Raise Equity

Pre Money Valuation

by

[video_lightbox type=”url” style=”3″ auto_play=”Y” auto_buffer=”Y” url1=”” url2=”” width=”720″ height=”405″ placeholder=”http://transcapitalpro.com/wp-content/uploads/pre_money_valuation.gif” placeholder_width=”640″ placeholder_height=”360″ align=”center”]aHR0cHM6Ly8zMjB2aWRlb3MuczMuYW1hem9uYXdzLmNvbS9UQ1B2aWRlb3MvcHJlLW1vbmV5LXZhbHVhdGlvbi5tcDQ=[/video_lightbox]

I was talking with a friend of mine that sits on the board of an angel investor group. He told me that one of the first (and favorite) questions they like to ask presenters is what their “pre-money” valuation is.

Unless you’ve been down this road before, or have been coached, then you might be caught off-guard.

In this short video, which I filmed in my car, I give you the simple formula to calculate your pre-money valuation.

In a nutshell, you take the “Post-Money” valuation and subtract the amount of money you are raising.

Your Post-Money valuation is simply the amount of capital you are raising divided by the amount of equity you are offering.

So for example, if you are raising $500,000 and offering 33% of your company to do that, then:

  • Post-Money Valuation is $500,000 ÷ .33 = $1,515,000 (rounded)
  • Pre-Money Valuation then is $1,515,000 – $500,000 = $1,000,000 (rounded)

How To Price Your Warrants

by

One of the tricky aspects of structuring a private security offering is how to price your warrants, i.e. your equity give-up. The answer (in short): As much as it takes.

There is a price at which your transaction will clear the market.  A price that you pay in equity dilution and the price investors receive for the risk they are accepting.

When you go to market with a private placement, do the math upfront to make sure i) you’re providing your investors with an appropriate return, and ii) that you’re not giving away too much equity. To do that, there are six basic steps:

  1. Determine a base case forecast for the business.
  2. Determine the structure and terms (except for the actual warrant position) of the security you are issuing.
  3. Determine the expected enterprise value at the end of the investment horizon.
  4. Determine the equity value at the end of the investment horizon.
  5. Determine the dollar amount required that results in the targeted IRR.
  6. Divide the result you get in step 5 above by the result in step 4. That quotient results in the percent of equity you will need to make available for your investors.

Let’s walk through an example with real numbers so you can see how this all comes together. But first, some assumptions to frame the example:

  • You are acquiring a business for $5 million, or 4x the business’s EBITDA of $1.25MM;
  • You’ve arranged bank financing of $3MM;
  • You are able to invest $500 thousand of your own money;
  • The financing gap is $1.5MM; and,
  • Your investors will require a 30% IRR.

First you need to determine what your base case is for the business over the next five years. What will you be able to grow the EBITDA to over the next five years – the investment horizon? Lets assume for this illustration that you will be able to grow your business to $1.8MM in five years. Or approximately 7.6% compounded annual growth rate. We’ll also assume that at the end of five years that you’ll still have debt outstanding of $1.2MM (you may have borrowed more to grow your business), and cash of $100K.

Second, you’ll need to determine the terms and structure of the security you will be issuing to your investors (yes, you are issuing a security). Again for illustration purposes, we’ll assume that you will be issuing Preferred stock (the ‘why’ is beyond the scope of this article) in the amount of $1.95MM.

If you’ve noticed that the Preferred issuance is $1.95MM, and not $1.5MM, it’s not a typo. The reason you are issuing $1.95MM is because you, the Sponsor of the transaction, will be investing $450K of your $500K investment alongside the investors. The remaining $50K of your investment will go in as common.

This Preferred issuance will have a five-year maturity, will pay an 8% dividend in cash each year, and will have warrants for some percentage of the common equity of the business; again, the question is how much of the equity?

So, lets look at the math:

– Year 5 enterprise value (or terminal value) is equal to EBITDA times your exit multiple. Lets assume that there is no multiple expansion, so that the 4x you paid for the business is the same multiple for the terminal value. The terminal value $1.8MM x 4, or $7.2MM.

– Equity value is enterprise value, less debt, less preferred, plus cash (unrestricted cash). Therefore, equity value is equal to $7.2MM less $1.2MM (debt), less $1.95MM (preferred), plus $100K (cash), or $4.15MM.

– The IRR your investors are targeting is 30%. Since the investors are receiving 8% of their return in cash dividends, 22% of their return needs to come from the increase in equity value. The math then is $1.95MM (the face amount of the Preferred), times 1.22^5 (that’s 1 plus the 22% in IRR required from the equity build up to the power of 5, which is the maturity of the Preferred). Doing this math results in $1.95 x 2.7027, or $5.27MM.

– From the $5.27MM we subtract the face amount of the Preferred (return the initial investment) of $1.95MM and end up with $3.32MM of equity value that the Preferred investors need to receive in order to receive a 30% IRR (including the Preferred dividend payments of 8%).

– Finally, since we already determined that the expected terminal equity value is $4.15MM, then the Preferred Stock Issuance should end up with 80% of the equity in your transaction in the form of warrants – $3.32MM divided by $4.15MM.

– The remaining 20% of the equity goes to the common equity holder.

So what is the math to you, the Sponsor?

Since $450K of your investment went into the transaction as Preferred, you share in the returns of all the Preferred investors. Your share of the 80% of the equity to the Preferred Shareholders is 23.08% ($450/$1950), or $766K.

Next, since you are the sole common equity holder – the $50K of your total $500K investment – the remaining $830K of equity value ($4.15 – $3.32MM) goes to you for an IRR of approximately 75% (($830/50)^(.2)).

In all, you tripled your money for a blended IRR of 26% – (($766+$830)/$500)^(.2).

There you have it. Pricing your warrants on the back of an envelop in six easy steps.

Using Warrants In Your Private Offering

by

If you’re in the market raising junior capital through a private offering, you will need to understand how warrants are used in structuring your offering. If you are floating a Private Placement of preferred stock or subordinated debt, your investors will expect to have warrants attached to their security.

What is a warrant?

A warrant is a security that gives the warrant holder the right to purchase equity at a specific price, within a certain time frame. Without the warrants, the investor or lender would only receive the dividend yield or interest rate on his shares or loan, hardly compensating him for the risk of making the investment. This equity-kicker is what gets investors excited.

Warrants are usually expressed as a percentage of the “fully-diluted” common stock of the company, which then equates to a certain number of common equity shares.

Fully-diluted refers to the total number of shares that would be outstanding if all conversions take place; e.g. convertible securities, employee stock options, and warrants, including the warrants which are part of your offering.

Warrants will usually have a “nominal” exercise price, also known as “penny warrants”. In the context of a buyout where the majority of the equity capital is in the form of preferred, the common equity will only have a nominal value. In other situations, the common equity may be valued at a higher number in which case i) the warrants will have an exercise price at the market value of the common equity, or ii) the warrants will have a nominal price, but the number warrant shares will be less.

As you structure your transaction and write your Private Placement Memorandum, you should become familiar with some terms that you’ll need to include in your term sheet:

Anti-dilution rights protect the warrant holder from equity dilution from a subsequent issuance of shares at a price lower than what the investor originally paid.

A simple example – suppose an investor received warrants for 20% of the equity for a preferred investment $1 million. If the Issuer subsequently issued another $1 million of preferred with warrants for 30% of the equity, the first investor would be diluted from 20% equity to 14% equity if there were not any anti-dilution protection language.

There are a number of ways to address anti-dilution, but that discussion is beyond the scope of this article.

Demand and piggyback registration rights refer to the right of the warrant holder to register his warrant shares for public issuance. The difference between the two types of registration rights is that Demand registration allows the holder to initiate the registration of warrant shares for public issuance. Demand registration is usually reserved for majority warrant holders, or warrant holders who have a significant ownership. Piggyback registration means that the warrant holder may have his warrant shares registered along with another holder or the company if there is a registering of the company’s shares. Piggyback rights are for the benefit of minority investors, as only the majority investors will have Demand registration rights.

Tag-along rights give a shareholder the right to join in a transaction to sell his shares if another shareholder is selling his stake.

Preemptive rights give shareholders the right to purchase new securities being issued by the company prior to them being issued to new, outside investors. In the dilution example above, a preemptive right would have given the first investor the right to purchase a proportional amount of the new issuance to preserve their equity ownership.

Note: since there would be an anti-dilution provision in the shareholders agreement, the anti-dilution provision would require waiver by the shareholders to proceed with the new issuance.

A Put Option allows the warrant holder to “put” the warrant back to the company. When the warrant is put to the company, the company has an obligation to purchase the warrant back from the investor. It is a way for the investor to monetize the value of his equity stake. The price that the company pays for the warrant is the product of the equity value of the company and the percent of the fully-diluted equity represented by the warrant shares.

A Call Option is a way for the company to “call” in the claims on its common equity. A company may call its equity back from investors if it anticipates an increase in the value of its equity down the road. It is also a way for the company to consolidate ownership back to, say the sponsors of the transaction.

I had a situation once where an investor requested that we eliminate the Call Option. His rationale was that he wanted to ride the value and did not the equity value get called away from him.

There are no rules for the number of years for the investor to have its Put right, or the Issuer to have its Call right, except that typically the advantage is to the investor with the Put right occurring before the Call right. My experience is that Put/Call rights will usually occur in years 4/5 or 5/6.

The issue you will face will be determining the value of the equity if and when the Put or Call gets exercised (except if there is a sale of the company to an unrelated third party).

I have been in transactions where the equity value for the purposes of the warrant was negotiated upfront as the greater of i) a liquidity event (such as a sale) or ii) a formula.

For example, if the original transaction was valued at 5x EBITDA, then the valuation for the Put/Call was also 5x EBITDA. Keep in mind that the product of a multiple and EBITDA gets you to an Enterprise Value, which is not the same thing as the equity value. To get to equity value, you’ll need to subtract debt and add cash (unrestricted cash).

My experience is that if there is no predetermined formula, the value of the warrant is usually negotiated. The “fair market value as determined by a …” language is for when you can’t agree; however, you should always have this language even if you have a formula.

As the Issuer you may find that the formula is based on the just-ended fiscal year, but by the time the audit gets completed, there might have been a material adverse change in the business such that the agree-upon formula overstates the value of the equity. Conversely, if you are the investor, events subsequent to the audit may point to a significantly higher equity value than what would be indicated following a formula using the year-end numbers.

Warrants are just another tool that help you raise the capital you need. The trickiest part of the whole warrant conversation will be anti-protection. As the Issuer you will want to run through a variety of scenarios to make sure you understand how your value will be impacted when anti-dilution triggers kick in.

Warrants

by

A Warrant, also called a Stock Warrant, is a certificate that entitles the holder (the person to whom the Warrant is issued) to purchase a certain number of shares of common stock, at a stated price, for a specified period of time. Warrants are the equity kicker which investors require to target their expected return Without the warrant, the return would be equal to the interest rate or dividend.

The amount of Warrants offered represents how much equity dilution you are taking, or how much equity you are giving up. The amount of equity you give up is a function of the investor’s expected return, which takes into account the dividend or interest rate, whether the dividend or interest is paid currently or accrued, and the value of the common equity at the end of the investment horizon.

Exercise Price

The exercise price of a warrant is the price at which the warrant holder pays for the common stock. In a private transaction, the exercise price warrant can be set at any price, and is typically set at $0.01 per share. A higher exercise price just means that the investor will require more shares to achieve the targeted return.

Cashless Exercise

A cashless exercise feature is a way to convert the warrant shares into common equity without writing a check. For example, if you have 5,000 penny warrants and the market value of the common equity is $5.00 per share. You would use 10 shares as currency to purchase your 5,000 shares at $0.01 per share, or $50.00. Your net proceeds would then be $24,950, or (5,000 – 10) x $5.00.

Put/Call Feature

Warrants will typically come with a Put/Call feature. The Put feature allows the warrant holder to monetize his investment by forcing the issuer to redeem the warrant. The Call feature allows the issuer to buy the warrant shares away from the warrant holder, which can be useful if the issuer believes that the value of the equity will be greater than it is at the time the Call is exercised.

The right to Put the warrant shares back to the issuer typically becomes available to the warrant holder any time after five years. The Call rights of the issuer will typically become available 12 months later, or after year six in this example if the Call is available after year five.

The Put or Call of a warrant is completed at the market price, which is tricky to say the least for a private company where the common equity is not traded. The Warrant Agreement should have language that either 1) predefines a formula to determine the value of the equity, or 2) provides for a process to determine the value of the equity.

Predefining the value of the warrant is straight forward, the simplest is assigning a multiple to the then-current EBITDA to arrive at an enterprise value. From the enterprise value subtract all debt and preferred stock, and add unrestricted cash to arrive at the equity value. The “exit multiple” is usually the “going-in multiple”. The downside of this methodology is that someone is potentially leaving money on the table; i.e. the company may be worth more or less than the value suggested by the formula.

Providing for a process to value the equity comes down to the hiring of a valuation firm to determine the value of the equity. In the event one of the parties disagrees with the value determined by the valuation firm, the warrant agreement should provide for a resolution that will usually allow for the dissenting party to hire a second valuation firm. If there is still disagreement, then the two valuation firms will hire a third firm with a final value determined by taking the average of all three valuations.