Private Equity and Venture Capital in Europe_9 potx

Valuation of the entrepreneur profi le and/or the management team — This phase follows the identifi cation of the target company and consists of a complete analysis of the entrepreneur and

175 Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals

The types of fi nancing available to venture capitalists are completely ent; for example, an entry strategy with a majority participation and a position

differ-of control (typical in a buyout) and minority participation that supports the tation of a fi rm for a short time

It is possible to identify standard phases common to all investments

Identifi cation of the target company — This is executed differently in US,

UK, and European markets In the US and the UK investment ties offered to venture capitalists are already defi ned and structured by the entrepreneur In Europe researching potential target companies is up to the institutional investor and done by direct marketing operations; there-fore, European venture capitalists need a developed and effi cient network

opportuni-or relationship to fi nd potential and interesting deals (deal fl ow)

Valuation of the entrepreneur profi le and/or the management team — This phase follows the identifi cation of the target company and consists of a complete analysis of the entrepreneur and/or the management team’s pro-

fi le, especially when they invest risk capital together with the private equity operator It is important to check the reliability, knowledge, expertise,

and reputation between the management team and the validity or ence of the business idea

Deep valuation of the target company and the operation structure — This phase is critical because it focuses on researching the equilibrium between the entrepreneur’s needs, the investor’s goals, and the real necessity of the target company Analysis verifi es the potential and actual market of the com-pany, its technology potential, possible increase of company value, and the likely exiting strategy If the results are satisfactory then the venture capital-ist proceeds with the deal structuring and defi ning the company’s value Negotiation and setting of price — This is the direct outcome of the previous phases It is focused on price setting as well as timing and payment execution Monitoring and exiting — After closing the deal the investor monitors the venture-backed company’s performance to identify any problems inside the target company On exit the venture capitalist realizes the economic return from the deal

12.2 FIVE PHASES OF COMPANY VALUATION

Company valuation calculates the fair value of the target company as well as supports value creation among investors so they can reach their economic goals

in terms of expected IRR The process of company valuation is realized through these phases

Business plan analysis

Financial needs assessment

Enterprise value analysis

Price setting

Exiting

It is important to accomplish the previously listed valuation steps in the right sequence Before this can be completed, it is necessary to know and use spe-cifi c techniques and methods to approach the items in the correct order First, the venture capitalist must have focused goals that support the whole valuation process to execute appropriate investing or exiting decisions However, the pro-cess has to be coordinated within the constraints of the investment vehicle such

as global portfolio IRR, residual maturity, capital requirements, and expected IRR on the specifi c investment and the entire portfolio

Before analyzing each valuation phase, it is necessary to clarify critical aspects and key issues This chapter identifi es and discusses the content of each phase, the equity investor’s role, and the goals and content of each stage

12.2.1 Business plan analysis

To start the valuation process the business plan must be created and analyzed This document explains and illustrates the strategic intention of the management team, competitive strategies, and concrete actions necessary to realize company objectives, key value drivers, and fi nancial outcomes It shows the management team’s vision and allows investors to evaluate and understand the potential returns of the business The business plan has a large target audience including not only the investors and the management team, but other fi nancial supporters such as banks or leasing companies and members of the Board of Directors

A typical business plan that supports risky capital investment contains the status of past strategies (history of the fi rm) in terms of performance and analysis

of strengths or weaknesses and opportunities or threats Based on the analysis, the business plan describes the future of the company regarding the develop-ment of strategic goals, an action plan needed to realize the value proposition, assumptions about fi nancial planning, and fi nancial forecasts (see Figure 12.1 )

A business plan contains these elements

■ Global view on the company — Information about the past, actual, and future organizational structure, relevant industries including the analysis of the com-petitive factors, and all the critical elements for an in-depth knowledge of the company such as legal entity structure, revenues, mission, and dimension

ACTION PLAN ASSUMPTIONS

FINANCIAL FORECAST

Yesterday

Tomorrow Today

FIGURE 12.1

Business plan structure

■ Technological characteristics of the product and or services of the fi rms — This section describes the product and/or the service of the company in the easiest possible way emphasizing the innovative content of the offer

■ Operation plans and fi nancial data — Contains detailed information ing the operative actions executed in terms of production and marketing plans and timing data and costs This part of the business plan shows a series of simulations about how the product and/or service would be real-ized considering different levels of bulk production

■ Financial structure — Based on the previous analysis and defi ned needs, this phase covers two main areas: fi nancial requirements and the desired equity debt ratio Financial requirements, satisfi ed by equity and debt, include differ-ent types of investments such as working capital investments, capital expen-ditures, immaterial expenditures, merger and acquisitions investments, and repayment of debts raised in the past Equity contribution does not create any charged interest guaranteeing the company in case of default, and the inves-tor is directly interested in the performance of the fi rm This structure limits the entrepreneur’s decision power as well as the profi t he must split with the new shareholders Raising debt avoids the entrance of new shareholders, but interest has to be paid regardless of positive economic results This form of

fi nancing requires collateral issuings, which are not obviously apparent to the entrepreneurs The key aspect of debt is the tax benefi t created by a signifi -cant contribution to the global value generated by the business idea

The business plan is usually prepared by the company with the help of a sultant and is the proposal sent to investors It is common for the private equity investor to take part in the business planning process, even if it is risky and time-consuming It usually happens with incubation strategies and previous venture-backed companies Private equity investor assistance comes from the network

con-of relationships in which the investor is involved

Different stages of investment, from the seed to vulture fi nancing, have cifi c capital requirements and assumed levels of risk This is refl ected in the busi-ness plan

Seed fi nancing — Three key issues: assessment of the potential entrepreneur’s curriculum vitae, creative understanding of the feasibility of the business idea, and identifi cation of the product’s potential market

Start-up fi nancing — Verifying both the market potential of the business idea,

in terms of potential demand trend and expected level of price, and plan

of investments is necessary

Expansion fi nancing — The expansion trend of the demand and the ability of the required investment must be checked

Replacement fi nancing — Key issues include the feasibility of the acquisition and restructuring the deal

Vulture fi nancing — Focuses on verifying the new potential market with an accurate analysis of costs and the investment plan

The validity of the business plan, decided by the private equity investor, depends on the fi nancial sustainability of the industrial project Sustainability is established based on the quality and quantity of the fi nancial resources, coher-ence between the realized strategies, strategic intention, real conditions of the

fi rm and its economic and fi nancial hypothesis, and its reliability The last tion is satisfi ed when the industrial plan is drawn based on a realistic and reason-able hypothesis and expected and acceptable results When the business plan includes a comparison with the past performance, it also includes further analy-sis related to forecasting possible scenarios and statements consistent with the competitive dynamics of the relevant industry

From the business plan the investor should trust the management about the business, the way capital will be used, the motivation of the management team, and the risk sharing

12.2.2 Financial needs assessment

If the analysis of the business plan is favorable, the investor moves to the second step of the company valuation process: fi nancial needs assessment This step cal-culates the amount of money required to sustain company growth

The fi nancial assessment adds forecasting statements to the business plan, and its goal is to defi ne external fi nancial requirements and verify their use by the company

This step further identifi es the size of the potential demand for investment, percentage of the potential equity investment, and potential new debt to be raised in a medium term run The fi nancial needs assessment is typically exe-cuted in house by the private equity investor, even if interaction with the com-pany is necessary to discuss and/or to revise the business plan

For an accurate fi nancial assessment it is necessary to answer a series of key questions to help decide whether or not it is convenient to launch an invest-ment First, the capital investor must understand the size of the fi nancial need and then have a clear idea of how much can be fi nanced from the investor, the correct mix of debt and equity and, at the end, if it is possible and or necessary

to recruit a new equity and/or debt investor

It is impossible to predict a fi nancial solution It depends on the deal’s level

of risk, risk profi le of the project, and trust in the entrepreneur skills

During the fi nancial needs assessment there are key issues to be addressed Seed fi nancing — Financial requirement consists of sustaining the investment

to study, develop, and test the business idea or the project It is very hard

to identify the correct mix of debt and equity The resources needed are not usually considerable, but it is necessary to have a large amount of sup-port for a high-tech initiative

Start-up fi nancing — Financial needs evaluation is the key point of the deal It

is critical to verify how much of the deal is fi nanced through equity tal The resources required are designed to defi ne and develop an already launched project The outcome of start-up fi nancing depends on the qual-ity of the previous investment (seed fi nancing) The investment require-ment is not urgent because it is needed for the enlargement of existing corporate and business competences

First stage fi nancing — Represents the moment of launch for the initiative and the consolidation of previous research This stage needs considerable

fi nancial support, because funds are necessary to hire suitable human resources and develop know-how The level of risk is quite high, but if the business initiative is successful, remuneration is considerable

Expansion fi nancing — Financial resources support corporate growth The business idea and the combination of product and market have already been tested, consequently, fi nancial resources support commercial and marketing activities Funds will probably be absorbed by the working capi-tal because warehouse goods increase and payment terms are postponed

to satisfy customer demand

Bridge fi nancing — The position acquired by the company is steady and forced by the introduction of new operative structures, the launch of new products or services, or an international expansion strategy The funds required are tremendous, but risk is limited because the company has the capacity to forecast the business trend

Replacement — Controlling how fi nances are used during the development

of corporate fi nance deals is a key issue Economic resources are vided to re-launch the company through restructuring and development operations Since the re-launch is a new activity for the fi rm, an enormous amount of money and specifi c competences are necessary

Vulture fi nancing — Similar to start-up fi nancing, the fi nancial needs tion is key in the decision to turnaround a business This type of fi nancing includes the re-launch and renewal of a mature company, and the available

evalua-resources are used to maintain market position and sustain the ment process, which can be realized with either existing or non-existing technology (diversifi cation strategy)

12.2.3 Enterprise value analysis

During the screening phase, the investor decides if the fi nancial need, as defi ned and evaluated, is sustainable In doing so he moves to the third step of this process — analysis of the company’s value This phase is based on the fore-casting statements included in the business plan The goal is to understand and quantify the real value of the company and the business plan to defi ne the value

of the investment

The enterprise value analysis identifi es the amount of money to be spent, the percentage of shares to buy, and the fi nancial impact on the company The pri-vate equity investor executes the enterprise value analysis in house and listens

to his advisors and technical committee The valuation of a private company, especially when it is in the early stages of the life cycle, is diffi cult and subjec-tive because early stage companies usually forecast a period of negative cash

fl ow with uncertain future economic returns

Enterprise value analysis fi nds a “ right value ” and an “ adjusted value ” of a company after comparing general trends in valuation within companies operat-ing in the same business Usually, the output of the analysis consists of values attributed to the equity of the company The analysis further focuses on differ-ent valuations for different stages of investment

Seed fi nancing — Equity valuation is impossible and can only be developed if the business plan is built on a realistic business idea

Start-up fi nancing — Valuation is based on forecasting, but there is a high risk

of uncertainty regarding the future sales trends and the terminal value Comparison with similar deals is useful here

Expansion fi nancing — Valuation analysis faces the same issues as start-up

fi nancing At this point comparison with similar deals can be very useful Evaluation is usually easier here than during start up because the com-pany is considered successful and there are similar fi rms with which to compare

Replacement fi nancing — Equity valuation is connected to the profi le of the deal and related to the replacement structure Typical deals are LBOs

or buy-ins and family and management deals where the ties involved are critical and affect the defi nition of the company value (inheritance)

Vulture fi nancing — Typical target companies are mature and equity valuation

is based on forecasting, but there is a high risk of uncertainty regarding sales trends The terminal value of the deal and the amount and structure

of costs carried are hardly quantifi able It is also diffi cult to support the equity valuation through comparison with similar companies

In later chapters the methods used for company evaluation will be analyzed more deeply Next are highlights of the most widespread methods

1 Comparables — Provide a quick and easy way to obtain a rough tion for a fi rm This method is used when a fi rm with similar values exists Elements compared include risk, growth rate, capital structure, and the size and timing of cash fl ow This method is quick, simple to understand, based

valua-on the market, and commvalua-on in the industry There are many potential lems when this method is used for private companies, such as the lack of public information on private companies and problems fi nding comparable

prob-fi rms When it is used to compare public companies, it is necessary to adjust the outcomes due to the private company’s lack of liquidity Their shares are typically less marketable then public fi rms, so a discount for the lack of liquidity is applied (lack of marketability discount falls between 25 and 30%)

2 Net present value — Most common method for cash fl ow valuation Net

present value of a company is obtained by computing the expected value

of one or more future cash fl ows discounting them at a rate refl ecting the cost of capital This method considers the potential tax benefi t created by leverage It presents a serious problem with forecasting cash fl ow because the terminal value is greatly affected by the interest rate used, so it is criti-cal to identify the correct interest rate when discounting future cash fl ow one solution is to use the weighted average cost of capital, which is quite easy to calculate based on the current debt equity ratio at the time In real-ity this ratio is always subject to change, especially in LBO operations

3 Adjusted present value — A variant of the NPV approach used when

a company’s level of indebtedness is changing or it has past operations losses that can be used offset tax obligations This method attempts to solve the problems faced by the NPR by calculating cash fl ow without debt and discounting by using an unlevered (defi ned as the equity capital invested in the company) interest rate It further requires the quantifi ca-tion of interest and the relevant tax benefi ts discounted at the pretax rate

of return on debt This method is appropriately used when the capital structure (highly leveraged transactions such as LBOs) and the tax rate are changing It is more complicated then the net present value and presents

diffi culties when estimating future cash fl ow and selecting the correct count rate

4 Venture capital — Values the company at the end of a defi ned period of

time using one of the methods previously discussed Then it discounts this terminal value by a target rate of return that is the yield assumed by venture capitalists as remuneration for the risk and efforts of this specifi c investment This TRR is usually between 40 and 70% and is the biggest source of criticism of this method Venture capitalists use such a high level

of discount because of the lack of liquidity of private fi rms, the provision

of strategic advisors to the target company, and because the neur’s forecasting, included in the business plan, is usually too optimistic

5 Asset option — The methods previously explained are not usable when

managers or investors are capable of making fl exible decisions This fl ibility affects the value of the company, and these changes are not accu-rately computed in the discounted cash fl ow methods According to the venture capitalist, the value of a company depends on the value assumed

ex-by independent predictor variables The asset option method is not well known and the real-world opportunity for simple options and the exact pricing of these options are diffi cult to defi ne

12.2.4 Price setting

Finance theory on company valuation states that value and price are two ent measures, not always coincident and sometimes clashing, that depend on various factors The theoretical concept of company value, which differs from market value, is connected with the idea of economic capital: the value of a company in normal market conditions compatible with company capital with-out the considerations of the parties, their contractual power, their specifi c interests, and potential negations As per this defi nition, the economic capital, as

differ-a mediffer-asure of the compdiffer-any vdiffer-alue, is independent from the eventudiffer-al dediffer-al between the parties, the possibility that a new buyer will interfere, the contingent demand and supply situation, and the status of the M & A market Calculating the economic capital is necessary to have an objective value creation realized by management defi ned as fair value

It is easy to understand that the market value of a fi rm is affected by the same external pressures as company value These pressures are infl uenced by

fi nancial market effi ciency and demand and supply The price of a public pany depends on the participation negotiated; should the participation allow a minority presence in the capital subscribed or a majority control of the fi rm

com-Market and company values are also measured by cash fl ow forecasting and the determination of risk and other stock variables computed through specifi c for-mulas, whereas the price is defi ned by market dynamics

For private equity deals, the valuation of a fi rm is never theoretical; it is always linked to a real and concrete price so the fi nal value defi ned is the result

of the counterparty’s negotiations The estimate of the target company’s value is usually executed using simple and proven methods and techniques such as the comparables approach to avoid complicated fi nancial models

Price setting while negotiating equity value with the entrepreneur moves from the value of the company to the price (value) of the deal During this phase the entrepreneur has specifi c personal goals, over self-estimation, and per-sonal and moral involvement while the investor reduces the amount of money requested by the single deal and aligns the capital requirement and IRR targets

It is impossible to identify any standard rules within this negotiation, because it

is a complex struggle to agree on a fi nal price and, consequently, many deals fall apart over price disagreement

Price setting is typically developed by the management team with the port of the directors and advisors during the negotiation phase The negotiation for price setting is more relevant than valuation with mature companies and corporate governance based deals The way negotiations are conducted is infl u-enced by both technical and structural variables from the operations side and psychological and cultural values related to the profi le and knowledge of the counterparts and their advisors It is critical to select appropriately skilled advi-sors and intermediaries during negotiation

The fi nal step in this phase is closing the deal Investors need to understand how price setting is used during specifi c stages of the investment

Seed fi nancing — Insignifi cant because it does not affect this phase

Start-up fi nancing — Company valuation is more relevant than price setting because money is channeled to the development of the investment

Expansion fi nancing — Investors balance company valuation with price setting, but fi rm valuation is more relevant

Replacement fi nancing — The main point is the price setting

Vulture fi nancing — Price setting is insignifi cant

12.2.5 Exiting

During this phase enterprise value and price are calculated based on the tor’s exit The same enterprise value analysis and price setting activities are carried out, but the investor has to calculate the “ right value ” of the fi rm and negotiate with the potential buyer of the stake

Price setting is critical for the investor to get the effective IRR of the ment and to sustain global portfolio IRR For that reason, price setting becomes more relevant than enterprise value analysis when choosing an exit strategy

12.3 VALUATION OF THE COMPANY AND MARKET DYNAMICS

Before concluding this chapter, it is important to consider the impact of the ital market on the banker’s attempts to fairly valuate deals The consequences of the current heavy losses and market volatility make it diffi cult for fi nancial inter-mediaries to valuate companies

Valuation of a company covers a wide range of topics starting from casted cash fl ows to the selling prices of company assets In 2008 – 2009 capi-tal markets suffered tremendous depreciation of quoted securities and a high level of volatility; this situation directly affected the validity of the old and tested methods based on historical data The current fi nancial world is completely dis-torted compared to before 2008 and, consequently, the usual metrics for valua-tion are no longer applicable

This situation makes it likely that gaps between the expectations of buyers and sellers will increase until the restart of the M & A market It also makes it hard for fi nancial operators to analyze valuation with traditional methods

The combined dynamics of the present credit crunch and the low level of competition in the M & A market, linked to a minor presence of private equity, affected the prices paid for acquisitions Acquisitions are at a minimum level when compared to the previous 15 years, volume of trading activities are reduced 30 to 60%, and the premium paid for control is now around 20 to 22% compared with the historical average of 30%

Aligned with the information in this chapter and the fi nancial market, during the last quarter in 2008 and the fi rst quarter of 2009, the value of acquisitions that have been cancelled is almost equal to the value of deals that have been completed This current slowdown should be spent by relevant operators to bet-ter understand the function of the market, to protect the value of their current portfolio, and to be ready for any opportunities that may come their way