the original shareholders

5. Management “Sweet Equity”

This is the carrot part of the exercise.  In a Management Buyout, the management team typically will not have much capital of their own or a significant stake in the business.  The Management Sweet Equity enables the management team to purchase a disprortionately large percentage of the equity, typically between 15% and 25% between the whole team.  This strongly incentivises the team to be successful and aligns the interest of the management team with that of the investor.  If the deal is very successful the Management team can make many multiples of their original investment.

6. Shareholder Agreements

One of the weapons that investor include in their armoury to help them to make money is the shareholder agreement.  This sets out the rules of the game and essentially puts the investor in control of many if not all of the key business decisions and vetos over a whole range of business decisions, regardless of the % level of their shareholding.  In fact, if they are minority investors this document is even more important.  In extremis, if the business is not doing well, the investor is able to remove the executive team and appoint their own and this includes any founders.  The agreement will also regulate the rights and value of the executive team and their shareholding if they are dismissed.

I hope you have found this series to be both helpful and informative.  Do check out my offer to Start Up Companies below.  If you have any questions send me an email or leave me a comment below.

What Next?

Take a look at my FREE video Tutorial “How to Turn Your Great Idea into a Business” which is all about Starting a Business and Raising Capital.

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