Sophie Manigart. Olivier Witmeur

Transcription

1 GROWTH CAPITAL AND BUY-OUTS GUIDE FOR BELGIUM Sophie Manigart Tom VANACKER Olivier Witmeur

2 The English-language version of this guide was made possible by the kind support of Stibbe to the Belgian Venture Capital & Private Equity Association vzw/asbl. Stibbe is a leading full-service multi-specialist law firm in the Benelux. With over 350 lawyers worldwide, among whom 71 partners, we advise both national and international clients from both the private and the public sector. Our expertise and unique approach in bringing together specialists from specific areas of law ensure a quick processing of each file. They represent a broad spectrum of sectors, including finance (banking, investment funds, private equity). Brussels Amsterdam Luxembourg London New York Dubai

3 FOREWORD Dear Reader, Private equity is a field that often remains obscure or baffling to society at large. Nevertheless, private equity plays an important role in the development of companies. Private equity or venture capital is funding that our sector makes available to companies in order to provide them with mid to long term support. In Belgium, the sector invests in some 200 projects each year, providing capital and equity to companies with the primary emphasis being on sustainable growth. Last year, the BVA published a guide covering the sector of venture capital, in other words, the financing of very young companies in their initial years, quite often with a significant technological component. This year, we have written a new guide that is focussed on the way that private equity helps mature companies by providing capital for growth and for financing buy-outs. The sector typically works in partnership with our highly dynamic SME segment as well as even larger companies. This guide was written by respected academics from the Vlerick Leuven Gent Management School, Ghent University and the Solvay Brussels School, who explain the concepts in clear, simple terms. The purpose of the guide is to demystify private equity for company directors and their advisors. On behalf of the non-profit Belgian Venture Capital & Private Equity Association (the BVA ), I hope you will find it useful! Koen Dejonckheere Chairman of the Belgian Venture Capital & Private Equity Association vzw CEO Gimv Guy Geldhof Secretary-General of the Belgian Venture Capital & Private Equity Association vzw Growth capital and Buy-outs Guide for Belgium For more information on the BVA and its activities, please visit the website 1

4 This guide was written by Dr. Sophie Manigart, Dr. Tom Vanacker and Dr. Olivier Witmeur with the support of the non-profit Belgian Venture Capital & Private Equity Association. If you have any questions, please feel free to contact us at Sophie Manigart Sophie Manigart is a Partner at the Vlerick Leuven Gent Management School where she holds the Gimv Chair in Private Equity and she is also a professor at Ghent University. She specialises in corporate finance (angel financing, venture capital and private equity) and has written numerous articles and books on the subject. Her additional activities include a position on the investment committee of the Baekeland Fund II (investment fund for spin-offs of Ghent University). Tom Vanacker Tom Vanacker works as a postdoctoral researcher for the accountancy and business finance research group at Ghent University. He received his PhD in Applied Economics from Ghent University in 2009; during this period, he also spent a year as a research fellow at the Carlson School of Management (University of Minnesota). His research is chiefly focussed on the relationship between the financing and growth of non-publicly traded companies. 2

5 Olivier Witmeur Olivier Witmeur is a professor at the Solvay Brussels School of Economics and Management (ULB) where he holds the Bernheim Chair in Entrepreneurship. He is specialised in strategies for the establishment, growth and financing of emerging companies. He is also chairman of the Council for Science Policy of the Brussels Capital Region and is on the board of various companies. Previously, he was an entrepreneur in a strong growth company and director of the EEBIC, an incubator for innovative companies in Brussels. Growth capital and Buy-outs Guide for Belgium 3

6 contents FOREWORD p INTRODUCTIOn p WHAT IS GROWTH, EXPANSION OR DEVELOPMENT CAPITAL? p WHAT ARE BUY-OUTS? p the investment process and the search for suitable investors p introduction TO THE CHIEF VALUATION TECHNIQUES p Financial instruments used by private equity p the role of private equity investors after the investment p THE WITHDRAWAL OR EXit p A FEW EXAMPLES p. 50 BIBLIOGRAPHY p. 52 4

7 INTRODUCTION A tiny minority of all companies are responsible for a disproportionate share of the innovation, job growth and value creation within an economy. One of the most challenging activities for growth-oriented entrepreneurs is obtaining sufficient and appropriate financing to support their ambitions for growth. Financial resources are after all essential for growth-oriented entrepreneurs in order to be able to invest in tangible assets, intangible assets and working capital. A good knowledge of various financing alternatives is crucial for securing efficient financial resources and arriving at a financing mix that meets the needs of both the company and its owners. Insufficient knowledge of or misconceptions about certain financing alternatives can lead to a suboptimal financial structure. In turn, this can result in limited prospects for further growth, financial difficulties, tensions between the various financiers or shareholders, and even bankruptcy. The goal of this guide is to provide entrepreneurs and other interested parties (such as accountants, bankers, consultants, politicians or government officials) with a better insight into the role that private equity can play as a financing alternative for supporting the growth of companies or the transfer of their ownership. Private equity financing is a medium-term (quasi) equity financing for non-publicly listed companies with high growth potential. The role of private equity investors is not restricted to providing financing, they also function as an active partner for the entrepreneur. They can provide strategic or operational advice, or actively mobilise their network on behalf of the companies in their portfolio. However, many myths persist about private equity. Private equity financiers are idealised by some as the ultimate saviours of our companies, whilst by others they are decried as ruthless predators only out for quick profits. That is why the aim of this guide is to present a realistic picture of the functioning of private equity investors and to dispel a number of popular misconceptions. Figure 1.1. gives an overview of the various forms of private equity in function of the developmental phases of a company. Private equity not only entails equity financing for start-ups, but also financing for the subsequent phases as a company develops. Growth capital and Buy-outs Guide for Belgium 5

8 Figure 1.1. Developmental phases of the company and the role of various forms of private equity financing Sales Profit/loss Cash flow Product development Initial commercial activities Market penetration Product maturity Seed phase Start up and initial growth phase Rapid growth phase Maturity phase Venture capital Growth capital Buy-outs Time 6 Source: Smith & Smith (2000) Entrepreneurial Finance.

9 In a previous guide Venture capital guide for Belgium the focus was on venture capital, which is only one aspect of private equity. The goal of the first guide was to offer beginning and young entrepreneurs greater insight into the functioning of venture capital investors. This guide is focused on the role and use of private equity in more mature companies. There are times when healthy, established companies can also need an injection of external equity, for example when they wish to develop new products and bring them to the market, or when they want to tap into new (international) markets or to grow by means of takeovers. Private equity financing can also facilitate the takeover of an established company by the existing management team or by a new one - known as a buy-out and finally, the buy-out of a (minority) shareholder, for example one branch of a family, can also be realised with the help of a private equity investor. Are there alternatives aside from private equity? Of course there are. Three of the commonly used alternatives for financing growth are self financing, obtaining financing from banks, or collaborating with an industrial partner. CAN PRIVATE EQUITY HELP YOU TO REALISE YOUR AMBITIONS? Are you prepared to allow third parties to share in the decision-making on the strategy for your company? Do you have the ambition to grow and create value with your company? Is your team willing to follow you in your plans? Does the management team have sufficient experience? Do you have a well thought out business plan? Is there a realistic exit option for the financial shareholders within a few years? Do you wish to leave your company yourself? If you have answered yes to the majority of the above questions, then private equity would appear to be an appropriate financing method for realising your ambitions. Self financing An entrepreneur may choose to use the resources generated internally to finance the growth of the company in a way that is fast and straightforward. This is probably the simplest form of financing. An entrepreneur can also invest personal resources or call upon family or friends. One disadvantage of limiting equity growth to the profit reserves is the limiting effect this can have on the growth of the company. After all, growth also automatically means that the company will need to invest in tangible assets and in working capital. If the profit Growth capital and Buy-outs Guide for Belgium 7

10 reserves fall short of the required investments, the company runs the risk of growing faster than its financial capacities allow, which can result in an imbalanced financial structure and ultimately, financial difficulties. The advantage of private equity investors is that larger amounts can be made available, which allows a greater increase in equity, so that more investment and faster growth can be realised. Bank financing Bank financing is probably the most frequently used form of financing for companies, which are not listed on the stock exchange. However, bankers limit their loans to the company s maximum borrowing capacity, which is determined on the basis of the cash flow the company generates in its day-to-day activities. What s more, bankers will generally require guarantees: either business guarantees based on the company s property, or personal guarantees. For companies with limited borrowing capacity, which possess little or unsuitable property (such as intangible assets) or for entrepreneurs who have already made significant (financial) commitments with their company, it can be difficult to obtain additional banking financing for new growth plans. A private equity investor, however, provides share capital. This leaves the debt bearing capacity of the company intact, and no guarantees are required. Industrial partners There are various ways in which an industrial partner can help to finance growth. A company can establish joint operating contracts with an industrial partner, for example for research or distribution, whereby its own investment remains small. But an industrial partner can also participate in the capital of another company, if this potentially represents a strategic added value for it. By becoming a shareholder, an industrial partner can, for example, be exposed to new areas of research or markets and market trends that it is not actively exploring itself. In this type of transaction, the strategic added value is often more important than the hoped-for financial returns. 8

11 2 WHAT IS GROWTH, EXPANSION OR DEVELOPMENT CAPITAL? An established company can turn to private equity in order to support its growth. Typically, a company will first use its internal resources to finance investments. If it has more projects than it has cash, then the company seeks banking or other forms of credit. However if its debt bearing capacity has been expended, whilst attractive investment opportunities remain, then an injection into the equity is desirable. The company needs to carry out a capital increase and issue new shares. This capital can come from various parties, including the existing shareholders, industrial partners, or the capital markets. Private equity financiers are another alternative. Typically, private equity financiers look for established companies that have a proven track record. This may include companies with a strong management team, a strong market position and good, stable cash flows from their operations. Growth opportunities, either through internal growth, or through takeovers, are essential. These opportunities may be situated in innovative sectors, but they can also be found in quite traditional sectors. A strategy for growth through takeovers can be highly attractive, for example, in a mature but fragmented sector, where a company that is supported by private equity is able to buy up multiple smaller competitors thus expanding its scale. Thanks to this expansion, economies of scale can be realised, allowing the company to then outperform any remaining competitors. This is referred to as a buy-and-build strategy. Once a company has established a strong local position in this way, further growth can be realised through international expansion, which may be focused on new growth markets. In addition to a capital increase, the introduction of private equity financiers may also be driven by the desire on the part of several shareholders to sell their shares. In this way, private equity can offer a solution for the transfer of family businesses, whereby some of the shareholders wish to remain active but others prefer to sell their shares. If the value of the sellers shares is more than the remaining shareholders are capable of paying, then a private equity financier can purchase (a part of) the available shares. In this case, there is no capital increase and the company s resources are not increased. Generally, private equity investors are only interested in this type of operation if the company offers considerable prospects for growth. Often, in these companies, there is sufficient debt capacity (specifically a relatively low debt position compared to the working cash flows generated by the company) to finance the future investments through debt. Of course the private equity player itself can make additional growth capital available to the company. Finally, private equity can also offer a solution for companies in trouble. Typically, these companies have fewer resources than they are required to repay to their creditors. These companies will first seek internal solutions to their problems, by restructuring their operations or selling assets. They will also attempt to take out new loans to finance the repayment of their old debt, or reschedule their debts. However, this strategy is Growth capital and Buy-outs Guide for Belgium 9

12 not self-evident: few creditors will be prepared to finance a company in difficulty. In such cases, private equity can again offer the solution. The company will carry out a capital increase, whereby private equity financiers subscribe to the new shares. Obviously, the capital increase will take place at a lower price. If the reorganisation is successful and the company faces renewed prospects for the future, then the private equity financier stands to realise a tidy profit. 10

13 3 WHAT ARE BUY-OUTS? DEFINITION, TYPES AND FORMS OF BUY-OUTS 3.1. Definition In a buy-out transaction, a manager or management team takes over a company and thereby acquires a significant interest in the company s capital. The company being taken over may be a family business, which no one within the family is prepared to carry on, or a publicly listed company (what is known as a public-to-private transaction), but may also be a division of a larger company. The simplest and most common way of financing a buy-out is to supplement the manager s own resources with bank credit. Primarily smaller transactions are financed in this way, without the term buy-out being used. For larger transactions, the amount of financing that can be put together between the management and banks will be insufficient to pay the price of the takeover. That is why most medium-sized to large transactions are financed with a combination of own resources, credit, and private equity. An aspect that is specific to the Belgian context is the absence of very large private equity funds. The consequence of this is that the largest buy-out deals are generally not financed by Belgian funds but rather by foreign funds. Figure 3.1 illustrates how a buy-out is typically structured. A new company is created especially for the transaction (Newco); this company buys the target company. The target company s shares may be purchased, or all (or a selection of) its assets. In order to finance the purchase, Newco raises various forms of financing, made up of share capital (ordinary share capital, preferred share capital, etc.) and debt capital (traditional debt, mezzanine debt, etc.). Share financing is typically contributed by the management and private equity investors, but the seller may also take a partial interest. Debt financing is contributed by financial institutions such as traditional banks, but also by mezzanine financiers. For other forms of debt financing (such as, for example, high-yield bonds) the public capital markets, or the seller ( vendor loans ) can be engaged. In Figure 3.1, it is assumed that Newco purchases the target company s shares ( shares transaction ). This involves taking over both the assets and liabilities. Once the transaction is completed, Newco can merge with the target company or continue to exist as an independent company (holding) that owns the shares in the target company. The decision to merge or remain independent will be determined by legal, financial and fiscal aspects. Sometimes only the assets or a part of the assets of the target company are taken over ( asset deal ). In this case, Newco becomes the new direct owner of the assets Types of buy-outs There are different kinds of buy-outs. There are, however, no clear divisions and different names are often used interchangeably. Buy-outs are categorised according to the main buyers and the financial structure of the transaction. Growth capital and Buy-outs Guide for Belgium 11

14 Figure 3.1. The typical structure of a buy-out transaction SOURCES OF DEBT CAPITAL Banks Institutional investors Seller Public capital markets SOURCES OF SHARE CAPITAL Management Private equity investors Seller DEBT Traditional debt Mezzanine debt High-yield bonds EQUITY Ordinary share capital Preferred share capital Shareholder loans NEWCO TARGET COMPANY Management Buy-Out A Management Buy-Out (MBO) is a buy-out in which the present management of the company to be taken over is the driving force in the purchase. The management plays a crucial role in the negotiations with the seller(s), potentially together with external investors, and typically acquires a significant percentage of the shares in Newco. Depending on the financial contribution of the management and the value of the target company, they will have either a minority or majority interest in the capital. The existing management team is often best placed to further develop the company since they possess the business specific knowledge. The success of the MBO therefore largely depends on the input of the management. Management Buy-In With a Management Buy-In (MBI) an external management team acquires control of the company to be taken over after the buy-out. The generally small management team that takes the lead in a management buy-in typically consists of individuals who have had a successful career in the target company s industry. The management team does not generally take the initiative for the transaction 12

15 itself, but it is put together by private equity investors after negotiation with the sellers(s). It can also occur that managers from outside the company purchase the target company together with (a part of) the acting managers; this becomes what is known as a buy-in management buy-out (BIMBO). The transaction structure of a management buy-in is equivalent to that of a management buy-out. Management buy-ins are riskier than management buy-outs, however, because the management team taking over does not yet have any experience in the target company. The advantage of a management buy-out is that the acting management team in the target company has a more detailed knowledge of the company. With a management buy-in, the external managers typically don t have access to the same information before the transaction, which means that a number of problems may arise in the company that has been taken over only after the fact. The advantage of a management buy-in is that a new vision of the activities is brought in, enabling new strategies to be explored. Leveraged Buy-Out A Leveraged Buy-Out (LBO) is a buy-out that is financed with a large debt package. Most buy-out transactions are partially financed through debt, but proportionately, in a leveraged buy-out, a greater amount of debt is used. In transactions involving a lot of debt, private equity investors will typically play an important role in negotiations with both the seller(s) and the debt financiers in order to devise an optimal financial structure. Both the private investors and the creditors will ensure that they have control mechanisms in place that allow them to intervene if the management does not perform as expected. Creditors will not only demand guarantees but will also look at the size and the stability of the cash flows of the company to be taken over, since these are necessary in order to pay the interest and principal repayments. In order to limit the risk for the creditors, restrictive clauses form an integral part of the borrowing contracts. Other types of buy-outs A Management-Employee Buy-Out (MEBO) is a buy-out transaction in which, along with the management, a significant portion of the employees becomes shareholder as well. The employees will typically hold a minority interest. In an Investor-led Buy-Out (IBO) an institutional or private equity investor will assume leadership over the transaction and take over the target company directly from the seller(s). The investor can either retain the existing management within the target company or opt to engage a new management team Origin of buy-outs Buy-outs may originate in different situations. An overview of the major sources is presented below. Succession within family businesses Management buy-outs often form a solution for succession issues in family businesses when the owners or founders decide to leave the company. If no one within the family has the necessary capacities or is prepared to take charge of the company, the family may choose to sell the company to the management. Divestment of a division Buy-outs also frequently occur when companies Growth capital and Buy-outs Guide for Belgium 13

16 wish to divest themselves of an activity. There are different reasons why companies or holdings may decide to sell certain components. When companies revise their strategy, certain parts of the company may no longer fit within the picture. Companies may also have problems with their operations, leading to cash flows that are no longer sufficient to meet their debt obligations. In this way they are forced to sell off certain activities or components in order to improve their cash position. Furthermore, competition legislation may require companies to sell certain parts. Buy-outs as a consequence of divestment are often driven by the entrepreneurial spirit of the management. Managers in a large company often see valuable opportunities within their unit, but are sometimes unable to pursue them due to a relatively inflexible structure or the non-strategic nature of their unit. In that case, a buy-out can offer the potential to these managers to develop these opportunities. Public-to-private transaction In a public-to-private transaction, the management or a private equity investor makes a bid for the shares of a publicly listed company in order to then take the company off the stock market. Given that the transaction value is typically high, these transactions are often characterised by a great deal of debt financing. Since the management itself acquires a significant percentage of the shares, the private equity investors retain oversight of the management and the free cash flows must be used to service the high interest payments and principal repayments, after the transaction there will be a strong discipline to work highly efficiently and in such a way as to create value. Public-to-private transactions can also offer a solution for small, publicly listed companies in which the shares are often non-liquid, and which are therefore not very attractive to institutional investors. This often makes it difficult for these companies to raise additional financing to support further growth. The shares of these companies are also often undervalued, which offers the opportunity to purchase the shares at a good price. The withdrawal of a different financial investor ( Secondary ) A secondary buy-out takes place if a buy-out company performs a second buy-out sometime later in order to offer a way for existing investors to withdraw. The existing investors thus have the opportunity to sell their shares to new financial investors. Secondary buy-outs are becoming more frequent and currently form an important exit mechanism for the initial investors. 14

17 4 THE INVESTMENT PROCESS AND THE SEARCH FOR SUITABLE INVESTORS How should an entrepreneur proceed to attract private equity? The process is similar for both growth financing and a buy-out transaction. In the first place, a business plan needs to be drawn up. A welldesigned business plan is a conditio sine qua non for convincing investors. Then, it is important to identify a suitable investor. Later on in this chapter, a short overview will be given of the different steps in the negotiations with private equity investors once you have gained their attention. We shall also briefly discuss the role of other parties in addition to the managers and private equity investors in the financing process. Table 4.1. shows a summary of the various steps in the investment process from drawing up the business plan to the ultimate investment. Table 4.1. the various steps in the investment process Phase Entrepreneur Entrepreneur and PE investors Search for investors / evaluation business plan Initial negotiations Due diligence Final negotiation Closing / investment - Drawing up business plan - Appointing advisers - Contacting Investors - Providing additional information - Providing all relevant information - Discussing business plan - Making contact with banks - Developing relationship - Drawing up draft term sheet - appointing accountants and advisors - Negotiating with banks - Negotiating final term sheet and shareholder agreement - completing the administrative formalities PE investors - Reviewing business plan - Thorough analysis of the business plan - Valuation - Financial structure - Starting up external due diligence - Drawing up necessary documents Growth capital and Buy-outs Guide for Belgium Source: BVCA/PWC (2003) A guide to private equity. 15

18 4.1. Business plan Attracting private equity financing starts with creating a sound business plan. A business plan is an analytical instrument that systematically charts the different variables that determine the success of the company. Essential parts include the entrepreneur s team and their experience, the opportunity, the market, the competition, etc. The business plan is a crucial document for a number of reasons 1. It forces the management to establish concrete goals. It is a strategic and operational aid that shows how everything will be organised by breaking the project down into a number of clearly identified steps (known as milestones). It is a financial tool that contains the prognosis for the financial performance and the need for liquidity. This is also the point of departure for the valuation of the company. A financial plan is therefore only a part of the business plan; it is the financial translation of the intended strategy and its operational implementation. It forms a communication tool for convincing potential financiers to invest the money that the company will need. That is why the business plan is a central document in negotiating with investors. Each year, Belgian private equity investors receive hundreds of business plans, whilst they end up financing just a few of them. So attracting the attention of an investor is certainly no easy matter. An executive summary is therefore an essential part of any business plan. The entrepreneur must be able to express in the space of two pages, in specific and non-technical terms, what the company does, its objectives and how these objectives will be realistically met. Although the executive summary is placed at the front of the business plan, it will be the last part that is written since it forms a summary of the entire business plan. The appeal of the executive summary will often determine whether or not the investor will be inspired to read the rest of the business plan in detail. BEAUTY CONTESTS Despite the fact that private equity investors are highly selective, it often happens that private equity funds are forced to compete with one another in order to invest in the best buy-out companies and the best management teams. Sometimes intermediaries organise beauty contests, in which a limited number of private equity investors are invited to make a bid based on the business plan. Detailed due diligence and negotiations are then only pursued with the private equity investor that has made the best bid. This often affords entrepreneurs greater choice and more negotiation power to find the most suitable financiers in light of their growth ambitions. However, Beauty contests are never used when it is a matter of investing in young companies by venture capital financiers, because the specific sectoral knowledge of the investor and a thorough knowledge of the project are crucial for investing in this type of company Although the business plan is an essential document, we shall not go into detail here about how to draw up a business plan. At the back of this guide a number of excellent references are provided concerning business planning.

19 4.2. Identifying suitable investors Private equity investors are highly selective and invest in just a fraction of the companies that request financing. Selecting the most promising companies and best management teams is therefore an essential skill for successful private equity investors. Investment opportunities that do not fit within the investment strategies of private equity investors are typically ruled out immediately. Private equity investors tend to focus on specific phases in the development of a company, specific sectors, or specific geographical locations. Moreover, they also establish a minimum and maximum investment amount. A targeted search for financiers whose investment criteria match the characteristics of the company is therefore important. Phase in a company s development cycle Some private equity financiers apply a broad investment strategy and invest in all phases of development. Others focus exclusively on companies in a certain developmental phase, such a young companies (venture capital), established companies or buy-outs. Sector Suppliers of growth capital or buy-out financing are not generally likely to exclude many sectors. Nevertheless, they may have a preference for companies within certain sectors. In that case, (a part of) the investment company s management team consists of sector specialists. In fact, in addition to financing, private equity investors provide other services such as strategic and operational advice and access to their networks. The added value that investors can contribute will typically be greater when the investment managers have built up sector specific experience. There is no question that it is hardly productive for an entrepreneur to appeal to private equity financiers who do not wish to invest in the company s sector. An investor with limited sectoral experience may however later on invite investors with more relevant experience and networks to form an investment syndicate and invest in the company jointly. Geographical location Providers of risk capital typically have a geographical preference ranging from regional investors, national investors, investors with a European focus to worldwide investors. For certain companies, it can be important to seek private equity investors from beyond the national borders. In this sense, companies who are looking to attract growth financing to support their internationalisation strategy may find it advantageous to attract strong foreign investors. They may, for example, be able to contribute relevant information about the intended international market, or offer access to their networks or give the company greater legitimacy towards employees, clients or suppliers abroad. On the other hand, it is more difficult for foreign investors to be closely involved in the development of the company, as the greater distance inevitably leads to communication challenges. Bringing together a syndicate that is made up of both local and foreign investors can be a way to combine the best of both worlds. Moreover, a strong national investor is often a conditio sine qua Growth capital and Buy-outs Guide for Belgium 17

20 non for attracting a strong international investor. The local investor then functions as a bridgehead for the international investor. Investment amount Private equity investors carry out a thorough screening before investing. Also after the investment, they remain closely involved, since they want to maintain control over the policy and wish to make their knowledge and networks actively available. It is clear that all of this involves fixed costs (Costs that do not vary depending on the amount of financing required), which can only be recuperated if the invested amount and the potential returns are large enough. That is why risk capital providers are only interested in investing larger amounts. It is very difficult to find a private equity investor for a project requiring capital of less than several million euros unless the potential returns are exceptionally high. For smaller amounts, entrepreneurs should call upon other financiers. Private equity investors will also define a maximum investment amount, as they want to spread the risk for their portfolio. Smaller investors for example, will want to invest a maximum of 10 percent of their investment fund in a single company. Again, it should be pointed out that an investment syndicate bringing together various private equity investors who jointly provide the necessary financing, can form a solution here. After all, this allows them to jointly invest a greater amount in a company. The largest Belgian buy-out deals, however, are often done by foreign private equity investors, since the Belgian investors are too small to finance the largest deals. Some foreign private equity investors do however have branch offices in Belgium. Even if the characteristics of the company match the investment criteria of the private equity investor, it remains a challenge to raise private equity financing. The complete process takes a long time and there are no guarantees for success. Below, we shall discuss the negotiation process between the entrepreneurs and private equity investors after an entrepreneur has attracted the initial interest of an investor Deal structuring Entrepreneurs often underestimate the time required by negotiations with private equity investors. In its entirety, the process from the initial contact up to the final investment takes at least three months, but on average it takes approximately half a year. This, however is an average, and depending on the economic situation, the process can also take much longer. It is therefore important to start searching for private equity financier well ahead of the time when the financing will effectively be needed. Although private equity investors have their own ways of working, they generally follow the steps presented below. When the business plan has aroused the interest of a private equity investor, the entrepreneur is invited to give a brief presentation of the project. The purpose of this is to explore whether the initial expectations are confirmed, and to get to know the people behind the initiative. If all goes well, a number of follow-up meetings are usually held in which the various aspects of the business plan are 18

21 reviewed. The investment manager will especially scrutinise the assumptions on which the business plan is based. The financial aspects will also be discussed. An initial evaluation is necessary to establish the percentage of the shares that the investor will be able to claim. Based on these meetings, the investor will indicate whether it is an attractive project, in principle, which is referred to as the viability decision. When this decision is positive, it will result in a nonbinding letter of intent and the thorough due diligence research will begin. Since a due diligence process involves many costs, an investor will request exclusivity from the entrepreneur. It is up to you to decide whether or not you wish to grant this. In the due diligence process, the project is thoroughly investigated, both by the investment manager and by external technological, industrial, accounting, financial or legal experts. The process involves, but is not exclusive to: Management due diligence: verification of the motivation and reputation of the key players within the company. Commercial due diligence: research into the company s products and customers and the markets in which the company is active. This may be supplemented by a market study. Financial due diligence: research into the historical financial data of the company, the real value of its assets, and taxes owed or other financial commitments. Legal due diligence: this will typically focus on the implications of ongoing disputes, the property rights to assets and intellectual property rights. The insights gained through the due diligence process may form the basis for readjusting the business plan. If the result of the due diligence is positive, then the chief conditions for the investment will be discussed, and usually set down in a term sheet. Thus, for example, the valuation of the company as initially agreed upon during the first phase of negotiations may be adjusted based on the new information obtained during the due diligence. In addition, the term sheet contains the stipulations concerning the financial structure of the investment, the control of the company, such as the composition and functioning of the Board of Directors, the compensation for the management team or the desired exit arrangements. The stipulations of the term sheet will be further elaborated later in the detailed investment contract. Once an agreement has been reached about all aspects of the term sheet, this is followed by the closing. The investors will carry out the final formal controls and necessary legal steps will be taken, such as modifying the articles of association and drawing up a detailed investment contract including a shareholder agreement. Only when all of these steps have been positively concluded, can the investment take place. Up until the last moment, any mishap may derail the entire investment process. Growth capital and Buy-outs Guide for Belgium 19

22 NEGOTIATIONS WITH BANKS Particularly in buy-outs, in addition to private equity investors and the management team, banks will also play a crucial role. In smaller transactions, a single primary banker will be sufficient, but for larger transactions, multiple banks will form a syndicate and generally provide financing according to similar terms. Together with the private equity investors, the management will present a business plan to the bankers. Given the extensive experience of the private equity financiers, they generally maintain good relations with multiple banks and can make a good prediction in advanced of the possibilities for bank financing. This facilitates the negotiations, of course. Based on the business plan, the banks will indicate how much and subject to what conditions they wish to provide financing. Together with the private equity investor the management team will have to choose one or more banks based on a number of criteria, such as: the size of the loan and interest; the flexibility for obtaining additional financing; the stringency of the protective clauses ( covenants ); the banker s experience and the personal relationship with the banker. The contracts established between the private equity investors and entrepreneurs are often highly complex. Entrepreneurs are clearly in a weaker position here compared to sophisticated and experienced investors. Professional investors have undergone a learning process through previous investments or through the input of their co-investors, so that they know which clauses they can use to protect the investor and to transfer a part of the risks from the investor to the entrepreneur. For entrepreneurs who have little experience in this area, it is important to gain advice before signing any investment contracts. However, it is important to realise that contracts, no matter how sophisticated they may be, can never resolve all potential future problems. An investor should therefore be treated in a fair way and the relationship should be one of trust, worthy of any partner. Despite the importance of contracts, in the end an investment depends on trust. Both entrepreneur and investor must respect this trust. The due diligence process also provides the entrepreneur with an opportunity to assess whether the investor is worthy of this trust. It is advisable for the entrepreneur to perform a due diligence process on the investor as well. Talking to entrepreneurs who have already worked together with the intended investor can be useful in this context. 20

23 4.4. The role of professional advisors in the investment process In addition to management teams and private equity investors, numerous advisors play a crucial role in the investment process. Both managers and investors typically call upon professional advisors to assist them during the negotiations. For entrepreneurs, accountants or consultants are often the first people to turn to. They will chiefly help entrepreneurs in translating the company strategy into a business plan. Good accountants and consultants will draw attention to a number of critical aspects in the business plan, such as the feasibility of the major fundamental assumptions in the financial plan. Then they will help the entrepreneurs in their search for suitable investors, potentially through the organisation of a beauty contest. Lawyers and tax advisors will be largely responsible for the legal aspects of the investment and for optimising the fiscal aspects of the company prior to the investment, but also in connection with the transaction. As already indicated, private equity investors tend to use complex contracts. Lawyers can help the management to better understand all of the aspects of these contracts. Access to professional advice does not come for free, of course. The costs can mount rapidly. That is why it is important to have a good view of the costs for all the tasks that will be carried out on your behalf by external experts. Furthermore, it is important to agree in advance who will be responsible for the costs for the extensive due diligence. In addition, accountants and consultants also form a central contact point for the private equity investors during the due diligence process. Thus, they can play an important role in the negotiations with the private equity investors about the valuation of the company, the structuring of the investment and other important contractual stipulations. They also play an important role in the negotiations with banks about the bank credit. In fact, it is not only a matter of negotiating the amount of bank debt that one wishes to carry and the interest payments associated with it, but also about the protective clauses ( covenants ). Since these protective clauses, such as the demand for the retention of a certain amount of net working capital, can have an important impact on the way that business is conducted later, clear agreements in this area are essential. Growth capital and Buy-outs Guide for Belgium 21

24 5 INTRODUCTION TO THE MAJOR VALUATION TECHNIQUES For various reasons, it is necessary to assign a value to the company when private equity is sought. After all, when private equity investors acquire shares in exchange for their investment, the value of the company needs to be known in order to determine the percentage of shares that they will acquire. Just as with the valuation of any other economic property, the value of the company is determined, in the first place, by the value of future cash flows that the company will be able to generate for the investors. The risk of these cash flows is also important, since this will determine the returns demanded by the investors. The result of a valuation exercise will be highly dependent on who is performing it. For example, a strategic investor will typically value companies higher than financial investors since, in the first case, not only financial motives play a role but also strategic reasons such as access to knowledge, technologies and expected synergies. Below, we shall restrict our attention to a brief discussion of the valuation methods that are typically used for the valuation of established companies Discounted Cash Flow (DCF) method The DCF method is the standard method that is used for the valuation of established companies. According to this valuation method, the value of a company is equivalent to the current value of all future free cash flows that the company is expected to generate: the free cash flows are the funds that the company generates through its operations and which are available for distribution to its financiers (shareholders and creditors) without jeopardising the company s business continuity (in other words, after investment in tangible assets and working capital, which are necessary to ensure the future operational cash flows). CALCULATION OF THE FREE CASH FLOWS: Operating profit before taxes (EBIT: Earnings Before Interest and Taxes) - Operational taxes (EBIT x tax rate) + Depreciation and amortisation = Operational cash flow - Investment in tangible assets - Investment in net working capital requirement = Free Cash Flow Since the free cash flows are payable to all financiers (shareholders and creditors), the average required return, which is used to calculate the current value of the cash flows, reflects the returns required by the creditors (or the average interest costs on the debt after taxes) as well as the returns demanded by the shareholders. This is the Weighted Average Cost of Capital. Value of the company = Σ FCFt (1 + R) t = t=1 FCF 1 + (1 + R) 1 FCF 2 + (1 + R) 2 FCF 3 (1 + R) With FCF = Free Cash Flow and R = investors required rate of return. 22

25 Called (WACC). The WACC is calculated as follows: WACC = required returns (on E) x E/T + Interest (on D) x (1 - t) x D/T E = equity D = loan capital (debt) T = E + D The return required by private equity investors is higher than the return that investors hope to obtain through the stock market. A number of factors underlie this difference. On top of the compensation for the systematic risk, private equity investors in fact demand a premium because they are acquiring non-liquid shares. Moreover, they not only want to see returns for their financial contribution, but also for the fact that they are very actively involved in the management of the companies in their portfolio. Investors on the stock market are generally passive investors, who simply track their shares from a distance. The time and effort that private equity managers invest in their portfolio companies also needs to be remunerated. All of these factors together therefore make the returns required by private equity investors for growth financing and buy-outs typically between 25% and 35% per year. The cost of the loan capital is the average interest rate that the company would pay if, at the time of the valuation, it would enter into new debts with comparable characteristics. The cost of the loan capital is multiplied by (1-t) since interest payments constitute a tax advantage for profitable companies. Naturally, non-profitable companies cannot take advantage of this and for these companies it would be equal to zero. Cash flows that are expected in the future are worth less than the same cash flows obtained today. That is why the current value of the future cash flows is calculated at a discount (or by calculating back to their current value). The sum of all the discounted future free cash flows reflects the value of the total company to which all financiers are entitled. Predicting cash flows in the distant future is exceedingly complex, time-consuming and unreliable. That is why a valuation of a company according to the DCF method is divided into two parts. In the first phase, the explicit phase, a detailed calculation is made of the free cash flows over the course of C years. In the next phase, it is assumed that the last explicitly predicted free cash flow in year C will grow at a constant rate of growth indefinitely. The value of all of the cash flows after the explicit phase (calculated on time C) is what is known as the continuing value and is calculated as follows: Continuing value c = FCFc (1 + g) R - g With g = expected annual growth rate of the free operational cash flows It is important to determine the continuing value with due care. The rate of growth (g) must certainly Growth capital and Buy-outs Guide for Belgium 23