Letter number 86 of February 2015
- QUESTIONS & COMMENTS
From a financing point of view, we can divide start-ups into two categories - those that can partially finance their operations using debt, and those that can't.
The former can rely partially on debt because they use tangible or intangible assets which have a value that is independent from the way in which they are currently exploited by the start-up with an active secondary market - trucks or cars, real estate, business or lease rights, etc.
Whenever the economic model of a new company is not clearly established and whenever its operation does not require that it hold assets with a value that is independent from its activity, the only reasonable way for it to finance its operations is with equity.
Because of the regular instalments for repaying capital and paying interest, debt is totally unsuitable when the generation of cash flow is unpredictable and negative over an undetermined period. The entrepreneur needs time to test his/her product or service, to get it right, to adapt it in line with feedback from the first customers, to drop 80% of what has already been achieved if necessary, and start out again in another direction. The entrepreneur is fully focussed on the adventure that lies ahead and should not be worried about having to meet payments on a debt which is ticking away like a time bomb.
Most often, equity takes the form of standard ordinary shares, and this is a good thing. It means that the interests of the founding managers and the investors in equity capital are aligned as well as is possible, the only difference between them being the difference in the cost price of their shares, which correspond to different investment dates and different roles.
They sometimes take the form of preference shares which correspond to real equity, unless the issue prospectus contains clauses which undermine the nature thereof. Fortunately, this is not a very common occurrence. But the great contractual freedom that is characteristic of preference shares may lead to schemes that transform them into debt. Accordingly, we have seen investments through preference shares structured as follows:
At the end of five years, the preference share benefits from a priority dividend calculated on the amount of the investment at the Euribor rate +15%. This priority dividend is paid as soon as there are distributable profits on the balance sheet and even if the company has no intention of paying dividends in order to favour self-financing. Additionally, this dividend can be cumulated, i.e. if it is not paid in a given year because there are no distributable earnings, it is carried forward in time, and capitalised at 15%. So, after eight years, it is 52% of the investment that the company has to pay as a dividend.
The entrepreneur enjoys an option to buy back the preference shares at a price that is partly fixed, partly in line with the company’s sales, with a cap which results in a cost of these preference shares, if the option is exercised, of between 3.5% and 14% per year. These rates do not factor in fees which the company has to pay to the intermediary or investors and which are not negligible – we’ve seen rates of around 5% per year.
For entrepreneurs who fail completely – remember that 71% of US companies set up in 2004 had disappeared 10 years later– there is no difference. They will go bankrupt or be properly liquidated and that's where the story ends for them. Preference shares will be treated like ordinary shares and will be worth nothing.
For the successful entrepreneur, the preference share structured in this way is a great product, because it enables him/her to exit the investors after five years at a price that is capped and lower than the value of the share, all at an annual cost of around 20% (fees included), which is less than the cost of equity capital.
But for every very successful entrepreneur, how many others just get by or achieve mediocre results?
In this case, after five years, when the company makes a distributable profit, it is forced to remunerate the bearers of preference shares, reducing by as much the investments in operations that it may want to make. The aim of holders of preference shares is of course to put heavy pressure on entrepreneurs to buy the preference shares (or have them bought), and to do so as soon as possible, given the cumulative and capitalised nature of this dividend.
Bearers of preference shares and their representatives (if any) on the board of directors, are only interested in creating value up to the level of the cap set in the purchase option. Above this cap, it is in their interest that investments be limited in order to maximise the company’s earnings and liquidity, which is a source of conflict of interest between the bearers of the different categories of shares.
Entrepreneurs are generally optimistic and often dream of creating a new Facebook or The Lending Club in their sectors. Accordingly, they may be attracted by preference shares, which in the case of great success, are rather favourable to them. They should know that this is a type of share that, as a result of great contractual freedom, can lead to the best of times and in the worst of times. So, we cannot stress sufficiently how important it is to look very carefully at the clauses of a share preference contract and think about potential conflicts of interest that they contain.
We witnessed one case of an entrepreneur who, having done such an analysis, declined the investment proposal. He was immediately offered, by the same intermediary, a capital increase by ordinary shares with an undertaking by the entrepreneur to buy back these shares at 140% of the amount subscribed at the end of five years. This was only possible because investors had a tax advantage to invest in this kind of securities allowing them to reduce their tax paid in addition to the 40% capital gain over 5 years.
We’re no longer in the domain of equity, but clearly in the domain of debts, not at the level of the company, but at the personal level of the entrepreneur.
Firstly, as it’s not the company that is taking out debt, its equity is strengthened and its possible capacity for taking out debt is not affected. This new debt at the level of the entrepreneur is in some ways a junior debt compared with any of the company’s debts.
The interest rate on this debt (7% excluding fees) is relatively low for what is in fact junior debt, but the risk taken by the entrepreneur should not be forgotten. If all goes very well, there is no problem, the entrepreneur pays back this debt by getting the company to pay him/her a dividend and, if necessary, to finance it, new shareholders can be brought in at that time.
But if in five years the entrepreneur is facing difficulties, for example, the concept has not proved itself or it has aged, or because a more efficient competitor has emerged, or for any other reason, it will be difficult to obtain a dividend or to bring in new shareholders. There is a strong chance that the entrepreneur will be forced to sell the whole of part of the company in order to pay back his/her personal debt. We’ll try not to think about a scenario where the company is worth nothing but the debt still has to be repaid!
Obviously, because this is debt disguised as equity, the entrepreneur will not get advice and support from such investors, unlike that provided by business angels or investment funds providing real equity, advice and a network.
We find it hard to see how an entrepreneur who gets good financial advice could accept such a scheme. In fact, if the company is mature enough to allow the entrepreneur to take the risk of debt, he/she will find that, on current market terms, there are 5-year loans at less than 7% (excluding charges) available. And if the company is not mature enough to enable the entrepreneur to take the risk of debt, he/she would be better advised to look into crowdfunding financing, business angels or investment funds that do not require preference shares.
But not all entrepreneurs get good advice. So we cannot emphasise how important it is always to ask a third party (lawyer, asset manager, banker, investment professional, etc.) to take a second look and to analyse a financing arrangement on the basis of the most pessimistic consequences – only the paranoid survive! (Andrew Grove, founder of Intel).
Finally, let’s look at the convertible bond which does not masquerade as equity, except in the mind of the entrepreneur who is a novice when it comes to finance and who wants to limit his/her dilution and who thinks of issuing shares today at a price that is higher than their value, since in his/her mind, conversion is something that goes without saying. This is confusing miracle and mirage!
The convertible bond is a useful and intelligent product in a certain number of circumstances, but is not adapted to companies in the very early stages of their development, when their economic model has not yet been fully demonstrated. At this stage, the challenge is not to avoid or to minimise dilution, but to show that the company is viable. It's better to have a small share in a company that has had the time to show that it is viable, than a large share in a company which is running the risk of bankruptcy or whose liabilities have to be restructured, because in this case, dilution will be massive.
In a few years, when the generation of positive free cash flows is firmly established, there will be time to think about issuing convertible bonds.
The sales multiple, i.e. the ratio between enterprise value and sales is sometimes used for valuing companies. We’d advise against this, except when operating margins are very similar from one player to the next. In fact, as illustrated by the graph below, levels of sales multiples are closely linked to the level of companies’ margins, because, ultimately, through sales, profitability is achieved.
With Simon Gueguen – Lecturer-researcher at the University of Paris Dauphine
The exact value of a firm’s shares is crucial at the time of certain events such as IPOs, share issues, mergers and acquisitions, etc. Since share prices are influenced by the flow of information, management may be tempted during such periods to produce more press releases with the aim of increasing the firm's share price, even temporarily. This premise is looked at in an article on public share exchange offers.
The idea of the article, which seeks to prove the existence of such a manipulation, is to exploit the difference between two techniques of share acquisitions. The first technique involves fixing an exchange ratio between the shares of the acquiring company and those of the target. This is the case with Bolloré’s public exchange offer on Havas (9 Bolloré shares for 5 Havas shares). The second technique is not quite as common. It involves fixing a purchase price and providing the target’s shareholders with a number of shares in the acquiring company that correspond to this price, according to the acquiring company’s share price at the time of the transaction. This is the case with the offer underway in the USA in the banking sector between BNC Bancorp and Valley Financial.
The difference for the acquiring company lies in the timing. In the first case, the acquiring company’s share price must be as high as possible during the negotiation period before the public offer, in order to obtain a more favourable exchange ratio. In the second case, it is when the public offer is being finalised that the share price must be high. Ahern and Sosyura focused on the negotiation period, during which the acquiring company has a greater incentive to manipulate press releases in the case of an acquisition with a fixed exchange ratio than in the case of an acquisition at a fixed price.
The study shows that initially, there is very little difference in the features of transactions with a fixed exchange ratio compared with transactions at a fixed price. The only criterion of choice between these two methods seems to be the volatility of the acquiring company’s share price. The fixed exchange ratio method is more frequent when the volatility of the acquiring company's share price is high. This result is interesting. In the case of high volatility (of the acquiring company’s share price), the target prefers a fixed price and the acquiring company a fixed exchange ratio. It seems that most often, it is the acquiring company that is in a position to choose the technique.
This similarity between the acquiring company’s features and the two techniques makes it possible to implement an econometric technique that is currently in fashion – difference-in-differences regressions. The principle (applied to our subject) is to measure increase in the number of press releases by a firm in the event of an acquisition with a fixed share exchange ratio, and to compare it with the increase in press releases in the event of an acquisition at a fixed price. If the former is substantially higher than the latter, then it is likely that the acquiring company is manipulating information in cases where it is in its interest to do so. This is confirmed by the empirical results of the study, based on a sample of 507 transactions carried out by listed US firms between 2000 and 2008. On average, acquiring companies send out 10% more press releases during the negotiation period if the transaction is at a fixed exchange ratio (which works out at 9 additional press releases over a period of 65 days). And it works! Ahern and Sosyura note that the increase in media coverage enables the acquiring company to save between 5% and 12% on the acquisition cost, compared with a fixed price transaction.
Providing further support for their analysis, they show that the share price increase attributed to manipulation is partially corrected in the two months following the transaction. The greater the number of press releases, the stronger the correction of the share price. Investors, once they have been informed of the transaction, apply a discount on the information that they have received during the negotiation period because they know that a manipulation is possible.
Additionally, this article demonstrates the complexity of the relationship between information and price, which is crucial in finance. According to the classical view, there is no ambiguity in the causal relationship – the price is the consequence of the information. It is possible that, in certain critical situations in the life of a company (acquisitions, but not solely), part of the information provided is also the consequence of an attempt to manipulate the share price.
We all understand the mechanism of the leverage effect of debt. It leads to an increase in return on equity thanks to the use of debt, as long as the company’s ROCE is higher than the cost of debt after corporation tax. But we know that this increase in return on equity does have consequences, since the flip side is an increase in the company's risk.
Less well-known, but equally clear, is its impact on the volatility of the share. The greater the debt, the more volatile the share price will be. In fact, a small variation in the value of capital employed will have a practically equal knock-on effect on the value of equity. If the value of equity is low compared with the value of capital employed because debt is high, then the impact will be greater for a heavily indebted company than for a company that is carrying very little debt. Accordingly, companies carrying a lot of debt have a higher b coefficient.
Even less well known, but just as real, is the impact of debt on the growth rate of a company’s earnings per share. As soon as the growth rate of EPS is positive, any increase in debt increases the growth rate of EPS. You just need to imagine an initial amount, EBIT after corporation tax per share which increases at a regular pace by a certain rate. If now, we subtract every year from this initial amount, a second amount of financial expense per share, which remains stable over time, we realise that the third amount, the difference between the first two amounts and corresponding to EPS, grows at a faster rate than the first amount, EPS of a company that is carrying no debt.
A higher growth rate of EPS does not mean a higher P/E ratio and accordingly a higher share price because, unless you’ve mistaken the investor for the village idiot, he or she will not be fooled and will understand that the higher growth of EPS is the consequence of a higher risk. So, if the growth rate of EPS at a company carrying no debt, or more generally the growth rate of EBIT, becomes negative, the decline in EPS will be sharper for a company carrying debt. Here we see the classical expression of the leverage effect of debt.
 See an illustration on page 533 of the Vernimmen (2014 edition).