You have a great idea about a new business

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JWI 531 (1202) Page 1 of 10

JWI 531: Financial Management II

Week Eight Lecture Notes

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SHOW ME THE MONEY What It Means In order to grow, even financially healthy organizations may need to secure additional funding beyond what is available to them from cash flows alone. To pay for large-scale strategic initiatives, companies may procure additional funding either through borrowing – debt funding – or through selling a portion of the company – equity funding. Each has advantages and disadvantages which must be carefully considered. In some cases, however, options may be so limited or terms so unfavorable that securing additional funding from either route is not a viable path to growth. Why It Matters

• Understanding the advantages and disadvantages of debt and equity funding options is critical to developing a sound strategic plan that maximizes return on investment while minimizing risk.

• Securing additional funding may be the only way to successfully compete in the market.

• Companies that are too highly leveraged may not have sufficient reserves to protect against a downturn in the business.

“I do not like debt and do not like to invest in companies that have too much debt,

particularly long-term debt. With long-term debt, increases in interest rates can

drastically affect company profits and make future cash flows less predictable.”

Warren Buffett

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THE CHALLENGE AND OPPORTUNITY FOR MANAGERS

Sooner or later, most businesses will require additional funds beyond what they can generate from revenues or what they can tap into from cash reserves. They may need the money to pay for the design and development of new products, they may need to fund an expansion into new markets, or they may need to cover operating expenses for a period. None of these are necessarily signs that the business is struggling. In fact, it is often just the opposite. The business leaders have taken the company to a certain level of success, and now see opportunities that are even bigger. In order to beat the competition, they have developed a strategy to generate more revenue or to cut costs by investing in new production capabilities that are more efficient. While the opportunity may be great, business leaders must secure the necessary funding under terms that are favorable to the company. If the company has a good track record of success, and their current financials are healthy, they may be able to get a short- or long-term loan or line of credit. To do this, they need to convince a lender, typically a bank, that the risk of not getting paid back is low. Since banks make relatively low margins on loans, the key to their success lies in minimizing default rates and having sufficient collateral as a backup if the loan can’t be paid back on time. As an investor, you must pay close attention to the balance sheet – which, as the name implies, shows balances, debt and equity – when making investment decisions. Carrying debt is not necessarily bad as long as the terms are favorable and the cash flows are sufficient to service the debt. But when you see trends that show an increasing amount of cash coming in is going toward debt payments, while revenue and income are flat or declining, this may be a sign that the company’s financials are in trouble. In some cases, business leaders may choose to exchange partial ownership of the company for the funds they need. If you watch the popular show, Shark Tank, this is exactly what is happening. This is the same fundamental principle, although at a larger scale and with more regulatory control, as what happens when companies sell their stock in a public market. The challenge for finance leaders is not only to weigh the pros and cons of each option, but to negotiate the best terms. When done effectively, leveraging additional funding can be the key to successful and stable growth. Evaluating these funding options is the focus of our readings and activities this week.

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YOUR STARTING POINT

1. What is the relationship between the debt and equity in your own company? If the company is public, you can easily locate this in the 10-K. If it is private, it is likely something that will be known only to the senior-most executives and owners.

2. Do you think your competitors have a similar debt and equity structure? Why?

3. How much debt is the “right” amount for a company to carry? What factors must be considered in determining this?

4. If your business went through a downturn, would you rather have used debt or sold equity to fund growth? Why?

5. If your business became a lot more profitable, would you rather have used debt or sold equity

to fund growth? Why?

6. How does knowing your options for funding provide you with new ways to take advantage of growth opportunities for products and services?

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JWI 531 (1202) Page 5 of 10

FUNDING WITH DEBT AND EQUITY The Business of Lending Banks, the most common lenders, are not in the business of owning companies. They make their money from writing loans that will be paid back on time and with the agreed-upon interest. Thus, they are not primarily concerned with how the money will be used – not that this isn’t important – but are more interested in the strength of cash flows and the company’s track record. As a safety net, they are also concerned with the security – collateral – the company can provide as a back-up if the repayment plan goes awry and the lender has to take action to collect on the debt. Keep in mind, no reputable lender ever wants to do this. Seizing assets pledged as collateral for a loan can be a very costly and time-consuming process for the lender. It seldom results in the lender recovering the full value of the loan if it was paid back under the agreed-upon terms. Bragg begins chapter 12, Fund Raising with Debt, by providing an overview of the three ways a company can get debt financing:

• Asset-Based Financing: Company assets are used as collateral for this type of debt. Examples are the line of credit, invoice discounting, factoring, inventory financing, and leases.

• Unsecured Financing: No company assets are used as collateral. Instead, lenders rely upon the cash flows of the business to obtain repayment. Examples are long-term loans and floating-rate notes.

• Guaranteed Financing: A third party guarantees debt payments by the company. Government entities, such as the Export-Import Bank, usually provide these guarantees.

The CFO Guidebook, p. 230

The True Cost of Borrowing As Bragg advises (p. 231), it is important for finance leaders to consider the entire cost of borrowing. While the interest rate being charged is an obvious cost, there are a number of other factors that influence overall expenses:

• On the negative side, any additional fees charged by the lender, requirements such as additional auditing, or restrictions placed on business operations in order to receive the loan could have significant costs associated with them.

• On the positive side, the incremental increase in sales/revenue the company will hopefully realize

through the use of the new funds and the reduced tax liability from deducting the interest charges for the loan should more than offset the cost of borrowing.

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The variations on how debt funding can be structured are myriad, but depending on circumstances, some may or may not be available to an organization. Bragg presents an overview of the most common options, along with the pros and cons of each. One of the most flexible options is for a company to secure a line of credit. This allows, but does not require, the company to borrow funds up to a preset amount when needed without carrying the full debt when it is not needed. This is ideal for businesses that have a higher level of unpredictability in cash flows. Borrowing Base A lender may not require collateral in order to extend a loan or line of credit. But this is not common, and if it is offered, it is available only to organizations with a strong track record of success. Collateral can come in several forms which lenders refer to as the “borrowing base.” This is the total amount of collateral against which a lender will lend funds to the business (p. 232). Examples of ways to secure loans include:

• Invoice Discounting – using unpaid invoices as collateral for the loan • Factoring – selling accounts receivable to a third party • Inventory Financing – using the inventory the company has as collateral • Purchase Order Financing – getting a loan to service a purchase that has already been made

Many of these options are very risky for lenders. Thus, they are used only by businesses that are in desperate need of cash and are willing to accept the higher fees and interest rates charged by the lender. Leasing An option worth considering if the funds are being borrowed for a capital investment in equipment is to find out if the manufacturer or vendor offers a lease. As Bragg explains, “When cash is needed to acquire a fixed asset, an excellent choice is to do so with a lease, rather than using cash from other sources.” He does note, however, that there are two problems with leasing: “First, the company is committing to a minimum set of lease payments, which can be quite expensive to terminate early. Second, it can be difficult to ascertain the interest rate used to compile lease payments, so be sure to manually derive the interest rate before agreeing to a lease” (p. 236). Fund Raising with Equity Bragg concludes his chapter on debt funding by presenting several tips on how CFOs and financial leaders can negotiate the best terms when borrowing. He also outlines the risks that come with taking on too much debt or accepting a loan that comes with covenants that place excessive restrictions on the business (pp. 241-243). He then sets the stage for our next topic – equity financing – which he introduces as follows:

“The first source of funding that most CFOs turn to is debt financing, since interest expense is tax deductible and it does not change the ownership of a business. However, lenders are risk-averse, and will only lend a certain amount of cash. When that point is reached, the main alternative for fund raising is to sell shares in the business.

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Though there is no legal obligation for a company to make regular payments to its investors, there is an expectation by investors of substantial returns, which they can achieve either through dividend payments or the appreciation in value of the company’s stock. This expectation for returns is higher than the interest cost associated with debt, which is why the average CFO is reluctant to advocate the sale of stock when there are still opportunities for other types of fund raising.”

The CFO Guidebook, p. 244 Raising funds by selling ownership – equity – in the company presents significant challenges. It typically requires that an investor be presented with an upsized opportunity for gains. This normally translates into selling the stock at a discount to what a “realistic” valuation of the company would suggest, or offering the investor a preferred arrangement which includes benefits like conversion privileges or liquidation rights ahead of other investors. Beyond all this, the investor may want a seat on the board or other controlling interest in the company. Equity Fund Raising on Primetime If you want to see this negotiation at work, tune into the popular show Shark Tank. After the participants have pitched their business ideas and are picked apart by the sharks, they will get one of two responses. Either the business is not appealing to the investors because of the risk and lack of potential for return or, if there is interest, an offer will be framed as, “I will give you X dollars in exchange for Y% of the company, and for this, we will do the following…” This is the essence of an equity investment in one sentence. It is: (1) the amount of the investment they are willing to make and what percentage of the business they want for that investment, (2) the valuation of the business in the investor’s eyes, and (3) the requirements they are placing on the operation of the business in exchange for making the investment. Additional Equity Funding Sources and Advice Bragg presents an overview of other topics in equity financing, including restricted versus unrestricted stock, accredited investors, Regulation A and Regulation D stock sales, and warrants. While these may not be part of your day-to-day business as a finance leader, it is an excellent summary of important terms and options in equity financing. No discussion of fund raising with equity would be complete without considering three special categories of investors. These are:

• Angel Investors, who invest between $25 thousand and $1 million in businesses that are in their very early stages of development

• Crowdfunding, where companies take to social media to secure a large number of relatively small investments

• Venture Capital, firms who will typically take on a controlling interest in the company with a specific agenda and exit strategy

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JWI 531 (1202) Page 8 of 10

In terms of this third category, Bragg advises:

“A strong case can be made that most businesses should not even attempt to gain VC funding. A VC firm will push a company to expand extremely rapidly in order to increase its valuation as quickly as possible. As noted in our discussion of pacing in the strategy chapter, an excessively rapid pace of growth can severely damage a company and increase its long-term risk of failure. Instead, it may make more sense to adopt a slower- growth stance with more traditional forms of equity and debt funding.”

The CFO Guidebook, p. 251 In summarizing the challenges of equity financing, Bragg writes:

“It can be quite difficult to obtain equity funding in a privately-held company, since an investor’s prospects for reselling the shares are not especially good. In order to obtain such investments, expect a negotiating battle with prospective investors, who will want a variety of extremely favorable terms…The situation is substantially different for a large public company, which can routinely issue new common stock whenever the market price is reasonable. Thus, the decision to raise funds through the sale of stock is substantially different for a private company and a public company.”

The CFO Guidebook, p. 253 The advantages and disadvantages of going public will be the topic of next week’s class. Credit Ratings The final topic we touch on in our readings this week is credit agencies, the big three of which are Moody’s, Standard & Poor’s, and Fitch. Credit ratings are relevant to CFOs only if the company wants to issue debt – typically bonds – through a public exchange. This type of debt funding is not to be confused with securing a loan or line of credit from a bank. But, as in all financial strategy decisions, the risk-reward relationship is central. To attract investors, companies that have a lower rating will have to offer better interest rates on their debt in exchange for taking a greater risk. It is worth noting that, while these agencies have been established to act as safeguards for the public interest, there is no guarantee that their ratings offer failsafe guidance for investors. If you want a fascinating, albeit painful, look at how they have failed spectacularly, read the book or watch the movie The Big Short to see how exuberant confidence in mortgage-backed securities helped send the world into economic recession in 2008. This included the collapse of two of the largest financial institutions in the world: Bear Stearns, taken over by JP Morgan at $2 a share, backed by a $30 billion loan from the Federal Reserve, and Lehman Brothers, the fourth largest investment bank in the United States and one that had been in business since 1850.

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SUCCEEDING BEYOND THE COURSE

As you read the materials and participate in class activities, stay focused on the key learning outcomes for the week and how they can be applied to your job.

• Explore the reasons organizations need to raise money in order to grow Where are the greatest opportunities for growth in your own organization? If an investor or senior manager came to you and said they were willing to fund a new initiative with an injection of $1 million in capital, how would you deploy that money and why?

• Examine the advantages and disadvantages of debt and equity funding

This week, we explored the pros and cons of both debt and equity funding, and we considered situations where one or the other may be the superior choice. How would your company fund a new venture if you did not have the cash flow or reserves to pay for it? In fact, even if you did have the funds available, under what conditions should you tap into these funds instead of securing additional capital from lenders or investors?

• Develop funding strategies that maximize growth and create sustainable financial benefits appropriate to the corporate lifecycle of the business Take your best idea for a new business venture and develop a funding strategy to get it off the ground. Assume that you are starting from scratch and need to secure enough capital to develop the new product/service, launch it, and fund operations for at least one year while you build your customer base. What would your funding model look like? If you have the choice, would you rather borrow the funds or exchange partial ownership? Which strategy will give you the greatest chances for success and why? How might your strategy be different if you are developing this business within a mature company as opposed to an independent startup?

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JWI 531 (1202) Page 10 of 10

ACTION PLAN To apply what I have learned this week in my course to my job, I will…

Action Item(s) Resources and Tools Needed (from this course and in my workplace) Timeline and Milestones Success Metrics