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Business Plan Chapter 8 part 3

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Chapters:  1  2  3  7  8  10  11 Oil & Gas  publications

Subordinated Debt (also called Mezzanine Financing)

This is an unsecured loan (i.e., it is not backed by collateral). Therefore, the claims of this lender are behind those of the banks or other asset-based lenders. Of course, this debt comes at a higher interest rate. In addition, warrants (the right to purchase stock in the future at a set price) for a minority position in the company are typically also part of the deal. The effective cost of interest and warrants for mezzanine financing will likely total over 20 percent annually. The cash interest payments will usually equal half to two-thirds of this total expected cost. Since the subordinated debt holder will want the ability to cash out of the transaction at a known time, the debt will need to be repaid at a specific term (say 5 years). At that time, the stock warrants will usually be "put" (i.e., a forced sale) back to the company based upon a valuation of the company at the point of buyback.

Equity Financing

This is simply selling stock. In the first round, so-called "angel" investors will often be involved. Angels are often individuals. As additional money is needed, private equity funds or venture capitalists may be interested. Because many of their deals turn out poorly, venture capitalists will be looking for returns in the range of 30 to 60 percent annually. Consequently, you will need documented plans that support big opportunities. In working with stock sales, your ownership percentage will be significantly diluted, and you will need to give up portions of the control of business decisions.

Although the stock being sold will not have a specific term, these investors will want to know how they will convert their stock back into cash. Without an "exit", private equity funds and other investors will not be interested in your company. This will require you to have a long-term plan that is credible.

 

 

Bolster your Negotiation Position

In the early 1990’s, some teasingly called venture capitalists "vulture capitalists". This is due to the significant ownership interest sought for seemingly small amounts of capital. This would translate into a lower overall valuation of the company. Similarities exist today. Too many entrepreneurs are not prepared for this valuation discussion and potentially give up equity that is not warranted. To avoid be lumped in with everyone else, you need to have documentation as to what your business and its intellectual property are worth.

To do this, obtain an independent appraisal of your business’s value. The appraisal’s cost will almost always be more than repaid by being able to negotiate a better deal.

Not obtaining an appraisal is a common shortcut, but one that is almost always a mistake. Without a thoughtful appraisal, the percentage of stock obtained for the investment is a random demand, usually more based on control desires than value being sold. In these situations, the investor ends up in the driver’s seat. Not having a solid business value also makes the owner appear relatively unsophisticated. After all, what kind of competence is communicated about someone who is selling a portion of his company without knowing its value?

In lieu of an appraisal, some attempt to determine value using a simple rule of thumb that is out-of date and/or does not consider the important and unique attributes of the business. Such rules are expressed using a formula such as "two times sales", "three times net assets", or "six times earnings". These rules of thumb often come from other transactions in which complex discussions and appraisals are summarized at the end of the completed transaction. A summary statistic of "x times a specific financial statistic" does not provide a broad review of cash flows, industry information, business risks, specific financing, and timing within capital and economic markets. All of these are needed to establish an appropriate value.

Part of this appraisal process is building a data arsenal that supports the valuation. When discussing the percentage of ownership to be given, the owner needs to educate the investor with specific and credible information. The data should include all comparable transactions and companies from the appraisal report, studies from industry organizations, published information about competitors, local studies regarding business conditions, and any other information that is helpful to assessing business risk, market opportunities and valuation results.

In addition to the specific ownership percentage, analyze what control is being given up in the deal being proposed by the investor. Investors are not shy about asking for control, and it can take several forms. For example, the existence of supermajority voting can paralyze a business if the investor will not agree with your ideas. An investor could thereby force the sale of the business simply by not agreeing to items that are needed. To avoid this, insist on a provision that provides that additional funding or approval will not be "unreasonably" withheld. In other circumstances, a change in control occurs when an optimistic performance benchmark contained in the agreements is missed. If not cautiously considered, a change in macro-economic conditions, vendor performance, or short-term challenges could cause you to loose control of your business.

All of these demands can be altered by solid research and business assessments. The greater the risk that an investor perceives, the greater the return and control that they will want. Competitor analysis, market studies, and other statistics regarding important items for your business will help funding sources properly assess their risks and will change their demands.

Admitting Weakness is a Strength

If all of this seems a bit daunting, you are right. If you do not feel a bit insecure about any of this, especially in the beginning, then chances are you do not appreciate the difficulties that you are facing. Get help in the areas where your plan is weak.

Our firm has expertise in finance, business appraisal, business plan preparation, operational/strategic planning and accounting. We supplement our in-house capabilities with university professors having expertise in specific areas and industries. We regularly help businesses develop, finance, and implement their business plans.

Chapters:  1  2  3  7  8  10  11 Oil & Gas  publications

 


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Revised: 16 Aug 2005 03:53:30 -0400 .
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