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- By issuing
new shares, earlier investors may
face dilution if they do not participate
in the latest capital raising.
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- Staged capital
raisings allow the founders and management
to retain more of the company value.
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- Staged capital
raisings provide earlier investors
with the option to participate in
the follow on funding.
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- Discount
rates reflect the risk profile for
the stage of the investment.
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- At the time
of their investment, investors may
need a higher shareholding to offset
the dilutionary impact of future capital
raisings.
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By spreading your capital raisings
over several rounds, rather than
one single upfront raising, it
preserves your ownership value.
The timing of capital raisings
will generally correspond with
the various stages of the company’s
development.
The issue of shares to external
investors to fund these stages
of development will help to create,
build and retain value in your
company.
Shares will also need to be issued
to other parties: to lock in and
motivate key employees, to shareholders
of potential acquisition targets,
and to any key specialist service
providers.
With these new share issues, the
earlier share investors may face
dilution of their interests if
they do not participate in the
future rounds.
Several factors need to be considered:
the future value of the company,
the number of new shares to be
issued, and the estimated ownership
percentage each shareholder will
eventually retain.
Valuing
you Business
The valuation of any business
generally reflects two components:
the value attributed to earnings
generated from current activities,
and the value attributed to earnings
from future activities.
Earnings can be projected for
the next five years, but beyond
that, some future value or “terminal
value” needs to be determined
for the business. See the articles
Preparing Financial Projections
and Valuing your Business for
further information.
The terminal value can be determined
by applying a price/earnings ratio
to the net earnings of the company.
If a price/earnings ratio of 10
is used, along with a net profit
figure of $5 million (expected
in 5 years), the terminal value
is $50 million i.e. 10 times $5
million. This number would then
be discounted back to today’s
dollars.
Ownership
Percentage
Once the year 5 valuation has
been determined, the ownership
split between owners and management,
and the investors needs to be
determined.
It is not unusual for the founders
and management to end up with
between 10% and 30% of the company
at some future point in time after
starting out initially with 100%.
This may seem a broad range but
it depends on the capital requirements,
the timing of the capital raisings
and the value that the founders
and management bring to the company.
The value of the intellectual
capital will depend on the uniqueness
of the underlying technology or
products.
If we say the split in 5 years
time is 20% founders and management
and 80% to the investors, we can
work out the value of the investor’s
contribution in today’s
terms.
For example, if the following
assumptions are made: 5 year investment
period, a 40% discount rate and
a terminal value of $50 million,
the value of the investors share
is $7.4 million.
This is determined as follows:
80% * $50 million
-------------------------
(1.4)^5
= $7.4 million
The above calculation assumes
no further capital raisings, and
that the assumptions (especially
earnings) prove to be correct.
If more capital is required, this
80% ownership figure may be diluted.
Staged capital raisings can be
dilutionary, but they can also
provide the investors with an
option to provide follow on funding.
Investors do not need to commit
all their capital upfront, and
may value the option of abandoning
future investment, if things don’t
go according to plan.
Dilution
Impact
If three rounds of capital are
raised, instead of one, the impact
of dilution and the value of the
founders and management shares
can be considered.
If capital requirements are as
follows: $4 million upfront, $2.4
million in year 2, and $1 million
in year 3. Some assumptions also
need to be made in respect of
discount rates. Assume 40%, 30%
and 25% respectively. The terminal
value is still assumed to be $50
million in year 5.
Different discount rates have
been used to reflect the change
in the risk profile of the company
for its stage of development.
For example, a start up company
is perceived to be riskier than
a late expansion company. A higher
discount rate will be applied
to the start up company.
VC Managers will generally apply
a range of discount rates, from
40% through to 80% depending on
the stage of the company. Although
these rates might seem high, they
take into account the uncertainty
of future earnings streams and
the likelihood of poor investment
performance.
Based on these numbers and assumptions,
the change in percentage share
ownership can be calculated:
First
Round:
(1.4)^5 * $4.0 million
----------------------------
$50 million
= 43%
Second
Round:
(1.3)^4 * $2.4 million
----------------------------
$50 million
= 14%
Third Round:
(1.25)^3 * $1.0 million
------------------------------
$50 million
= 4%
The percentage shareholding issued,
based on three capital raisings,
adds to 61%.
Raising all the capital upfront
requires an 80% allocation to
investors, whereas raising capital
in stages only requires a 61%
allocation. The difference in
dollar terms, at $9.5 million
(19% of $50 million) is very significant.
It represents the value retained
by the founders and management.
Apart from raising capital on
a staged basis, it is also just
as important to raise the capital
at increasing share prices.
In this example, the various investors
will hold 43%,14% and 4% of the
final shareholding at year 5,
depending on the round that they
participated in.
So what does this mean to the
investor at the time of the investment?
Because the second and third round
investors hold 18%, the allocation
required by the first round investor
will need to be higher than the
43% if dilution is to be avoided.
The first round investors will
require a 52% shareholding at
the time of their investment to
avoid any dilution, while the
second round investors will require
a 15% ownership level to avoid
dilution by the third round investors.
With these ownership levels, the
number of shares and the share
prices can be calculated for each
of the rounds.
Some of the assumptions may vary,
in terms of earnings projections,
earnings multiples and the size
and timing of capital raisings.
Each of these variations will
drive different terminal values
and different ownership levels.
It is important to perform scenario
analysis with the different assumptions
and determine what the impact
will be before you embark on your
capital raising.
The above example shows in fairly
broad terms the benefit of raising
capital in stages and the dilutionary
impact for investors.
By raising capital in stages,
more value can be retained by
the founders and management.
It also allows the company to benefit
from declining discount rates
as the risk profile of the company
improves with more sustainable
earnings.
Peter T Gow is the
Managing Director of Creative
Capital Pty Limited. He founded
Creative Capital to accelerate
the learning skills of entrepreneurial
CEO's and develop their expertise
in capital management, business
and strategic planning, cash flow
management and market research
and analysis. Peter has over 12
years of experience in working
with growth companies and has
been involved in the completion
of over 30 financings in the software,
manufacturing and medical areas.
His expertise covers company evaluation,
strategy and market analysis,
capital raising, transaction structuring,
documentation and completion.
Peter has also set up several
venture capital funds for a major
financial institution and appraised
a range of venture capital managers.
Creative Capital Pty Limited
Peter T Gow
61 412 235 455
petergow@creativecapital.com.au
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