the lawyer's mba - association of corporate · pdf file · 2015-10-29the...
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2 Presented by WilmerHale
• Understanding key financial concepts is critical to the ability of in-house attorneys to advise their business clients in the context of capital raising transactions
• Being an effective counselor requires an understanding of the legal aspects of different capital structures
• In-house counsel may be called upon to structure and negotiate key deal terms, including appropriate financial covenants, and monitor ongoing compliance
Why are we here today?
3 Presented by WilmerHale
Financial accounting• Financial statements and accounting terminology• How it is used in making investment and financing decisionsWorkshop – Calculating and understanding the impact of financial metrics
Financing the business• Capital structure considerations• Sources of capital
Understanding equity and debt financing • Types and sources of equity and capital• Key terms and considerations• Negotiating financial covenants in debt agreements Workshop – Drafting financial covenants in commercial agreements
What we will cover
4 Copyright © 2015 Deloitte Development LLC. All rights reserved.
• 8:00-8:30AM Registration/Check-in
• 8:30-9:45AM Welcome and Introduction to Financial Statements
• 9:45-10:15AM Workshop Activities
• 10:15-10:30AM Break
• 10:30-12:00PM Financing the Business Part I
• 12:00-12:45PM Lunch
• 12:45-2:15PM Financing the Business Part II
• 2:15-2:30PM Break
• 2:30-3:15PM Workshop Activities
• 3:15-3:30PM Debrief/Wrap-up
Agenda
6 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Financial reporting building blocks and concepts
• US GAAP financial statements and analysis points− Balance sheet− Income statement− Statement of owner's or stockholder’s equity − Statement of cash flows− Notes to the financial statements
• Common accounting terminology
• Introduction to financial statement fraud
• Summary of learning points
• Questions and answers
Agenda
Note: Any definition not sourced are from Financial Accounting/Kermit D. Larson, Paul B. Miller – 5th Edition.
8 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
Financial statement reporting:A full set of financial statements
Set of financial statements
Balance sheet
Statement of cash flows
Statement of owners’ or stockholders’ equity
Notes to the financial statements
Income statement
Description
• Shows the financial position (assets and liabilities) of the company at the end of the period.
• Shows the results of the operations for the period.
• Shows cash inflows (receipts) and outflows (uses) for the period.
• Explains investments by and distributions to owners during the period.
• Provides qualitative data.
9 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
Sources of financial statements/reporting
Public• www.sec.gov− Form 10-K — Annually, audited financial
statement with notes, and Management Discussion & Analysis (MD&A)
− Form 10-Q — Quarterly, reviewed financial statements, MD&A
− Form 20-F — Foreign Private Issuer− Form 8-K — Filed for significant events− Form S-1 — Initial registration
proceedings− Form S-3 — Debt/Equity offerings− Other Filings
Private
• Company website
• Dun & Bradstreet
• Hoover’s
• Dow Jones Interactive
10 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Provide useful information in:− Investment and credit decisions − Assessing cash flow prospects
• Provide useful information about:− Enterprise resources, claims to those resources, and changes in the resources− Economic resources, obligations, and owners’ equity− Enterprise performance and earnings− Liquidity, solvency, and funds flows
Financial statement reporting: Objective
“…intended to provide information that is useful in making business and economic decisions.”
Source: FASB Statement of Financial Accounting Concepts No. 1
11 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Accounting information used for Financial Reporting requires:
− Relevance: capacity to make a difference in a decision◦ Predictive Value: increases the likelihood of forecasting the outcome of events◦ Feedback Value (timely): enables users to confirm or correct prior expectations
− Reliability: information is reasonably free from error and bias◦ Representatively Faithful (validity): information represents what it purports to
represent◦ Verifiable: ability to ensure that information represents what it purports to represent◦ Neutral: absence of bias to attain a predetermined result
Financial reporting concepts
Source: CON 2, Qualitative Characteristics of Accounting Information
12 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• The significance of information, especially quantitative information, depends on the users ability to relate it to some benchmark:
− Comparability◦ The quality of information that enables users to identify similarities in and differences
between two sets of economic phenomena
− Consistency◦ Conformity from period to period with unchanging policies and procedures
Financial reporting concepts (cont.)
Source: CON 2, Qualitative Characteristics of Accounting Information
14 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• “Generally Accepted Accounting Principles”• Rules or conventions that govern what, when, and how to
record transactions• Prescribes what information should be disclosed and how it
should be disclosed• Promulgated primarily by the Financial Accounting
Standards Board (“FASB”)• Cash vs accrual accounting
GAAP
15 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Established accounting standards promulgated by the London-based International Accounting Standards Board (IASB)
• IFRS is a broad, globally accepted set of accounting standards:− Principles-based approach with a greater emphasis on interpretation and
application of principles− Less extensive body of literature than U.S. GAAP, with limited industry-specific
guidance and less detailed application guidance
• IFRS will require more exercise of judgment, supportedby contemporaneous analysis and documentation
• No definitive plan or timeline of mandating IFRS in U.S.
IFRS
16 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Corporate attorneys will need to work with management to confirm strong documentation of policies, procedures, and protocols to reduce the risk of litigation based upon the application of management’s judgments and estimates
• M&A attorneys involved in the drafting of contracts will need to consider the impact of IFRS on earn-outs, credit agreements, purchase agreements, sales contracts, and bonus plans
• White collar defense and corporate investigation attorneys may see a shift in cases to IFRS based regulatory proceedings
• Malpractice attorneys will need to prepare themselves for the way audits are performed under IFRS
How will IFRS impact attorneys
18 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
Classification of Assets
Assets
TangibleAssets
(physical)
CurrentAssets
(<1 year)
Non-CurrentAssets
(>1 year)
Intangible Assets
(not physical)
CurrentAssets
(<1 year)
Non-CurrentAssets
(>1 year)
examplescash
inventory
examplesproperty plant
equipment
examplecopyrights patents
licenses (expiring <1 year)
examplescopyrights patentslicenses goodwill
19 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
Classification of Liabilities
Liabilities
KnownAmounts
Current Liabilities(<1 year)
Non-CurrentLiabilities(>1 year)
Estimated Amounts
Current Liabilities(<1 year)
Non-CurrentLiabilities(>1 year)
examplelitigation accrual
exampleaccountspayable
examplenotes
payable
exampleproduct warranty liability
20 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
As of December 26, 2014 (in thousands)Example: Dynamites, Inc. Balance Sheet
ASSETSCurrent assets:
Cash and equivalents 13,150$ Marketable securities 25,594 Accounts receivable, net of allowance of $25 7,792 Inventory 4,043 Prepaid expenses 2,375 Taxes 8,893 Restricted assets 27,346
Total current assets 89,193
Property and equipment, net 198,679 Other assets 21,891 Intangible assets* 11,383
Total assets 321,146$
LIABILITIES AND STOCKHOLDERS' EQUITYCurrent liabilities:
Unearned franchise fees 1,186$ Accounts payable 19,274 Accrued compensation and benefits 19,536 Accrued Expenses 4,855 Current portion of deferred lease credits - System-wide payables 28,344 Current portion of long-term debt 641
Total current liabilities 73,836
Long-term liabilities:Other liabilities 989 Deferred income taxes 24,669 Deferred lease credits, net of current portion 14,763 Long-term debt 3,203
Total liabilities 117,460
Commitments and contingencies (notes 4 & 8)Stockholders' equity:
Common stock 72,708 Retained earnings 131,167 Accumulated other compensation loss (189)
Total stockholders' equity 203,686Total liabilities and stockholders' equity 321,146$
* One type of intangible asset is goodwill which will be discussed in detail later in the module.Data is for illustrative purposes only.
21 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• How liquid are the assets?
• How leveraged is the company?
• What is the breakdown between short-term and long-term debt?
• What is the quality of the assets?
Several things to look for on the balance sheet
22 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
If Dynamites wanted to assess its liquidity, which of the following elements could be useful?
a) Cash
b) Accounts receivable
c) Marketable securities
d) All of the above
Knowledge Check
24 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
Revenue• Inflows or other enhancements of assets of an entity or settlements of its
liabilities from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations
Gains• Gains are increases in equity (net assets) from peripheral or incidental
transactions of an entity and from other transactions and other events and circumstances affecting the entity, except those that result from revenues or investments by owners.
SOURCE: SFAC 6, Elements of Financial Statements
Income Statement Elements
25 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
Expenses• Outflows or other “using up” of assets or “incurrence” of liabilities from delivering
or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.
Losses• Losses are decreases in equity (net assets) from peripheral or incidental
transactions of an entity and from other transactions and other events and circumstances affecting the entity, except those that result from expenses or distributions to owners.
SOURCE: SFAC 6, Elements of Financial Statements
Income Statement Elements
26 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
For the years ended December 26, 2014 and December 27, 2013 (in thousands)
Example: Dynamites, Inc. Income Statement
Dec. 26, 2014 Dec. 27, 2013
Revenue:Restaurant sales 459,527$ 355,623$ Franchise royalties and fees 42,970 37,198
Total revenue 502,497 392,821
Costs and Expenses:Restaurant operating costs 366,778 290,339 Depreciation and amortization 31,972 25,113 General and administrative 46,561 34,587 Preopening 9,329 5,379 Loss on asset disposals and store closures 1,236 1,314
Total costs and expenses 455,876 356,732
Income from operations 46,621 36,089 Investment income 76 438 Earnings before income taxes 46,697 36,527 Income tax expense 14,397 11,930 Net earnings 32,300$ 24,597$
Data is for illustrative purposes only.
27 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Is the company profitable?
• What portion of the income is from non-recurring/non-operating transactions?− Were there any one-time occurrences during the year?− Have any operations been discontinued?
• Are there any expense items that seem out of line?
Several things to look for on the income statement
29 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Presents the changes (the composition of additional capital, dividends, earnings) in owners’ equity over a certain period of time
• Reconciles the balance of the retained earnings account from the beginning to the end of the period
• Shows the interaction between the income statement (net income) and the balance sheet (retained earnings)
Statement of Changes in Owners’ Equity
30 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
For the year ended December 26, 2014 (in thousands)
Example: Dynamites, Inc. Statement of Stockholders’ Equity
OtherRetained Comprehensive
Shares Amount Earnings (Loss) Income TotalBalance at December 27, 2013 18,214,065 65,647$ 98,866$ (6)$ 164,507$
Net earnings - - 32,300 - 32,300Other comprehensive loss - - - (183) (183)Comprehensive income - - - - 32,117Purchase and cancelation of common stock - - 1 - 1Shares issued under employee
stock purchase plan 30,127 879 - - 879Shares issued from restricted stock units 142,797 - - - -Units effectively repurchased for
required employee withholding taxes (45,539) (4,183) - - (4,183)Exercise stock options 36,470 216 - - 216Tax benefit from stock issued - 2,858 - - 2,858Stock-based compensaton - 7,291 - - 7,291Balance at December 26, 2014 18,377,920 72,708$ 131,167$ (189)$ 203,686$
Common Stock
Data is for illustrative purposes only.
32 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
Statement of cash flow ingredients
Operating ActivitiesCollections from Customers,
Franchise fees, Other
Investing ActivitiesSale of Productive Assets , Net
Investment Income
Financing ActivitiesIssuance of Long-Term
Debt and Equity
Operating ActivitiesPayments to Suppliers,
Employees, Interest, Income Taxes, Other
Investing ActivitiesPurchase of Productive Assets,
Debt, or Equity
Financing ActivitiesPayment of Dividends and
Loans, Acquiring own Equity Securities, Other
Pool of Cash
33 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
For the year ended December 26, 2014 (in thousands)
Example: Dynamites, Inc. Statement of Cash Flows (Indirect Method)
CASH FLOWS FROM OPERATING ACTIVITIES:Net Earnings 32,300$ Adjustments to reconcile net earnings to cash provided by operations:
Depreciation 31,389 Amortization 583 Loss on asset disposals and store closures 1,076 Deferred lease credits 2,326 Deferred income taxes 8,209 Stock-based compensation 7,291 Excess tax benefit from stock issuance (2,857) Changes in operating assets and liabilities, net effect of acquisition:
Trading securities (203) Accounts receivable (783) Inventory (1,179) Prepaid expenses 13 Other assets (1,633) Unearned franchise fees (165) Accounts payable 11,322 Income taxes 2,093 Accrused expenses 5,185
Net cash provided by operating activities 94,967$
CASH FLOWS FROM INVESTING ACTIVITIES:Purchase of property and equipment (83,353)$ Purchase of marketable securities (62,228) Proceeds of marketable securities 73,239 Acquisition of franchised restaurants (21,615)
Net cash used by investing activities (93,957)
CASH FLOWS FROM FINANCING ACTIVITIES:Issuance of Common Stock 1,095 Excess tax benefit from stock issuance 2,858 Tax payments for restricted stock units (1,589)
Net cash provided by financing activities 2,364 Effect of exchange rate changes on cash and cash equivalents (30)
Net increase in cash and cash equivalents 3,344 Cash and cash equivalents at beginning of year 9,806 Cash and cash equivalents at end of year 13,150$
Data is for illustrative purposes only.
34 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Does the company have positive cash flow?
• Did the company’s cash position change significantly?
• How is the company using its cash?
• What were the sources of the company’s funds?
• Comparison of Income Statement to Cash Flow Statement:− Strong income from continuing operations versus weak cash flow provided by
operating activities
• Assess the ability of the company to meet its obligation, pay dividends, need for external financing
Several things to look for on the cash flow statement
35 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
Relationships Among Financial Statement Line Items
Income Statement Balance Sheet
Revenue 502,497$ AssetsCost of Sales 366,778 Cash 13,150$ Depreciation and Amortization 31,972 Other Current Assets 76,043 Other Operating Expenses 57,126 Property & Equipment 306,988 Other Non-Operating Expenses 14,321 Accumulated Depreciation (108,309) Net Income 32,300$ Other Non-Current Assets 33,274
Total Assets 321,146$ Cash Flow Statement
Net Income 32,300$ LiabilitiesDepreciation and Amortization 31,972 Current Liabilities 73,836$ Other Cash Flow From Operating 30,695 Long-Term Liabilities 43,624 Cash Flow From Operations 94,967 Total Liabilities 117,460 Cash Flow From Investing (93,957) Shareholders' Equity 203,686 Cash Flow From Financing 2,364 Total Liabilities + Equity 321,146$
Effect of exchange rate changes Statement of Stockholders' Equityon cash and cash equiv. (30) Beginning Balance 164,507$ Increase in Cash 3,344 Net Income 32,300 Beginning Cash Balance 9,806 Other Comprehensive loss (183) Ending Cash Balance 13,150$ Stock & Option Repurchase (3,087)
Other Equity Transactions 10,149 Total Stockholders' Equity 203,686$
B
C
D
E
Data is for illustrative purposes only.
37 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
Provides further explanations and may provide the only explanations for significant transactions and contains required disclosures
Financial statement reporting:Notes to the financial statements
• Overview of the business
• Significant accounting policies‒ Revenue recognition‒ Principles of consolidation‒ Property, plant & equipment‒ Intangible assets & goodwill‒ Long-term debt
• Discontinued operations
• Business combinations
• Debt offerings and credit risk
• Income taxes
• Related party transactions
• Subsequent events
• Commitments and Contingencies
38 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Information often results from approximate, rather than exact measures.– Example: Estimates include the allowance for doubtful accounts receivable,
carrying value of certain intangibles, contingencies, etc.
• Information is based upon historical data and does not measure or discuss management’s plans for the future.– Example: The benefits of a company’s restructuring plan might not benefit the
company until several years after the plan is announced/implemented.
• Information is generally recorded at cost and may not reflect the current market value.– Example: Generally, fixed assets are accounted for at cost, and not at their fair
market value (FMV). For example, a building built in the 1950s will be recorded at the amount for which it was constructed and not at its FMV in 2012.
Financial statement reporting:Limitations on financial statements
40 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• A measure of the significance of a transaction or event. A transaction is considered material if its omission or misstatement would affect the judgment of a reasonable person relying on the financial statements.
Materiality
Source: Staff Accounting Bulletin (SAB) No. 99
41 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• A prudent reaction to uncertainty to try to confirm that uncertainty and risks inherent in business situations are adequately considered.− If two estimates of amounts to be received or paid in the future are about
equally likely, conservatism dictates using the less optimistic estimate; however, if two amounts are not equally likely, conservatism does notnecessarily dictate using the more pessimistic amount rather than the more likely one.
Conservatism
42 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
Definition
“a contingency is defined as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. Resolution of the uncertainty may confirm the acquisition of an asset or the reduction of a liability or the loss or impairment of an asset or the incurrence of a liability.”
Contingencies
Source: ASC 450, Accounting for Contingencies
43 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
Loss contingency
Determination and consideration of facts by company management and auditors
Probable (high) Reasonably possible (medium) Remote (low)
Can amount be reasonably estimated?
Is loss guarantee of indebtedness?
Accrual, with disclosure required Disclosure required Neither accrual nor
disclosure required
*Includes estimation of range of loss, in which case the minimum amount is accrued and the amount of the range is disclosed
Probability that future event(s) will confirm loss
YesNo
NoYes*
44 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Pro Forma — provides information about the continuing impact of a particular transaction by showing how it might have affected historical financial statements if a transaction (acquisition or disposition) had been consummated at an earlier time. − Example:◦ For a business combination, the financial statements shall include certain pro forma
information, such as the “results of operations for the current period as though the business combination(s) had been completed at the beginning of the period”
◦ Source, ASC 805, Business Combinations
• Historical — measures income or presents a financial position for past events. The information as reported in historical financial statements is a summarized presentation of the operations of the business during a specific period of time.
Pro Forma vs. Historical financial statements
45 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• GAAP are the rules that govern what, when, and how to record transactions and prescribe what information should be disclosed and how it should be disclosed in the financial statements.
• Non-GAAP amounts are amounts that are not defined in the GAAP accounting literature, such as EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization)
• Public companies are required to reconcile Non-GAAP measures to the corresponding GAAP measure
• Area of manipulation on which regulators focus their attention
GAAP vs. Non-GAAP measures
46 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
If Dynamites determined that the probability of a future loss was probable, but the dollar impact could not be reasonably estimated, what action could you suggest Dynamites take?
a) Book an accrual for an amount agreed upon by management
b) Disclose the future event in the notes to the financial statements providing adequate detail
c) Both a) and b)
d) No action is required
Knowledge Check
48 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
Source: 2014 ACFE Report to the Nation on Occupational Fraud & Abuse
Fraud Types
• Asset Misappropriation – billing (fictitious services, inflated invoices, etc.), payroll, expense reimbursement schemes • Corruption – wrongly using influence in a business transaction• Financial Statement Fraud – falsification of statements (overstating revenue, understating expenses, etc.)
49 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
Accounting anomalies
Internal control symptoms
Analytical anomalies
Lifestyle symptoms
Behavioral symptoms
Tips and complaints
Categories of Fraud Symptoms
─Source: Internal Auditor Magazine, October 1996, “Employee Fraud” by W. Steve Albrecht─www.theiia.org
51 Module 1 – Introduction to Accounting & Financial Statements Copyright © 2015 Deloitte Development LLC. All rights reserved.
• A set of financial statements includes the following:− Balance sheet− Income statement− Statement of cash flows− Statement of stockholders' equity− Notes to the financial statements
It is important to understand (1) how to read them, (2) how they relate to each other and (3) how to pull insights from them all.
• Terms such as: materiality, conservatism, and contingency are often used to describe accounting matters.
• Financial statement fraud is an intentional act designed to misstate financial performance in order to deceive financial statement users.
Summary of Learning Points
53 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Capital structure
• Cost of capital and time value of money
• Equity capital and investors
• Required rates of return
• Financing example
• Capital budgeting
• Summary of learning points
• Questions and answers
Agenda
55 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Funding a start-up business
• Funding growth after a business is established− Dynamites is looking to fund its international growth plans
• Opportunistically refinancing – “optimizing” the capital structure
• Funding working capital
• Funding major growth initiatives – capital expenditures or acquisitions− Dynamites needs capital to fund the potential acquisition of an international company
• Extending maturities
• Restructuring when financial performance is suffering
What are the basic reasons for raising capital?
56 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
What are the basic reasons for raising capital?
$
FundingRequirements
Start-UpCapital
GrowthCapital
Major Initiatives
Typical Capital Structure
100% Equity
LimitedDebt
Optimal Debt and
Equity
Time
Working Capital
57 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
Elements of capital structure
The capital structure of a company is the mix of different sources of capital issued by the company to finance its operations.• Sources of Capital:
– Debt: Bonds, bank loans– Equity: Ordinary shares (common stock), Preference shares (preferred stock)– Hybrids: warrants, convertible bonds
CapitalStructure
Operating Assets
Operating Liabilities
Debt
Preference Shares
Ordinary Shares
58 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
Balance SheetAs of December 28, 1990 US$
ASSETS
Cash and Equivalents $503,444
Accounts Receivable 5,556
Inventory 3,000
Total Current Assets $512,000
Net Plant, Property & Equipment 239,583
Net Intangible Assets (Liquor License) 14,750
Total Assets $766,333
LIABILITIES
Accounts Payable 3,000
Interest Bearing Debt -
Total Liabilities $3,000
MEMBERS EQUITY
Members Equity 800,000
Retained Earnings (36,667)
Total Members Equity $763,333
Total Liabilities & Members Equity $766,333
CapitalStructure
Debt
Equity
Operating Assets
Operating Liabilities
Data is for illustrative purposes only.
59 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
Knowledge Check #1
What was Dynamites' capital structure as an early stage company in December 1990?
A. 100% equity / 0% debtB. 75% equity / 25% debtC. 50% equity / 50% debtD. 5% equity / 95% debt
CapitalStructure
Operating Assets
Operating Liabilities
Debt
Preference Shares
Ordinary Shares
60 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
Secured Bank Loans
Enterprise Value Coverage
Unsecured NoteMezzanine Unsecured
Note
Institutional B/C Tranches
2nd Lien Loans/ Notes
Secured Bank Loan
1st Lien Note
Common Equity/ Shareholder Loan Common Equity/
Shareholder Loan
Hybrid PreferredCommon Equity/ Shareholder Loan
Debt
Elements of capital structure (cont.)
Capital structures can range from simple to complex
Payment-in-Kind Loans / Notes
62 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
Time Value of Money
• Money has a time value because money can be invested with the expectation of earning a positive rate of return− In other words, a dollar received today is worth more than a dollar received tomorrow− TIME allows you the opportunity to postpone consumption and earn INTEREST− That is because today’s dollar can be invested so that we have more than one dollar
tomorrow
Which would you prefer -- $10,000 today or$10,000 in 5 years?
$10,000Present Value = $6,210
10% interest
0 1 2 3 4 5
63 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
Time Value of Money ExerciseKnowledge Check #2
$1,000,000Deposit now (closest answer)?
A. $1,200,000B. $200,000D. $900,000
3.5% interest
0 1 2 3 4 5 6
Dynamites wants to buy a new software system that will revolutionize the way customers order their food. The new software system will not be ready for six years but Dynamites has put its name on the list to buy the system. The new software system will cost the company $1 million dollars. Company management wants to reserve some cash and put it away in a bank account until they actually make the purchase. How much money should they put in the bank account now in order to have $1 million in six years assuming the bank account earns an interest rate of 3.5%?
64 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
Cost of Capital
Debt versus Equity
• A company’s cost of debt is typically less than its cost of equity – debt has seniority over
equity– debt has a fixed return – the interest paid on
debt is tax-deductible
• It may appear that a company should use as much debt and as little equity as possible due to the cost difference, but this ignores the potential problems associated with debt
65 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
Capital Strategy
Stability• Tenor• Financial/
other covenants
Costs• Interest
margin• Other fees
Financing requirements• New transactions• Existing business
requirements
Security considerations• Assets• Guarantees• Unencumbered assets
Supporting business objectives
Stability of debt
Properly structured security
Financial flexibility
Optimal Capital Structure – A Practical Approach
• Theoretical approaches to “optimal” capital structure result in a cash rich and debt light company.
• The optimal allocation of capital may be sourced from various instruments and the choice of instruments is based on the prevailing capital market conditions.
• There are a number of interactive and practical considerations that drive this decision, including the specific objectives of the company, the requirement for a stable financing structure for the business, the asset security package available for debt and financial flexibility within the company’s cash flows.
66 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
Rank the cost of capital from lowest to highest.
A. Debt, preferred equity, common equityB. Preferred equity, common equity, debtC. Common equity, debt, preferred equity
Dynamites uses primarily equity capital to fund the business. What are some reasons that they may not have used debt even though it would reduce the overall cost of capital?
Knowledge Check #3
68 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Long term capital
• Generally comes with no repayment schedule
• Dividends can be paid to equity holders
• Most “expensive” capital
Basics of Equity Capital
69 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Common stock− A voting interest and ownership in an entity. Stock ownership typically does not entitle owners to
scheduled dividends and returns can be highly variable
• Preferred stock− Characterized by a “preferred returns” usually in the form of scheduled or guaranteed dividend
payments. Typically a non-controlling interest
• Partnership shares− Structure in which multiple partners, or general partners together control the business.
Partnerships are not taxed at the entity level and profits are passed to the partners and taxed at the individual level
• Limited partnerships shares− Structure in which a group of partners, one or more of which are considered “general partners,”
control the business, while the rest are passive partners or investors.
• Limited liability companies member interests− A hybrid structure that blends the characteristics of partnerships and corporations
Types of Equity Capital
Source: investopedia.com
70 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
Seed/Start Up: • Typically $200,00 to $1 million• Provided by friends & families, nonprofit venture development groups, and grants • Crowdsourcing: Online matching of investors on a micro loan (equity) basis• Alpha and Beta stage products – early testing phase
Early Stage:• $1-5 million• Angel investors, regional venture capital firms, high net worth individuals• Beta stage product or early adoption period
Growth Stage: • $5 million+• Variety of sources including venture capital, strategic investors, debt capital and hybrids• Scaling products and services up to full capacity• Venture capital investors may start to think about how to exit down the road and look for ways to pull
out capital
Companies have different capital circumstances at each stage of growth and may approach different capital providers at each stage of the process. Each stage has very different risk profiles and each investor pool has different tolerances for those risks.
Capital Sources & Stage of Company
71 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
If Dynamites were to raise $30 million of equity capital during the middle stage of growth, from whom would it most likely receive interest in investing?
A. Angel investors
B. Venture Funds
C. Private Equity
D. Public equity market
Knowledge Check #4
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Required Rates of Return
$
Time
Seed / Start Up
IPO Stage
Stage
Expected Rate of Return 1
Growth: 1st Stage
Growth: 2nd Stage
Growth: 3rd-4th Stage
Mature Stage
50-70% 25-35%40-60% 30-45% 7-20%35-50%
InvestorTypes
Owner, Friends & Family
Funds, Institutions
Angels, Venture Capital
Private Equity, Strategic
Funds, insurance, pensions
1) See Appendix A for more detailed information
75 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
Sample Capitalization Table
1. The Johnson brothers each invested $200,000 of personal savings in 1990, which gave them each 25 percent ownership of Dynamites
2. At the same time, friends and family collectively provided $400,000 of additional capital to help start the business. The investment provided friends and family with a 50 percent ownership stake in Dynamites.
A capitalization table (cap table) details the ownership of the company
1
2
Stage 1 – Initial Investments
Common Stock # of Shares % Ownership $ Investment Share Price
Andrew Johnson 2,000,000 25% $200,000 $0.10
Bob Johnson 2,000,000 25% $200,000 $0.10
Friends & Family 4,000,000 50% $400,000 $0.10
Total Common Stock 8,000,000 100% $800,000
1
Data is for illustrative purposes only.
76 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
Balance SheetAs of December 28, 1990 US$
ASSETS
Cash and Equivalents $503,444
Accounts Receivable 5,556
Inventory 3,000
Total Current Assets $512,000
Net Plant, Property & Equipment 239,583
Net Intangible Assets (Liquor License) 14,750
Total Assets $766,333
LIABILITIES
Accounts Payable 3,000
Interest Bearing Debt -
Total Liabilities $3,000
MEMBERS EQUITY
Members Equity 800,000
Retained Earnings (36,667)
Total Members Equity $763,333
Total Liabilities & Members Equity $766,333
As of December 28, 1998 US$
ASSETS
Cash and Equivalents $3,297,671
Accounts Receivable 36,390
Inventory 19,651
Total Current Assets $3,353,712
Net Plant, Property & Equipment 1,566,048
Net Intangible Assets (Liquor License) 99,891
Total Assets $5,019,651
LIABILITIES
Accounts Payable 19,651
Interest Bearing Debt -
Total Liabilities $19,651
SHAREHOLDERS EQUITY
Shareholders Equity 2,800,000
Retained Earnings 2,200,000
Total Shareholders Equity $5,000,000
Total Liabilities & Shareholders Equity $5,019,651
Data is for illustrative purposes only.
77 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Based on market research as well as a few preliminary, non-binding offers to buy Dynamites, the Johnson brothers believed the value of Dynamites was approximately $3,000,000• This valuation implies a $0.38 share price ($3,000,000 value / 8,000,000 shares)
• In order to expand the business regionally, the Johnson brothers estimated that they need an additional $2,000,000 of capital• Two separate venture capital firms agreed to provide Dynamites with $1,000,000 each at a price of
$0.38 per share
Sample Capitalization Table (cont.)
Stage 1 – Initial Investments
Common Stock
Original # of Shares
Original % Ownership
Original Investment
AndrewJohnson 2,000,000 25% $200,000
Bob Johnson 2,000,000 25% $200,000
Friends &Family 4,000,000 50% $400,000
VC Firm 1 N/A N/A N/A
VC Firm 2 N/A N/A N/A
Total 8,000,000 100% $800,000
Stage 2 – Expansion Stage
New # of Shares
New % Ownership
New / Current Value
2,000,000 15% $750,000
2,000,000 15% $750,000
4,000,000 30% $1,500,000
2,666,667 20% $1,000,000
2,666,667 20% $1,000,000
13,333,333 100% $5,000,000
Difference
Inc / (Dec) in Value
$550,000
$550,000
$1,100,000
$0
$0
$4,200,000
Data is for illustrative purposes only.
79 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
Capital Budgeting Overview
Capital budgeting is often the most important functions financial managers perform
What is capital budgeting?
• Analysis of potential capital projects to undertake• Long-term decisions involving large expenditures• Projects selected are expected to produce a cash inflow over a period of time
Steps in making a capital budgeting decision:
• Estimate cash flows (inflows & outflows)• Assess risk of cash flows• Determine appropriate cost of capital or discount rate for project• Evaluate cash flows via Net Present Value, Internal Rate of Return, Payback Period or several other methods • Make Accept/Reject Decision• Payments to stakeholders (i.e. dividends, debt payments)
Sample capital budgeting categories include:
• Upgrade or replace to continue profitable operations• Upgrade or replace to reduce costs• Expansion of existing products or markets• Expansion into new products/markets• Research and Development (R&D)• Safety and/or environmental projects• Mergers & Acquisitions
80 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
Capital Planning Framework
Capital budgeting and planning is the process by which a firm sets capital allocation targets and builds towards an “optimized” portfolio of projects. This is achieved by: Establishing an iterative capital budgeting
process that allocates funding down to the direct ownership level
Developing an effective project prioritization methodology that quantities value and risk considerations
Implementing a capital management governance structure with clear roles and responsibilities
Capital ExpendituresBalance Sheet& Cash FlowWorking Capital
Dividend Policy
ShareRepurchase
Secured
Unsecured
Equity
The Business
The Stakeholders
The Market Raise
Minimize cost of capital
DeployMaximize
value creation
DistributeSignal
to the market
Cash Mobility
DeployMaximize
value creation
Executable Strategies with Measureable Results
Debt Repayment
Capital Budgeting – The Bigger Picture
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Allocation of Funds to Capital Projects
Capital can be invested to create shareholder value in several different ways.
Options for Investing Capital
Capital Investment Projects and Maintaining Capital
Assets
Merger and Acquisition Transactions
Investment in Securities or Minority Investments in
Other Companies
Investment in information technology systems
Investment in production equipment and machinery
Building or purchasing of new facilities
Maintenance of plant, property and equipment such as machinery and buildings
The incremental discretionary expenditures required to execute capital projects
R&D investments
Purchase of another company
Merger with a company that requires capital outlay
Purchase of investment securities
Purchase of a minority stake in another company
Opt
ion
Illus
trativ
e Ex
ampl
es
82 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
Example – Payback Period
Dynamites wants to invest in a new clean-energy fryer. Management is deciding between a $1,000,000 fryer and a $1,400,000 fryer, each with different cash flow expectations. If the decision were based on the payback period alone, which project should the Company undertake?
What is the payback period for each Project?
Weakness of this approach: Time value of money is ignored as well as the cash flows that occur after the payback period
Year Project A Project B
0 -$1,000,000 -$1,400,000
1 100,000 600,000
2 500,000 600,000
3 800,000 600,000
2.5 years 2.25 years
83 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
Example – Net Present ValueDynamites’ Management also evaluates each major project on an expected Net Present Value (NPV) method. The Net Present Value considers the time value of money and discounts the expected future cash inflows, net of the outflows, of the project to today’s value at an assumed interest rate.
Project A includes a new fryer that enhances the range of flavor possibilities. Project B is a new technology that reduces amount of oil needed which reduces operating costs.
While Project B has a faster payback period (2.25 years) than Project A (2.5 years), the NPV (assuming a 10% discount rate) of Project A is higher than Project B, which suggests that Project A would be the preferable project if only one project could be pursued.
Project A
Year 0 Year 1 Year 2 Year 3
Cash Flow (1,000,000) 100,000 500,000 800,000
NPV Year 0 (1,000,000)
NPV Year 1 90,909
NPV Year 2 413,223
NPV Year 3 601,053
Total NPV 105,184
Project B
Year 0 Year 1 Year 2 Year 3
Cash Flow (1,400,000) 600,000 600,000 600,000
NPV Year 0 (1,400,000)
NPV Year 1 545,455
NPV Year 2 495,868
NPV Year 3 450,789
Total NPV 92,111Data is for illustrative purposes only.
85 Module 2 – Financing the Business Part I Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Capital Structure− The capital structure of a company is the mix of different securities issued by the company to finance its operations
• Cost of Capital and Time Value of Money− A dollar received today is worth more than a dollar received tomorrow− The FUTURE cash flows are discounted at the cost of capital to arrive at their PRESENT VALUE − The risk inherent in the future cash flows is reflected in the discount rate− A company’s cost of debt is always less than its cost of equity
• Equity Capital and Investors− The different types of equity capital are:
◦ Common equity, preferred equity, limited and general partnership shares− There are many different sources of equity capital that differ based on how developed the company is and the need for
the capital.
• Required Rates of Return− Companies have different capital circumstances at each stage of growth and may approach different capital providers
at each stage of the process. − Each stage has very different risk profiles and each investor pool has different tolerances for those risks
• Capital Budgeting − Capital budgeting and planning is the process by which a company sets capital allocation targets and builds towards
an “optimized” portfolio of projects− Capital can be invested to create shareholder value in several different ways
Summary of Learning Points
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Agenda
• Overview of debt capital raising considerations
• Types of debt capital investors
• Types of debt capital investments and credit enhancements
• Examples of hybrid capital
• Ways to source capital and typical debt raise process overview
• Credit documentation overview
• Credit metrics overview
• Summary of learning points
• Questions and answers
89 Module 3 – Financing the Business Part II Copyright © 2015 Deloitte Development LLC. All rights reserved.
Capital Sources
Directly from Debt Providers− Traditional Banks
− Alternative Debt Capital Providers
− Founder’s Contributions
− Friends and Family
− Venture Capital
− Angel Investors
Indirectly through Arrangers of Debt and Equity Capital
– Investment Bankers
– Deal Brokers
– Placement Firms
Directly from Equity Providers– Founder’s Contributions
– Friends and Family
– Venture Capital
– Angel Investors
– Small Business Private Equity Investors
– Private Equity Investors
– Public Equity
90 Module 3 – Financing the Business Part II Copyright © 2015 Deloitte Development LLC. All rights reserved.
Detailed review of historical financial results, projections and existing capital structure
Coordinate multiple levels of funding
Understand client strategic objectives and conduct an “optimal” capital structure review
Review terms and conditions to ensure compliance with market standards
Set out and discuss potential funding sources
Present opportunity to a selected group of lenders/investors
Assist the Company in the creation and presentation of management meetings with potential lenders
Provide indicative views on pricing, structuring and covenant packages
Review legal agreements produced by the company’s advisors
Identify opportunity2–4 weeks
Lender/investor negotiation6–8 weeks
Financing execution3–4 weeks
Inter-creditor issues resolved
Timely closing
Typical Debt Raise Process Through an Investment Bank
Agree on a list of potential lenders/ investors with the company
Gather due diligence information
Work with management to create a Confidential Information Memorandum and draft of term sheet
Advise management on selection of favored terms
Manage the negotiation process with the lenders/investors
Assist the company with due diligence requests from the lenders/investors
Create a competitive process and generate proposals from lenders
92 Module 3 – Financing the Business Part II Copyright © 2015 Deloitte Development LLC. All rights reserved.
Debt Capital Providers
• Traditional Banks
– Large National Banks (LC)
– Foreign Banks (LC)
– Regional Banks (MM, LC)
– Community Banks (ES, MM)
LC = Large Cap
MM = Middle Market
ES = Early Stage
• Alternative Debt Capital Providers
– Senior Debt Funds (MM, LC)
– Opportunity Funds (MM, LC)
– Mezzanine Funds (MM)
– Collateralized Loan Obligation Funds (MM, LC)
– SBIC Funds (ES, MM)
– Business Development Companies (ES, MM)
– Hedge Funds (MM, LC)
– Venture Debt Funds (ES)
– Distressed Debt Funds (ES, MM, LC)
– High Net Worth Individuals (ES)
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What are the basic reasons for raising Debt Capital?
Extend Maturities
Opportunistically Refinance
Funding Growth –Organic and Acquisitions
RestructuringFunding Working Capital
Why Raise Debt Capital?
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• Secured Debt v. Unsecured Debt
• Senior Debt v. Junior Debt
Basic Ways to Describe Debt Capital
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Secured Bank Loans
Enterprise Value Coverage
Unsecured NoteMezzanine Unsecured
Note
Institutional B/C Tranches
2nd Lien Loans/ Notes
Secured Bank Loan
1st Lien Note
Common Equity/ Shareholder Loan Common Equity/
Shareholder Loan
Hybrid PreferredCommon Equity/ Shareholder Loan
Debt
Elements of Capital Structure
Capital structures can range from simple to complex
Payment-in-Kind Loans / Notes
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Types of Debt
More Collateral or Quicker Repayment = Less Risk = Less Cost
Revolver
Term Loan A (“TLA”)
Term Loan B (“TLB”)
Second Lien Loan
Mezzanine Debt
Subordinated Debt
Asset Based Loan (“ABL”)
Revolver
Revolving Credit Facility secured by the Company’s working capital assets with availability subject to a Borrowing Base (formula based, periodic (usually monthly) calculation of the maximum amount of borrowing the assets support)
Revolving Line of Credit that is usually pari passu with other senior secured debt (specifically the Term Loans) and is not subject to a Borrowing Base
Senior secured Term Loan, often referred to as “Bank Debt”, as banks typically invest in this tranche; banks often invest in what is referred to as the “Pro Rata Facility” which is a strip of the Revolver and the Term Loan A
Senior secured Term Loan, often referred to as the “Institutional” tranche, as institutional investors typically invest in the TLB, which most often has lower scheduled amortization than the Term Loan A (often 1% per year)
Senior secured term debt that is subordinated in right to the collateral to the first lien debt (Revolver, TLA, and TLB), but typically not subordinated in right to ongoing cash interest payment
Subordinated, usually unsecured debt investment typically seen in middle market (where middle market is defined as companies with annual revenues ranging from $50 million to $1 billion) transactions and often has equity like characteristics (equity co-invest, warrants, options)
We will touch on various subordinated debt investments including mezzanine, subordinated, high-yield debt, holdco, and seller notes
Unitranche LoanA type of facility that combines senior and subordinated debt into one debt instrument where a single blended interest rate is paid to a single lender. Unitranche loans are designed to simplify debt structure and accelerate the closing process. Eliminates intercreditor issues
Commercial PaperAn unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial paper rarely range longer than 270 days
L + 350
L + 350
L + 400
L + 400
L + 500
L + 900
L + 650
12% Cash + 2% PIK + 3%
Warrants
10%-20%
Indicative Pricing
98 Module 3 – Financing the Business Part II Copyright © 2015 Deloitte Development LLC. All rights reserved.
Products Which Provide Credit EnhancementLetter of Credit (operational)• An issuer provides a written commitment, called a
“Letter of Credit” or “LC”, supporting the payment owed by a debtor to a separate creditor, subject to certain conditions stated in the LC. In the event that the debtor is unable to make timely or accurate payment, the creditor or “beneficiary” of the LC can present the LC to the issuer for payment, after which the issuer of the LC would be required to fund the outstanding amount.
• Letter of Credit can be a cheap way to obtain credit enhancement as fees in today’s environment can be less than 1% of the LC amount
• Letters of Credit are frequently used between companies and their vendors, as well as for international transactions where local or common law may be substantially different
• The ability to issue Letters of Credit is commonly packaged under Revolving Credit Facilities used for working capital for companies doing business overseas or that require extended payment terms to their vendors
Guarantee (of debt)• A guarantee is a type of indemnity where the
guarantor promises to repay investors should the primary issuer default on its obligations or fail to provide timely payment
• The primary purpose of a guarantee is to achieve certain terms and conditions for the borrower that would otherwise only be available to a more credit-worthy borrower
• Guarantees can provide savings for the issuer as the credit enhancement can typically provide lower interest rates for securities
• Guarantees can be provided by commercial entities, financial institutions as well as by individuals
• Guarantees can come in several forms:
• Payment
• Financial performance
• Limited
• Unlimited
Second Source of Repayment = Reduced Risk
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• PIK Loans – Loans on which interest is paid-in-kind, or accrued, rather than paid in cash on a current basis
• Subordinated debt with warrants – Loans that contain a type of equity participation
• Convertible debt – Debt that can be converted into equity
• Participating preferred stock – Preferred Stock that participates in the growth or “upside” of the common equity
Examples of Hybrid Capital
102 Module 3 – Financing the Business Part II Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Credit Agreements− Typically for senior/secured/second-lien debt
• Subordinated Debt Subscription Agreements and Indentures− Typically for Subordinated Debt/High Yield Bonds/Hybrids
• Inter-creditor Agreements− An agreement between two lenders with the same borrower
• Stockholder Agreements, Membership Agreements, Stock Certificates− Typically for various equity investments
Major Types of Capital Documentation
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Events of Default • Events that will cause the Borrower to be in default of the agreement and remedies available to lenders after default
Important Sections of a Credit AgreementThe Loans • Description of the loans including: amount, interest and repayment rate
Collateral • Details the collateral pledged as security for the loans
The Guarantee • Details the terms of guarantees being provided by the borrower
Representations and Warranties
• Representations made by the Borrower prior to close
Conditions Precedent
• Conditions that should be satisfied before effectiveness of agreement
Affirmative Covenants
• Actions that the Borrower should take on a go forward basis, including financial covenants
Negative Covenants
• Actions the Borrower may not take on a go forward basis
Administrative Agent
• Detail of the roles of the Administrative Agent in management of the loan
Lender Voting Rights
• Details what % of Lenders may accept Amendments, Waivers and Consents
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• Credit metrics are the principal means to measure performance and risk for a creditor over time
• Metrics provide an objective measure for both creditor and borrower to analyze and provide the basis for continued communication
• Most importantly, metric ranges help lenders determine interest rates and other features (term etc.) and monitor risk of the loan
Credit Metrics Overview
Credit Rating Agencies
• Standard & Poor’s
• Fitch Ratings
• Moody’s
Observations
• Headline metrics are somewhat consistent
• Proprietary metrics and algorithms exist for lenders and agencies
106 Module 3 – Financing the Business Part II Copyright © 2015 Deloitte Development LLC. All rights reserved.
Interest Coverage
Fixed Charge Coverage
Liquidity / Availability
Loan to Enterprise Value
Return Analyses
Leverage
Specific Metrics in Credit Analysis
Ratio of Debt to TTM EBITDA – commonly tested leverage ratios include senior leverage, total leverage, and net leverage; quick test of the level of debt on the Company; helpful in assessing financial condition and in comp analysis
Ratio of EBITDA to Cash Interest – measurement of the companies ability to meet its debt service obligations
Ratio of EBITDA less CAPEX to Fixed Charges (interest, taxes, and scheduled debt amortization) – measurement of the Company’s ability to produce sufficient cash flow to cover its fixed obligations including debt service
Liquidity is availability under the Revolver plus the cash on the balance sheet –measurement of ability to continue to support operations and service debt in the event cash flow from operations is insufficient in a given period
Ratio of debt to enterprise value of the Company – provides an indication of how much deterioration in enterprise value the Company could withstand before the debt becomes impaired
Current Yield, Yield to Maturity, Yield to Call, and Effective Spread – various return analyses to assess whether or not an investment addresses investment criteria and/or the relative attractiveness of one investment vs. another
Credit metrics can be defined in many ways, the definitions on this page are examples.
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Leverage and Loan to Enterprise Value Calculations
Note: In all examples, EBITDA Multiples based an assumed Adjusted EBITDA of $5.0MM
Example Capital Structure #1Commitment Amount % of EV EBITDA MultipleRevolver ($5MM Commit) 0.0 0.0% 0.00Term Loan B 12.5 28.6% 2.50Senior Debt 12.5 28.6% 2.50
Second Lien Term Loan 5.0 11.4% 1.00Total Debt 17.5 40.0% 3.50
Equity 26.3 60.0% 5.25
Enterprise Value 43.8 8.75
Example Capital Structure #2Commitment Amount % of EV EBITDA MultipleABL Revolver ($7.5MM Commit) 5.0 11.4% 1.00Term Loan B 10.0 22.9% 2.00Senior Debt 15.0 34.3% 3.00
Mezzanine 5.0 11.4% 1.00Total Debt 20.0 45.7% 4.00
Equity 23.8 54.3% 4.75
Enterprise Value 43.8 8.75
109 Module 3 – Financing the Business Part II Copyright © 2015 Deloitte Development LLC. All rights reserved.
Summary of Learning Points
• Debt is a critical part of capital structures and is raised for a wide variety of reasons
• Debt capital comes in many forms and from many different types of providers
• Appropriate debt capital for a company is often determined by the company’s stage of development
• Primary debt considerations include: pricing, term, security, repayment terms, availability, and financial covenants
• Financial covenants are common – be familiar with the calculation of leverage, interest coverage, fixed charge coverage
• Debt documents, such as credit agreements, are written contracts containing definitive terms between lenders and borrowers
• Hybrid capital, which has certain advantages, can sometimes replace debt capital
• Companies can hire advisors to help them raise debt or equity capital, usually a 4-6 month process
111 Appendix – Module I Copyright © 2015 Deloitte Development LLC. All rights reserved.
• Established accounting standards promulgated by the London-based International Accounting Standards Board (IASB)
• IFRS is a broad, globally accepted set of accounting standards:− Principles-based approach with a greater emphasis on interpretation and
application of principles− Less extensive body of literature than U.S. GAAP, with limited industry-specific
guidance and less detailed application guidance
• IFRS will require more exercise of judgment, supported by contemporaneous analysis and documentation
• No definitive plan or timeline of mandating IFRS in U.S.
IFRS
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• Corporate attorneys will need to work with management to determine strong documentation of policies, procedures, and protocols to reduce the risk of litigation based upon the application of management’s judgments and estimates
• M&A attorneys involved in the drafting of contracts will need to consider the impact of IFRS on earn-outs, credit agreements, purchase agreements, sales contracts, and bonus plans
• White collar defense and corporate investigation attorneys may see a shift in cases to IFRS based regulatory proceedings
• Malpractice attorneys will need to prepare themselves for the way audits are performed under IFRS
How will IFRS impact attorneys
114 Module 3 – Financing the Business Part II Copyright © 2015 Deloitte Development LLC. All rights reserved.
Commercial Paper Overview
Pricing
Security / Collateral
Potential Borrowers
Cons
Variable pricing linked to LIBOR (e.g. one-month LIBOR plus 3.50%) with an unused fee (e.g. 50 bps on unused amounts); with typically a very small spread based on the short term nature of Commercial Paper as well as based on the typically high credit worthiness of the issuer
Commercial paper is not usually backed by collateral, so only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue. The proceeds from this type of financing can only be used on current assets such as accounts receivable and inventories and are not allowed to be used on fixed assets, such as a new plant
Companies with significant working capital assets inventory and accounts receivable and established access to capital markets may find commercial paper to be a useful funding source for its working capital circumstances
Short term nature of commercial paper requires frequent refinancing and is only available to companies having already demonstrated access to public debt markets
Pros Typically low cost, and does not need to be registered with the Securities and Exchange Commission (SEC) as long as it matures before nine months 270 days
Tenor 30 – 270 days
Repayment Due at maturity
The description of debt security terms above is an example. Actual debt security terms take many forms.
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ABL Overview
Pricing
Security / Collateral
Potential Borrowers
Cons
Variable pricing linked to LIBOR (e.g. one-month LIBOR plus 3.50%) with an unused fee (e.g. 50 bps on unused amounts); the spread and the unused fee will depend on the quality of the Borrower and the return requirements of the Lender (if it is not a “bankable” deal, a higher spread will need to be paid to an alternative investor)
Secured by the working capital assets of the Company; in some cases, lenders will require a lien on the assets of the business; in many cases, there will be a bifurcated collateral package where the ABL Lender will have a first priority secured interest in the working capital assets and a second priority secured interest in the other assets of the business and the Term Loan Lender will have a first priority secured interest in the other assets and a second priority secured interest in the working capital assets
Companies with significant working capital assets (inventory and accounts receivable) and seasonal companies (e.g. consumer products companies, retailers, auto manufacturers) with seasonal builds in working capital
Significant reporting and collateral monitoring requirements
Pros Low cost financing in situations where asset quality is strong and cash flow may be inconsistent
Tenor 3 – 5 years
Repayment Due at maturity
The description of debt security terms above is an example. Actual debt security terms take many forms.
116 Module 3 – Financing the Business Part II Copyright © 2015 Deloitte Development LLC. All rights reserved.
Pricing
Security / Collateral
Potential Borrowers
Cons
Tenor
Revolver
3 – 5 years
Variable pricing linked to LIBOR (e.g. three-month LIBOR plus 4.0%) with an unused fee (e.g. 50 bps on unused amounts); the spread and the unused fee will depend on the quality of the Borrower and will often be tied to a leverage based grid; LIBOR floors are common
First priority secured interest in the assets of the business, generally on a pari passu basis with other senior secured debt (Term Loans); in many cases, the Revolver and Term Loans will be under one Credit Agreement
Companies with strong cash flow that may lack significant “lendable” working capital assets; used for general corporate purposes
Availability subject to meeting financial covenants of loan facility and maturity is often prior to maturity of Term Loans; unused fees
Pros Available low cost liquidity for working capital and/or strategic objectives under a cash flow facility structure
Repayment Due at maturity
The description of debt security terms above is an example. Actual debt security terms take many forms.
117 Module 3 – Financing the Business Part II Copyright © 2015 Deloitte Development LLC. All rights reserved.
Pricing
Security / Collateral
Potential Borrowers
Cons
Tenor
Term Loan A
5 – 7 years
Variable pricing linked to LIBOR (e.g. three-month LIBOR plus 4.0%); the spread will depend on the quality of the Borrower and will sometimes be tied to a leverage based grid; LIBOR floors are common
First priority secured interest in the assets of the business, generally on a pari passu basis with other senior secured debt (Revolver and/or other Term Loans); in many cases, the Revolver and the Term Loan Facilities will be under one Credit Agreement
Companies with strong cash flow capable of servicing meaningful amortization schedules
Significant scheduled amortization strains cash flow
Pros Low cost; smaller, more “club”-like lender groups
RepaymentMeaningful scheduled amortization that often increases each year (e.g. amortization in years 1 through 5 of 5%, 5%, 15%, 25%, 50%, respectively); cash flow sweeps also possible
The description of debt security terms above is an example. Actual debt security terms take many forms.
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Pricing
Security / Collateral
Potential Borrowers
Cons
Tenor
Term Loan B
5 – 7 years
Variable pricing linked to LIBOR (e.g. three-month LIBOR plus 5.0%); the spread will depend on the quality of the Borrower and will sometimes be tied to a leverage based grid; LIBOR floors are common
First priority secured interest in the assets of the business, generally on a pari passu basis with other senior secured debt (Revolver and/or other Term Loans); in many cases, the Revolver and the Term Loan Facilities will be under one Credit Agreement
Companies with strong cash flow
Short tenor; often syndicated to large granular group of institutional lenders that can be difficult to deal with when seeking an accommodation
Pros Low cost; longer term
RepaymentRelatively low scheduled amortization compared to a Term Loan A (1% per year is the norm in the broadly syndicated institutional term loan market); cash flow sweeps are common on TLBs
The description of debt security terms above is an example. Actual debt security terms take many forms.
119 Module 3 – Financing the Business Part II Copyright © 2015 Deloitte Development LLC. All rights reserved.
Pricing
Security / Collateral
Potential Borrowers
Cons
Tenor
Second Lien Term Loan
5 – 7 years
Variable pricing linked to LIBOR (e.g. three-month LIBOR plus 9.0%); the spread will depend on the quality of the Borrower and will sometimes be tied to a leverage based grid; LIBOR floors are common
Second priority secured interest in assets of the business, effectively a third priority interest in situations where an ABL Facility and a Term Loan Facility have first and second priority secured interests in the collateral; a Second Lien Loan is not subordinated to the interest payment of the First Lien Loans (payments cannot typically be “blocked” by senior creditors)
Companies with strong cash flow
Often creates difficult inter-creditor issues due to multiple liens on assets
Pros Lower cost than Mezzanine or Subordinated Debt
Repayment Due at maturity
The description of debt security terms above is an example. Actual debt security terms take many forms.
120 Module 3 – Financing the Business Part II Copyright © 2015 Deloitte Development LLC. All rights reserved.
Pricing
Security / Collateral
Potential Borrowers
Cons
Tenor
Unitranche Loan
5 – 7 years
Variable pricing linked to LIBOR (e.g. three-month LIBOR plus 6.5%); the spread will depend on the quality of the Borrower and typically be a blend of senior and second lien pricing depending on the capital structure and balance sheet assets
First priority secured interest in the assets of the business, generally on a pari passu basis with other senior secured debt (Revolver and/or other Term Loans); in many cases, the Revolver and the Term Loan Facilities will be under one Credit Agreement
Companies with balance sheet assets and strong cash flow that may be looking to only deal with a single lender group and/or simplify their capital structure
Can have limited flexibility should problems arise. May not necessarily result in the “best” pricing terms given the blended nature of the interest rate
Pros Simplified capital structure with a single facility and a single lender. Usually results in a streamlined due diligence and closing process
Repayment Due at maturity
The description of debt security terms above is an example. Actual debt security terms take many forms.
121 Module 3 – Financing the Business Part II Copyright © 2015 Deloitte Development LLC. All rights reserved.
Pricing
Security / Collateral
Potential Borrowers
Cons
Tenor
Mezzanine Debt
5 – 7 years
Fixed rate pricing which usually includes a portion paid-in-kind (“PIK”) and often includes an equity interest (e.g. 12% cash pay plus 2% PIK plus 3% warrants);
Usually unsecured, but subordinated to first lien debt
Middle market companies and LBOs (Leveraged Buy Out)
Higher cost
Pros Available long-term unsecured financing for middle market companies; allows for retention of equity; used often in private equity LBOs
Repayment Due at maturity
The description of debt security terms above is an example. Actual debt security terms take many forms.
122 Module 3 – Financing the Business Part II Copyright © 2015 Deloitte Development LLC. All rights reserved.
Subordinated Debt
Pricing
Security / Collateral
Potential Borrowers
Cons
Tenor 5 – 30 years (depends on Company, situation, and type of Subordinated Debt)
Fixed rate pricing (e.g. 10%) with rate dependent on the quality of the Borrower, relative position in the capital structure to other tranches of subordinated debt (e.g. secured vs. unsecured and senior vs. subordinated), and tenor
May or may not have a secured interest in the collateral, but in the event it has a secured interest, its interest is subordinated to the senior debt and some tranches of subordinated debt may be subordinated to other tranches of subordinated debt; the right to interest payment is usually subject to “blockage” rights held by the senior lenders; public bonds are often structured as senior unsecured notes where the notes are subordinated and unsecured as it relates to the collateral, but the senior lenders do not have the ability to “block” the interest payment on the notes; one form of subordinated debt is Holdco debt, where the obligation is not of the Borrower, but rather an obligation of the Parent – in this case, only permitted distributions from the Borrower to the Parent can be used to service the debt (interest on Holdco debt is often paid-in-kind (“PIK”) or has a PIK toggle option (Borrower can elect to pay PIK or cash interest))
Companies with strong cash flow
Higher cost; riskier capital
Pros Longer tenor; security not required; facilitates more leverage for higher equity returns
Repayment Due at maturity
The description of debt security terms above is an example. Actual debt security terms take many forms.
123 Module 3 – Financing the Business Part II Copyright © 2015 Deloitte Development LLC. All rights reserved.
Sections of a Credit Agreement
• Although the sections and terms will vary by type of debt facility, the following is intended to give a general outline of the sections of an agreement and the terms captured within each section
Cover Page • Date of execution of the agreement• Total commitment of the facilities• Parties to the agreement including:− Borrowers− Guarantors− Arrangers− Administrative Agent
Table of Contents
• Outline of the agreement including:− Sections− Exhibits− Schedules
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The Loans • Detailed description of the borrowing(s) including:− Commitments− Initial and subsequent borrowing procedures− Interest rate (and fees) and calculation method− Schedule amortization, required prepayments, and application of
optional and mandatory prepayments to scheduled payments
Assignment of Collateral
• Details the collateral pledge as security for the loans:− References separate security documents (UCC filings, etc.)− References separate Security Agreement− Describes all lease assignments− Describes circumstances under which lenders will release collateral
The Guarantee • Details of guarantees being provided by the Borrower or its affiliates including:− Borrower(s)− Guarantors− The Guarantee, continuation of the Guarantee, and limitations of the
Guarantee
Sections of a Credit Agreement
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Representations and Warranties
• Being provided by Borrower prior to close including:− No significant adverse changes in the business− Properties are appropriately maintained− Insurance is sufficient and current− Taxes have been paid− Compliance with laws and agreements
Conditions Precedent
• Conditions that should be satisfied before effectiveness of agreement (and funding of initial and subsequent borrowings):− Credit Agreement and ancillary documents executed (including security,
subordination, and inter-creditor agreements, etc.)− Opinion(s) of legal counsel− Certificates delivered (that may be required from the Company, other
lenders, insurance providers, etc.)
Affirmative Covenants
• Actions that the Borrower should take on a go forward basis including:− Reporting requirements− Payment of obligations− Compliance with laws− Maintaining properties (collateral of lenders)
Sections of a Credit Agreement
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Negative Covenants
• Actions the Borrower may not take on a go forward basis including:− Limitations on additional debt and liens− Restricted payments (to subordinated lenders or shareholders)− Limitations on changes to the fundamental business
• Section also includes financial, or “maintenance” covenants
Events of Default
• Events that will cause the Borrower to be in default of the agreement, which provide the lender with the right to take action, including:− Failure to satisfy affirmative covenants (e.g. reporting requirements)− Failure to meet financial covenant tests (covenant default)− Failure to make a principal or interest payment (payment default)
• Section will also include grace periods and remedies available to the lenders after the occurrence of each type of default
Sections of a Credit Agreement
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Miscellaneous • Other important terms and conditions including:− Notice requirements− Assignment procedures− Survival of agreement (binding upon successors)− Governing law− Waiver/Amendment procedures− Lender voting rights (on next page)
Administrative Agent
• Detail of the roles of the Administrative Agent in management of the loan facility including:− Processing payments− Maintaining documentation− Delivering notices− Assignment and participation procedures
• Lenders agree to hold Agent harmless for actions taken as the Lenders’ representation (except gross negligence or willful misconduct)
Sections of a Credit Agreement
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Lender Voting Rights
• Typical “100% Vote” issues include:− Change loan pricing− Extend maturity date− Change amortization schedules− Change voting requirements− Change the “payment waterfall”− Release of the collateral
• Other issues are “Required Lender” issues, typically 50% - 75% vote requirement
• Some documents include some “Super Majority” issues, typically 75% -90% vote requirement
Sections of a Credit Agreement
DisclaimerThis presentation contains general information only and Deloitte is not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor.
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