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BETA PRIMER [INVESTMENT BANKING ADVANCED MODULE]

CONTENTS
CAPITAL BUDGETING ................................................................................................................................2
REAL OPTIONS ......................................................................................................................................2
MERGERS AND ACQUISITIONS ADVANCED CONCEPTS .........................................................................4
SYNERGIES ............................................................................................................................................4
CONTROL PREMIUM AND MINORITY DISCOUNT .................................................................................4
MODES OF PAYMENT ...........................................................................................................................5
EXCHANGE OF SHARES IN STOCK-FOR-STOCK TRANSACTIONS ...........................................................6
DEAL STRUCTURING .............................................................................................................................7
TAKEOVER DEFENSE .............................................................................................................................7
SHAREHOLDER ACTIVISM .....................................................................................................................9
CORPORATE RESTRUCTURING ...........................................................................................................10
VALUATION.............................................................................................................................................11
CASH FLOW VALUATION ....................................................................................................................11
ADJUSTED PRESENT VALUE (APV) ................................................................................................. 11
CAPITAL CASH FLOW (CCF) ............................................................................................................ 14
OTHER VALUATION METHODS ...........................................................................................................14
BOOK VALUE .................................................................................................................................. 14
REPLACEMENT COST METHOD...................................................................................................... 14
PRIVATE EQUITY & VENITRE CAPITAL ....................................................................................................15
WHAT ARE PE/VCs? ............................................................................................................................15
KINDS OF PE INVESTMENTS ...............................................................................................................15
STAGES IN VC INVESTMENTS......................................................................................................... 17
STRUCTURING OF PE/VC FUND ..................................................................................................... 18
PE/VC DEAL STRUCTURING ........................................................................................................... 19
MATHEMATICS OF A PE/VC DEAL ................................................................................................. 22
WHAT IS PROJECT FINANCE? ..................................................................................................................25

BETA PRIMER [INVESTMENT BANKING ADVANCED MODULE]

CAPITAL BUDGETING
REAL OPTIONS
Real Options, as the name suggests, stems from the application of knowledge developed regarding
options in the financial markets to capital budgeting decisions. Those unfamiliar with financial option
pricing would do best to turn to the relevant section on options in the financial markets primer.
This section would attempt to detail the needs for real option valuation in corporate finance and talk
about implementation issues faced in such applications.
Vis--vis standard methods of valuation (read DCF), real options differ by discarding the assumption
that management of a firm is passive once the initial investment decisions have been made. Which is
to say that in a standard DCF valuation, only the most likely or realistic possibilities are modeled and
the flexibility available to managers is ignored. Uncertainty is modeled by adjusting the discount rate
or changing cash flows. In a real model valuation, however, attempts to assume that management is
active and thereby considers all future outcomes and managements response to these outcomes.
In general real option valuation finds application in the following stages of capital investment:

Making a project, e.g. setting up a new factory


Abandoning a project, for instance selling off a factory to a buyer
Expanding/Contracting a project, for instance adding capacity to a pre-existing factory
Delaying a project, for instance obtaining a patent on a developed technology.

The above list is only indicative and not exhaustive.


Following is an example of the application of real options to a real-world scenario:
Valuing a Gold Mine:
The value is dependent on the estimated quantity of gold in the mine and the price of the resource. If
the cost of development of the resource be X and the value of resource be V, the payoffs to the
natural resource option are as follows:
Payoff = V-X if V>X
= 0, if V<=X
In this way the payoff is similar to a call option.
Assumptions that are needed to be made to value the mine:
Available reserves: These estimates would be provided by experts.
Estimated Cost of Developing the Resource: Obtained by management from similar past projects
depending on the specifics of the investment.
Time to expiration: This would be the minimum of the leased time-period or the time in which
the resource runs out (Inventory/Throughput).
Variance in value of Mine: This depends on two attributes: (1) price of resource in market, (2)
variability in estimate of available resources. Some mines might have a fixed minable quantity, in
which variation resulting from 2 is 0.

BETA PRIMER [INVESTMENT BANKING ADVANCED MODULE]


Cost of delay: This is the net production revenue (annual) as a percentage of the market value of
the reserve. In some ways it can be understood as the dividend yield of the asset.
Importantly, here the time the decision is taken (to invest) and the time the asset actually starts
delivering, i.e. time taken in development, can be substantial. In case the lead time is one year, the
reserve will be discounted back one year at the dividend yield rate.

Example: Gold mine with known inventory of 1 million ounces, output rate of 50,000
ounces per year. Price of gold is expected to grow at 3%. Firm owns the rights to mine for 20 years.
Cost of developing the mine is $ 100 million; average production cost is $250 and expected to grow at
5% per year. Standard deviation in cost of gold is 20%, and current price is $375, riskless rate is 6%.
Inputs to the model are:
Value of the underlying asset = Present Value of expected gold sales (@ 50,000 ounces a year) =
(50,000 * 375) * [1- (1.0320/1.0920)]/(.09-.03) - (50,000*250)*[1- (1.0520/1.0920)]/(.09-.05) = $ 211.79
million - $ 164.55 million = $ 47.24 million
Exercise price = Cost of opening mine = $100 million
Variance in ln(gold price) = 0.04
Time to expiration on the option = 20 years
Riskless interest rate = 6%
Dividend Yield = Loss in production for each year of delay = 1 / 20 = 5%
(Note: It will take 20 years to empty the mine, and the firm owns the rights for 20 years.
Every year of delay implies a loss of one year of production.)
Based upon these inputs, the Black-Scholes model provides the following value for the call:
d1 = -0.1676 N(d1) = 0.4334
d2 = -1.0621 N(d2) = 0.1441
Call Value = 47.24 exp(-0.05)(20) (0.4334) - 100 (exp(-0.09)(20) (0.1441)= $ 3.19 million The value of
the mine as an option is $ 3.19 million, in contrast the static capital budgeting analysis would have
yielded a net present value of -$52.76 million ($47.24 million - $100 million). The additional value
accrues directly from the mine's option characteristics.
(Adapted from The Promise and Peril of Real Options, Aswath Damodaran)

BETA PRIMER [INVESTMENT BANKING ADVANCED MODULE]

MERGERS AND ACQUISITIONS ADVANCED CONCEPTS


SYNERGIES
The concept of synergy in mergers and acquisitions has its origins in the belief that there are certain
untapped and latent improvements or benefits which the acquirer / merged entity can avail of and
which is not available to the two entities in their respective standalone forms. Another way of looking
at synergies is that if a firm worth $2 billion merges with an entity worth $4 billion and the combined
entity is worth $7 billion, then the additional value of $1 billion ( 7- (2+4)) is a result of the above
mentioned benefits or advantages which can now be exploited in the merged form and which were
not possible in their respective standalone forms.
These merger synergies could be obtained in various forms:
Vertical integration synergies Any company which acquires another firm in the same value
chain e.g. a supplier of raw materials stands to benefit from this vertical integration as it has full
control over the pricing and supply of raw materials. This can prove to be economically beneficial
particularly in environments of high volatility ih price and supply of the raw material. E.g. News
Corp.s acquisition of DirectTV meant that News Corp. was better positioned to distribute more
of its proprietary content to the end-viewers through DirectTVs satellite network. This is known
as a forward integration as it moves forward in the entire value chain.
Scale benefits Usually such benefits are obtained through horizontal mergers, where two
similar companies merge for the purpose of cost reduction and hence achieving economies of
scale. E.g. Bank of New York (BoNY) and Mellons merger anticipated an annual savings of $700
million which amounted to a substantial 8% of combined costs.
Inefficiency reduction Many times several firms are poorly managed as a result of which they
make poor utilization of resources and the corresponding opportunities. In such cases, the
opportunity to change the administration or management style will allow the merged entity to
exploit opportunities which were being passed upon earlier. E.g. iGates acquisition of Patni
Computers is being seen by experts as an attempt to inject fresh life into Patnis future strategy
by bringing in high quality management expertise, apart from scale benefits.
There are several other forms in which synergy could be achieved in the case of a merger or
acquisition, though we will limit our discussion to these three popular methods.

CONTROL PREMIUM AND MINORITY DISCOUNT


Control premium is the additional price which an acquirer is willing to pay the selling companys
shareholders over and above the fair value in return for acquiring a controlling stake in the company.
Control premium reflects the fact that given a controlling stake there is a greater likelihood that the
expected synergies will be achieved.
Moreover, control premium also reflects the excess price which a company will be willing to pay to
be able set the companys policies and make day-to-day decisions.

BETA PRIMER [INVESTMENT BANKING ADVANCED MODULE]

Control premium typically is 20% - 25% of the fair value of the company.
Minority discount is exactly contrasted to Control premium. It is the discount which is to be applied
to the fair value of the acquired company when the acquirer wishes to own a minority, noncontrolling discount in the company. The relation between minority discount and the control
premium is:

Typically, transaction multiples and trading multiples differ due to the control premium/ minority
discount which is embedded in the pricing of transactions.

MODES OF PAYMENT
The preferred mode of payment must be looked at from both the sellers and the buyers
perspective. The primary reason why stock-for-stock transactions are done is because the buyer
wants to share the risk of realizing the synergies, which may not happen. However, this comes at the
price of having to share the actual synergies which do get realized.

From the sellers perspective, the following will be pertinent issues:

The expected risk-return profile of the target


Taxation issues
Immediate cash situation and needs
The expected role of the sellers management

From the sellers perspective, he would prefer a complete cash transaction if he felt that either the
seller or the buyers stock was overvalued because in this case the seller would run the risk of
participating in the potential downside as a result of corrections in the valuation, if the transaction
was structured using stock. Similarly, if the sellers and the buyers stock was undervalued, he would
prefer a stock transaction as it allowed him to participate in the potential upside due to a potential
revaluation.

From the buyers perspective, the following issues will be considered when addressing
the question of modes of payment:

BETA PRIMER [INVESTMENT BANKING ADVANCED MODULE]


Extent of equity dilution, and as a result, the implications for control
The net debt situation of the buying firm
The expected risk-return profile of the target
From the buyers perspective, a deal can be made cheaper using a stock-for-stock transaction, since
the acquired companys shareholders can then participate in the upsides over a period of time
instead of immediate gains by not asking for an immediate premium to be priced into the
transaction. Also, the decision will depend on the nature of synergies which the acquiring company is
looking at reaping from the transaction. Since cost synergies are easy to achieve, the acquirer will
prefer paying out in cash, but in case of revenue synergies being a major component of the overall
synergy estimates, the buyer will prefer paying in stock in order to share the greater risks associated
with achieving these synergies.
Also, as we had discussed in the sellers perspective, current over-/undervaluation of stock will also
play a role in the decision. If the buyer perceives that either the sellers or buyers stock is
overvalued, he will prefer to pay in stock in order to share the risks associated with a revaluation.
Similarly, if the buyer perceives that the stock will be undervalued, he will prefer to pay in cash to
reap the complete benefits of a revaluation.
In many cases, the answers are not very obvious as above and will depend on a host of other factors
such as:

Selling company ownership structure


Shareholder preferences
Trade-off between sharing risk and managing EPS requirements
Speed of transaction
Desired capital structure of the merged entity

EXCHANGE OF SHARES IN STOCK-FOR-STOCK TRANSACTIONS


There are two broad rules using which the final exchange of shares in a transaction can be completed
in a stock-for-stock transaction.

They are:
Fixed number of shares
Fixed value of shares
In the first method, the exchange ratio gets fixed at the time of negotiating the deal and then is not
adjusted for any price changes which can occur on completion of deal closing. The parameters for the
valuation hence is completed pre-announcement and remains so till the end. As a result both the
acquirer and the acquiree share the price risk associated with the merger/acquisition, as the
proportional ownership is fixed.
In the second method, the exact exchange ratio is not fixed till the closing date of the transaction. As
a result, the ownership structure is not clear till the last day of completion of the transaction. In such

BETA PRIMER [INVESTMENT BANKING ADVANCED MODULE]


a situation, the acquirer bears the price risk related to a fall in stock prices from the date of
announcement to the closure of the deal. In fixed-value transactions, deals are structured in the form
of collars wherein if the price of the stock goes above or below a particular price range, the floating
exchange-ratio gets capped or floored, as shown below:
The number of shares of Company A to be issued to Company B shareholders will fluctuate within the
collar so that Company B shareholders receive $1.75 worth of Company A if the average closing
trading price of Company A, as determined in accordance with the merger agreement, is between
$6.00 and $18.00 per share. The exchange ratio outside of the collar will be fixed. Company B
shareholders will receive .291673 A Shares for each Company B share if the Company A stock price is
$6.00 or less and 0.097224 A shares if the Company A stock price is $18.00 or above.
(Example adapted from Risk Arbitrage Performance for Stock Swap Offers with Collars by Ben
Branch and Jia Wang)

DEAL STRUCTURING
While structuring a deal, a variety of financial structures can be used to complete the payout from
the buyers perspective, depending on the specific acquisition. In this section, we will look at two
specific methods which can be used while structuring the financials of a deal:
Use of preference shares
Earn-outs
Use of preference shares Preference shares can be used as a lucrative means of paying out the
sellers by issuing high coupons/dividends on the preference shares. These coupons are lucrative
because they are usually tax-free at the hands of shareholders, although the issuing company might
pay taxes on the redistribution of profits. Another benefit which such a structuring ensues is that the
preference shares can be redeemed after a year with/without a premium so as to qualify for a zero
tax regime.
Earn-outs Also known as golden handcuffs, deal structuring involving earn-outs entails paying the
base price in cash and making additional payments contingent upon achieving pre-specified levels of
revenues/profits. The typical period over which this payout is structured is 3-5 years. Such a structure
is usually used when you are wishing to retain the management over the transition period. Similarly,
one can use earn-outs when the acquirer cannot pay the full price or the seller wishes to defer taxes.
The issue with earn-outs is that very often this leads to a short-term focus, hurting the potential for
capture of synergies.
Usually an earn-out feature is combined with a catastrophe clause which allows the acquirer to
terminate the earn-out if the performance falls below a specified threshold.
Apart from the above two methods, several other methods of deal structuring can be used though
we will not discuss them in the Primer.

TAKEOVER DEFENSE
Very often an intended acquisition can turn sour when the company about to get acquired exhibits
resistance to being acquired. More often than not, the resistance comes from the management,
which could be because of a variety of reasons such as uncertainty regarding the managements
future in the combined entity or belief that the firm is being undervalued by the potential acquirer.

BETA PRIMER [INVESTMENT BANKING ADVANCED MODULE]


To prevent acquiring companies from placing a hostile bid under such circumstances, companies
adopt a variety of takeover defense mechanisms.
A hostile bid is an offer by the acquiring company directly to the shareholders of the acquiree
without obtaining the approval of the management. This is usually not the case otherwise, where the
management negotiates the offer with the acquiring company and then recommends the
shareholders to accept the offer when an agreement has been arrived at.
In order to make such hostile bids possible, several firms incorporate a variety of takeover defense
mechanisms to deal with such situations. Most of these defense mechanisms are triggered even
before an offer is made to fend off potential bidders at an early stage itself.

Some of these mechanisms are:

Poison Pill
Poison Put
Staggered Board
Supermajority
White Knight
Pac-Man Defense

Poison Pill In this mechanism, existing shareholders are given rights which allow them to be
purchase additional shares at a discount, if an acquiring company acquires more than a particular
percentage of the total outstanding stock in the market. This dilutes the stake of the acquirer and
makes it difficult and expensive for the acquirer to make further acquisition of the stock.
Poison Put By the mechanism, existing creditors have the option of seeking repayment of all
outstanding debt in case the management of the company undergoes a change. In case of use of a
poison put, the acquirer will have to initiate talks with the creditors of the company and seek their
support in completing the acquisition or else the poison put could be triggered. This again makes the
process of acquisition difficult, time-consuming and potentially expensive.
Staggered Board In this mechanism, the board of directors are selected in a staggered manner on
an annual basis, as a result of which any acquirer can only control a section of the board immediately
after the acquisition, and only after a reasonably substantial period of time, say 3 years, can the
board potentially be controlled completely by the acquirer.
Supermajority Very often, companies alter their charter to incorporate draconian requirements
such as the requirement of approval of 80% of the shareholders for an acquisition to go through.
White Knight - An extremely common takeover defense tactic, in this the acquiree prefers to find a
third company which can offer better terms of purchase or better trust as compared to the original
acquirer. E.g. Severstal was for long seen as a White Knight for Arcelor when Mittal Steels was
bidding for it. The White Knight strategy however failed in this case but did make the acquisition
process more difficult and expensive for the Mittals in the end.

BETA PRIMER [INVESTMENT BANKING ADVANCED MODULE]


Pac-Man Defense In this method, the defending company typically turns the defense into offense,
by retaliating with offers to acquire the bidding company either in back-room negotiations or by
acquiring significant amount of shares of the hostile bidder in the open market. In 2009, it was
believed that Cadbury would launch a counter-bid on Krafts hostile offer before negotiations moved
ahead.
Though there are several other defense mechanisms, we will choose to not venture into those
alternatives currently but rather try to look at the process of a hostile bid and the associated
takeover defense mechanisms through an example, as illustrated in Brearley-Myers Allen.
Software major Oracle launch a bid for PeopleSoft in June 2003 at $!6 a share, which was at a 6%
premium to PeopleSofts market value. PeopleSofts management responded to the offer with a
jaundiced eye and said that Oracles bid significantly undervalued the business. Since PeopleSoft was
in the middle of another merger negotiation with JD Edwards and Co., both PeopleSoft and JD
Edwards launched legal battles against Oracle. (Litigation is also used as a takeover defense
mechanism).
PeopleSoft was in the meantime also armed with a variety of takeover defense mechanisms including
a poison pill which kicked in when the acquirer purchased 20% of the stock and a staggered board
which would require an acquirer 2 years to control the board amongst several other such
mechanisms. Oracle revised its offer for PeopleSoft four times, offering $19.5, then $26 before
reducing it to $21 in order to create pressure before finally issuing an ultimatum to PeopleSoft with a
final bid at $24 per share. At this point, more than 60% of the shareholders were in favor of selling
their stake and this created pressure on the management. Oracle also launched its own offensive by
starting a proxy battle to replace the board of PeopleSoft and at the same time dragging the
management to court for not fulfilling their fiduciary responsibilities.
Under pressure, PeopleSofts management was forced to tone down its stand in court as a result of
which they expressed their interest to negotiate with Oracle and also remove its takeover defense
mechanisms if the offer price was pushed up to $26.5 per share. Oracle was more than willing to do
that, and finally after 18 months, 97% of PeopleSofts shareholders agreed to the offer and the
takeover battle ended.

SHAREHOLDER ACTIVISM
An activist shareholder is one who uses his rights guaranteed to him by his stake in a firm to put
public pressure on the management, particularly related to issues concerning governance standards
as well as broader strategic issues. Shareholder activism has been used as a potent tool in the USA
particularly given the lower costs associated with this mechanism as opposed to a full-blown
takeover attempt. However, in the past activist shareholders were perceived not so favorably by the
corporate community as well as the public and were popularly known as corporate raiders. Corporate
raiders were notorious for buying up small stakes (~8-10%) from other shareholders and use the
small yet substantial stake to pressure the management to force action which can unlock immediate
value for the shareholders. Very often the purpose of the activism was to force the management into
buying back the stake at a premium in return for a promise to not trouble the firm in the future. Such
a tactic was called greenmail.
In recent past, however activist shareholders have been perceived favorably particularly given the
series of corporate governance issues which have arisen in several companies across the globe. This
activism can take a variety of forms publicity campaigns, litigation, proxy battles and shareholder

BETA PRIMER [INVESTMENT BANKING ADVANCED MODULE]


resolutions. Some of the popular activist shareholders are Carl Icahn, Boone Pickens and Philip
Goldstein.

CORPORATE RESTRUCTURING
Corporate restructuring is mainly associated with the need to contract and reduce the scale and size
of operations, as opposed to mergers and acquisitions which mainly focus on business expansion.
Several reasons are attributed for companys using corporate restructuring as an effective tool of
executing business strategy and as a means of creating long-term sustainable value. These are:
Companies might want to sell specific business lines which have been underperforming
Specific assets/businesses might be sold purely because of the threat of an overall weak market
for that particular product/business
In some cases, companies can seek to sell off businesses which, as part of their strategy, is
classified as non-core businesses so as to focus on their core operations
Most importantly, firms might choose to pursue divestiture if the break-up value of all the
businesses is greater than the value of the firm as a whole.
Firms may also be forced to dispose of businesses as a result of regulatory issues or due to
immediate requirements for cash.

There are broadly five forms of divestitures

Asset sale
Equity carve-outs
Spin-offs
Split-offs
Split-ups

Asset sales can be broadly defined as the sale of any asset/business by a firm to another firm. In
some cases, the sale can be partial but in other cases it could refer to the complete sale of the
asset/business.
An equity carve-out is a method of disposing of an asset/business that involves the sale of the equity
interest in the business to external shareholders. In equity carve-outs, a new legal entity is created
with a stockholder distribution which will differ from that of the parent company
A spin-off involves the creation of a separate legal entity in which the current shareholders of the
parent company are issued fresh stock in the new entity on a pro-rata basis. The spun-off companys
management is different and is run as a separate company.
In a split-off, the existing shareholders of the parent company are given the option of being allocated
new shares of the divested business in exchange of the shares which they hold of the parent
company.
A split-up is a series of spin-offs as a result of which the parent company no longer exists, leaving a
set of new formed companies.

BETA PRIMER [INVESTMENT BANKING ADVANCED MODULE]


In several cases, a combination of a variety of instruments of corporate restructuring may be used to
complete the necessary transaction.
Also as an alternative to sell-offs, tracking or targeted stock has also been used to create shareholder
value. A tracking stock represents an equity-like interest in the earnings of a specific division of a
company, which can be traded as well. For example, when a company acquires another business and
if the market price of the merged company is undervalued, then in such situations the company
might want to send a signal to the market by allowing its divisions to trade separately in the market
using tracking stock.
One of the best examples of the use of various means of corporate restructuring is AT&T Corporation,
a company which has employed virtually every possible means of restructuring over a period of 20
years in tandem with a well-articulated corporate strategy. The details of the various corporate
restructuring instruments employed by AT&T have been shown below:

Source: Corporate Restructuring and Divestitures by Weston

VALUATION
CASH FLOW VALUATION
ADJUSTED PRESENT VALUE (APV)
The Adjusted Present Value (APV) method values a firm in two steps. First, it assumes that the firm is
financed entirely by equity. In the second step, the additional value which accrues due to the effect
of financing is added separately to calculate the total value of the firm.
To elucidate, in the Adjusted Present Value (APV) approach, the firm is first valued assuming no debt
followed by adding the positive (Tax benefits) and negative (Bankruptcy costs) effects of debt.

BETA PRIMER [INVESTMENT BANKING ADVANCED MODULE]

We follow three steps to value such a firm using the APV approach
Estimate the value of all equity (unlevered) firm
Calculate the present value of the expected tax shield using current debt level
Incorporate the change of default risk and of expected bankruptcy costs due to the current debt
levels
Unlevered Value of the firm
1. Calculate the unlevered cost of equity for the firm. Please note that, the unlevered cost of equity
for the firm can be different for the current period and the stable (further into future) period.
Unlevered Cost of Equity = Rf + (Unlevered Beta) * (Risk Premium)
2. Calculate the Free cash flows to firm using the method
3. Calculate the Terminal Value of the firm using the method
4. Calculate the Unlevered Value of the firm use FCFF and unlevered cost of capital.

Calculation of Tax Benefits


The Tax benefit to the firm is calculated by the assessing the debt tax shield (marginal tax rate *
interest payment) for each year which is discounted at the pre-tax cost of debt.

Expected Tax benefits = PV (interest tax shield over the valuation period)
Calculation of expected Bankruptcy cost
To calculate the expected cost of bankruptcy we first need the probability of default and present
value of bankruptcy costs.

PV (Expected Bankruptcy costs) = Probability of default * PV (Bankruptcy costs)


There are two basic approaches that can be used to calculate the expected probability of default
1. Estimate the bond rating for the firm. Once we know the bond rating, use the empirical
estimates of default probabilities corresponding to the bond ratings.
2. Second approach can be to use the statistical methods such as probability and observe the
firm characteristics at various debt levels to estimate the changing levels of probability of
default.
There can be both direct and indirect costs of bankruptcy. Generally, direct costs of bankruptcies are
pretty small but indirect costs can be considerable proportion of the unlevered value of the firm.
Applicability: This method is useful in cases where the proportion/ percentage of debt keeps
changing over the years, which makes the calculation of a single Weighted Average Cost of Capital
difficult. This is especially true in case of Leveraged Buyouts which involve a high proportion of debt

BETA PRIMER [INVESTMENT BANKING ADVANCED MODULE]


in the beginning which is gradually retired, though there would be other cases where the APV
method would also be preferred. Sometimes, when the company has access to subsidized sources of
financing, then an extra component to find the value-add due to the subsidized financing is also
calculated to find the total firm value, or as is previously mentioned we also value bankruptcy costs.
However, for the example, below we will ignore both the costs.

Illustration
The following particulars are available for a firm:

2011
150
EBIT
Depreciation 40
2000
Debt

2012
200
35
1500

2013
250
30
1200

Cost of equity
Interest Rate on Debt
Tax Rate
Terminal growth rate

2014
300
25
1000

2015
250
20
500

14%
8%
30%
4%

The value of the firm using APV can be calculated in the following manner:

EBIT
EBIT * (1-t)
Add:
Depreciation
Free Cash flow
(for 100% equity
financed firm)
Present Value @
14% discount
rate
Terminal Value
Base Case NPV
Interest paid
Debt tax Shield
(Interest * tax)
P.V. @ 8%
Terminal Value
of tax shield
NPV of
Financing effects
Value of firm

2011
150
105
40

2012
200
140
35

2013
250
175
30

2014
300
210
25

2015
250
175
20

145

175

205

235

195

641

2028
1694
160
48

120
36

96
29

80
24

40
12

124
312
336
2030
|

BETA PRIMER [INVESTMENT BANKING ADVANCED MODULE]

CAPITAL CASH FLOW (CCF)


This cash flow valuation technique is very similar to the Free Cash Flow (FCF) technique of
discounting cash flows with the WACC. However, whereas the FCF method factors in the effect of tax
deductibility of interest payments on debt in the discount rate, the CCF technique adjusts the cash
flows rather than the discounting rate to reflect the same.
Applicability: This method is useful in when the debt-equity ratio keeps changing. This would render
the calculation of a single WACC figure infeasible.
Calculation:

CCF= EBIT Capex + Depreciation + Changes in Net Working Capital (EBIT-Interest)*


Tax Rate
Or

CCF= FCF + Debt Tax Shield


The CCF is then discounted using the Return on equity required for an unlevered firm.
(Inputs from : http://odin.lcb.uoregon.edu/ldann/finl673/FreeCashFlow.PDF)

OTHER VALUATION METHODS


BOOK VALUE
This method values an asset at its historical cost of purchase or a liability at the amount claimed
initially less any payments made since then. While this is not a common valuation technique, it can
sometimes be used to value unquoted or illiquid investments held by a firm for which it is difficult to
find a comparable transaction for valuation purposes.
The use of this method can sometimes be advocated in case a certain instrument is held till maturity
but if there are wild fluctuation in its quoted market price which leads to volatility in earnings over
different periods.
REPLACEMENT COST METHOD
This method values an asset at an amount that would be required to replace it at any point in time.
While liquid assets can be easily valued using this method, it is very difficult to value the entire
portfolio of a firms asset using this method.

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PRIVATE EQUITY & VENITRE CAPITAL


WHAT ARE PE/VCs?
As the name suggests, Private Equity is private equity, i.e. investments in the equity of companies
that are not publicly traded.
Most of the capital markets and valuation literature is premised on the assumption that efficient
markets exist, and the securities of the company trade in that efficient market. When the securities
of a company trade on such a supposedly efficient market, such as NYSE, NASDAQ, NSE, BSE etc.,
they are subject to a lot of disclosure requirements. Such disclosures ensure that the investors have
ready access to information about the company and can construct valuation models based on the
same.
Private Equity (PE), generally, is devoid of all that. It involves investments in companies whose
securities do not trade on public bourses hence the information is difficult to come by. These
companies could either be small firms that have just started and need capital for expansion, or could
be companies that are sick and require a strong management for turnaround.

Venture Capital (VC) can be considered as a special form of PE, which specializes in small
firms, start-ups and provides funding, advice and support to entrepreneurs.
PE Funds and VC Funds are the companies that specialize in investing in such private companies.
While there are many well-known independent PE and VC funds such as Blackstone, KKR, Apax,
Temasek, GIC, Sequoia, Khosla Ventures, Kleiner Perkins etc., most of the large investment banks have
their own internal PE practice as well.
Some PE and VC funds specialize (or start by specializing) in certain sectors of the economy or certain
kinds of investments. As an example, Khosla Ventures currently focuses on investments in the energy
sector and KKR started out as a specialist in buyouts.

KINDS OF PE INVESTMENTS
PE investments typically differ based on the intent behind the investment, the quantum of
investment and the structure of the investment. Following are a few of the popular types of PE
investments:
Buyouts
Buyout refers to the investments that result in the change of ownership of the target company.
The buyout entity (which could be the management or a PE/VC fund) takes controlling interest in
the company by buying out existing shareholders.
If it is the management that buys out the equity interest of existing shareholders, it is referred to
as a Management Buyout or an MBO.

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Sometimes the companies being bought out are huge and the buyer (management etc.) does
not have enough funds on their own to buy the controlling stake on their own. In such cases, the
buyer takes huge amount of debt with the assets of the company being bought out as the
collateral, and uses the proceeds of this debt to buy controlling equity in the company. Such
buyouts are known as Leveraged Buyouts or LBOs. The LBOs were very popular in 1980s in the
US when debt was available at very low interest rates. One of the most popular LBOs is that of
RJR Nabisco, the food & tobacco major, by KKR. The book and the movie, Barbarians at the
Gates, are based on the true story of this LBO.
Buyouts are typically used when the management or an external entity believes that it can run
the company much better than the way it is being run currently. In the case of RJR Nabisco, it
was widely perceived that its foods business was undervalued and the existing management was
laundering the company by using luxuries such as private jets etc. for themselves on company
expenses.
Growth Capital
While buyouts result in the buyer obtaining control of the company, growth capital investments
are generally investments for minority stakes in private companies that provide the funds to
private companies for carrying out their expansion plans, be it geographic expansion or new
product development.
Growth capital companies are generally not very new companies, but are relatively mature
companies that do not present too much of concept risk to the investor, because they have been
doing business successfully in the market for a considerable amount of time.
Most of the private equity deals in Indian market currently are growth capital investments. As an
example, FIIT-JEE is looking to raise INR 20 Billion from PE investors (as on 7th January, 2011),
and would reportedly use the money to build a pan-India presence in coaching and also expand
product portfolio to include formal education.
Mezzanine Capital
While other kinds of PE investments are directed towards owning equity stakes in the company,
mezzanine capital deals give the buyer/investor some preferred equity or subordinated debt in
the target company. This investment in preferred equity or subordinated debt is obviously senior
to the common stock of the company, and junior to the senior debt on the companys books.
In most cases, a company raises capital through mezzanine route when it already has enough
senior debt on its books and is unable to raise further debt through direct bank loans.
Sometimes the PE funds doing a buyout also make some investment in the target company at
the mezzanine level. This is because mezzanine capital is senior to common equity and hence,
assures them of some returns at least.
As an example, SKS Microfinance raised INR 10 Million in subordinated debt (a form of
mezzanine capital) from one of its shareholders SIDBI in 2010, a few months before its IPO.

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Distress Capital
This refers to investment in companies that have gone under (become bankrupt) or are on their
way to go under. If the company has already filed for bankruptcy, certain investors might buy
out the debt of the company and take over control, in the hope of turning the company around
and then restructuring the company to take control of its equity. If the company is on its way to
become bankrupt, some investors might take control of the company by buying out the equity at
a cheap price and earn excess returns by turning around the company.
Many investment banks, including Goldman Sachs, have an internal Special Situations Group (or
a similarly structured/named group) that specializes in providing distress capital to companies
and then turn them around, earning excess returns.
PIPE (Private Investment in Public Equity)
As the name suggests, PIPE is an investment made by a PE fund or a private investor into a
publicly traded company. PIPE deals are typically structured as preferred stock or convertible
debt.
As an example, Actis along with Malaysian fund Khazanah invested INR 84 Million in IDFC in
return for compulsorily convertible cumulative preferred stock in August 2010. This was a PIPE
deal.

STAGES IN VC INVESTMENTS
Start-up companies generally have two distinct kinds of risks:
1. Concept Risk
The risk that the idea of the product/service itself might not be accepted
2. Execution Risk
The risk that the entrepreneur and his team might not be able to execute the idea well, might
not be able to manage a cash-constrained situation and/or might not be able to run the
company well to earn desired returns for the investors
Different kinds of VC investments vary depending on the development/maturity stage the target
company is in.
Angel investing is generally the earliest source of external investment in a start-up. It is also
referred to as Seed Stage Investment. The risk is the highest at this stage because both the concept
and the execution capabilities of the entrepreneurs team have not been proved. Hence, angel
investors take relatively higher % stakes in the companies for relatively lower absolute amount of
investment, commensurate with the risk that they undertake.
A start-up then generally does multiple rounds of raising further capital depending on its capital
needs for different stages. All subsequent rounds are based on reaching some milestones, such as
completion of product development, prototype development, obtaining necessary regulatory
approvals (such as FDA approvals in case of healthcare drug start-ups) etc. If the start-up is doing
well, all subsequent rounds are done at a price per share higher than the previous round. This is

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because both the concept and the execution risks borne by subsequent round investors are lower
than that borne by investors in the previous rounds.
A special round of financing called Bridge Financing is done by start-up just before doing an IPO, to
finance the process of going public.
As an example, the Paypal CEO, Peter Thiel invested $500,000 for a 10% stake in Facebook in 2005.
This was clearly an angel investment. In the subsequent round, Accel Partners invested $12.7 million
for another 10% stake in Facebook, valuing the company 25 times more than the previous round!
In another round for raising capital, Microsoft invested a whopping $240 million for a miniscule 1.6%
stake in Facebook, in 2007. Clearly the concept and execution risks had reduced substantially by this
time. Goldman Sachs invested $500 million along with a Russian firm Digital Sky for a 1% stake in
January 2011. This is widely perceived to be the bridge financing to finance Facebook for going
public.

STRUCTURING OF PE/VC FUND


PE/VC Funds are generally structured as Partnerships for tax purposes across the world. A
partnership is a pass-through entity for tax purposes, i.e. unlike a company that is subject to
corporate tax; a partnership does not get taxed at all. However, each partner in the partnership
recognizes personal income equivalent to his share of the net income (profit) earned by the
partnership in a particular time period.
PE/VC Funds are special kinds of partnerships and consist of two different sets of partners:
Partners who put in money
Partners who decide where to put money & when to take out money
The first set of partners is known as Limited Partners (LPs). The LPs could consist of wealthy
individuals, pension funds, university endowment funds (such as Harvard or Stanford etc.), insurance
companies etc. The only put in money in
The second set of partners is known as General Partners (GPs). The GPs are individuals with
extensive experience in specific sectors, either because of being entrepreneurs themselves (such as
Vinod Khosla), or because of being in advisory business in the sector (consulting/banking).
GPs raise money from the LPs by leveraging their previous experience and/or returns delivered on
past investments managed by them in the sector. LPs sometimes do impose restrictions on the
sectors; geographies etc. in which they want GPs to invest their money in.
The life of a PE/VC fund is generally 10-12 years. After raising the money from LPs, the GPs generally
draw down the funds (i.e. make investments) over the first 3-5 years. Investments are relatively long
term and are committed for 7-10 years based on the timing of the investment with respect to the life
of the fund.

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The GPs earn money through the following different mechanisms:


1. Management Fees
This is paid as a % of the total funds being managed by the GP for a particular fund. Typical range is 1
to 2% of the total capital committed. It is to be noted that the management fees is generally
calculated as a % of the total capital committed irrespective of whether all the committed capital has
been invested by the GP or not (it takes 3-5 years for a GP to invest all the committed capital, the
period over which the capital is actually drawn down).
The management fee is earned every year (or period) by the GPs.
2. Carry (or, Carried Interest)
This is a % of the total profits (typically 20% of total profits) earned by the fund. Thus, 20% of the
total profits earned by a fund are retained by the GPs, while the remaining 80% of profits go to the
LPs.
The LPs generally ensure that the carry becomes payable to the GPs only after they have earned their
original principal invested back, along with a minimum amount of returns, referred to as the hurdle
rate. Thus, if an LP had invested $1 Million in a PE fund and had set a hurdle rate of 5%, with the
investment horizon of 10 years, the GP would first need to pay a minimum of $1.63 million at the end
of 10 years, to be eligible to earn the carry.
It is to be noted that a PE Firm is different from a PE Fund. One PE Firm could have multiple PE Funds
active simultaneously, with different GPs across different funds. As an example, KKR is a PE Firm, and
has four PE funds active as of 7th January 2011, namely, KKR 2006 Fund, KKR Asian Fund, KKR
European Fund III and KKR E2 Investors. All these firms focus on different geographies and
companies.

PE/VC DEAL STRUCTURING


The structure of a PE/VC deal is a perfect example of risk management by the PE/VC investor. All the
terms and conditions are typically structured in a way to limit the potential risk for the investor.
The dilemmas facing a PE/VC investor are many. The investor does not have too much information
about the company he is looking to invest in so it needs to do a thorough due diligence. The
financials and the details of the business plan of a small private company are generally not available
in the public domain. Hence, due diligence becomes all the more critical.
Typically when a PE/VC investor is interested in investing in a company and wants to investigate
further, there is a no-shop clause put into the agreement between the company and the fund first
up. The no-shop clause reads something as below:
From and after the date of execution of this agreement until the termination of this agreement, the
COMPANY will not solicit offers to buy all or any of the portions of its assets, without the prior written
consent of the BUYER

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The no-shop clause is a part of the agreement that the PE/VC fund gets into with the target company,
when it is looking to invest in the company. This agreement is known as the term sheet in PE/VC
parlance. It is a precursor to the legal documents that the PE/VC fund would sign with the target
company if it chooses to invest ultimately, and lays down preliminary conditions of the expected
relationship between the investor and the entrepreneur.
Another concern that a PE/VC investor typically has is that it does not want the company to raise
further money without its prior consent. Also, it does not want the company to raise money at a
lower valuation than it raised from them. As an example, if a VC investor X invested in a company A
at a price of INR 10 per share, it would not want company A to do another round of financing by
raising more money at a price lower than $10 per share, because if the company does so, the value of
investor Xs investment would go down (since there is no secondary market where it call sell its
investment, and the investment value is generally measured on the basis of the most recent
transaction). Also, it dilutes the stake of investor X in the company A much more!
Suppose investor X bought 5 million shares at INR 10 per share for a 25% stake in company A,
investing INR 50 Million. The promoters hold the rest 75% shares (i.e. 15 million shares). Now
suppose company A does another round of financing, raising INR 50 million at the price of INR 1 per
share from another investor Y. Thus investor Y gets 50 million new shares in the company, and the
company has a total of 70 million shares outstanding now. This dilutes the stake of investor X from
25% to a meager 7%.
In such a case, the investor X puts in what is known as anti-dilution protection clause in the term
sheet. There are two popular types of anti-dilution clauses:
Full ratchet anti-dilution
If the anti-dilution is a full-ratchet, the investor X in our example would also 50 Million shares in
company A at a price of INR 1 per share (instead of the original INR 10 per share) for its initial
INR 50 Million investment. This clause would apply only if company A raises money at INR 1 per
share in a subsequent round of financing. Thus, with the full-ratchet protection, investor Xs
stake would not be diluted but would increase from 25% to 43% (or, 50/115), but would dilute
the promoters stake from 75% to 13% (or, 15/115) and hence, would take away any incentives
for the promoter to do a financing round at a discount.
Weighted average anti-dilution
While the full-ratchet gave investor X shares at the actual discounted price of INR 1 per share,
the weighted average anti-dilution would give the investor X shares at a price, which is the
weighted average of price per share across different rounds of financing. The weights given to
different rounds of financing are subject to negotiations. The protection available through
weighted average anti-dilution is lower than that in case of a full-ratchet, but it is not as tough
on the promoter as the full-ratchet is.
Another concern that a PE/VC investor generally has is that while it wants to have a share of the
upside in the company; it wants to restrict the potential downside it might face in case the company
does not live up to its expectations. Financially, thus, the PE/VC fund does not invest in the common
stock of the company but in the preferred stock, which is senior to common equity and also has an
accrued dividend component.

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Even within the preferred stock, there are different kinds of structures that PE/VC investors generally
use to protect themselves:
Preferred Stock
The preferred stock is senior to common stock and also gets other rights such as dividends, antidilution protection, liquidation preference etc.
Convertible Preferred Stock
The convertible preferred stock, in addition to the rights that accrue to preferred stock, also gets
an option to convert to common stock at a particular point in time. Thus, the investors get
accrued dividends as well as the right to take stake in the company after taking out those
dividends.
Participating Preferred Stock
The participating preferred stock, in addition to the rights that accrue to preferred stock, also
gives the investor to receive a fixed but negotiated amount of cash as well as stake in the
company at a particular point in time. Thus, the investors get accrued dividends, additional cash
(which is generally a multiple of their initial investment) and a stake in the company
In addition to the above kinds of preferred stock investments, the PE/VC investors also protect their
downside by inserting another clause known as the liquidation preference clause. As per this
clause, the senior investors are entitled to receive a particular amount of cash before the company
can pay out money to the junior investors. The amount of cash could either equal the initial
investment made by the investor or a multiple of the same.
As an example, suppose investor X had invested $5 million at INR 1 per share for Preferred Stock in
company A. Supposed the company does another round of financing, and the investor Y in this round
is more sophisticated. Investor Y invests $50 million at INR 10 per share, but receives Series A
Preferred Stock in return. The Series A Preferred Stock is senior to the Preferred Stock held by
Investor X and is obviously senior to the common stock held by the promoters. In addition, Investor Y
inserts a liquidation preference clause that entitles it to a 2x return before junior investors can be
paid off. In this case, in case the company is selling its assets to pay off its debtors/investors (i.e. it
has not been successful as a venture), then unless Investor Y receives INR 100 million, Investor X
cannot be paid off!
Another protection provision closely associated with liquidation preference is known as
Redemption. Since the life of a PE/VC fund is limited and it needs to pay back the money to its LPs,
the PE/VC investors cannot remain invested in a company forever. The redemption clause ensures
that the PE/VC investor has the right to take its initial investment out of the company in case a
specific amount of time has transpired since the investment was made, or if the company has not
been successful in meeting certain milestones by a specific point in time.
Further to all the above protection measures, PE/VC investors typically negotiate for veto rights and
voting rights on certain issues that are critical for running the company. These issues include making
significant capital expenditure, changing the business plan and hiring/firing senior management or
people critical to the business (such as, key research personnel etc.). The PE/VC investor also put a
super-majority clause (i.e. 2/3rd or 3/4th of shareholders or board of directors approval) for issues
such as sale of the company, liquidation of the company, raising further equity or debt capital,
appointment of directors etc.

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Besides all these protection measures, the PE/VC investors also want to be a part of any upside that
the company has to offer. One way to get the same is through the Mandatory Conversion clause.
The mandatory conversion gives the investors the right to convert their preferred stock (simple,
convertible or participating) to common stock in case of a major event such as an IPO or a QIP
(Qualified Institutional Placement) exceeding a specific amount (say INR 1,500 Million). This is to
ensure that the shares held by the investors are liquid and can be traded easily at the stock
exchanges or with other institutional buyers.
Pre-emption Rights are another way of ensuring that an early investor gets to be a part of the
upside of the company. These rights give the previous round investor the opportunity (an option) to
acquire shares in subsequent rounds of financing, if they wish to.
Another set of rights that ensures that the PE/VC investor gets a reasonable opportunity to exit the
investment is the Right of Co-Sale, Right of First Refusal and the Tag Along Rights. As is obvious
from the names, they give the investor the opportunity to exit the company if promoter or the
majority shareholder is exiting the company, or buy the stake being sold by another shareholder,
before it is offered to an external agency. The Drag Along Rights also ensure that the investor gets
a bargain if it is looking to exit. These rights give the investor the opportunity and the ability to force
other investors/shareholders to sell their shares at the same price as it is selling, resulting in an exit
event having the critical mass to attract sufficient interest.
While hedging its own risk is of paramount importance for a PE/VC investor, it also needs to ensure
that the promoters and the key management have sufficient stake in the company for their interests
to be aligned with those of the company. This is typically achieved by having Employee Option Pool
that vests over a period of time, commensurate with significant milestones in the life of the
company. 15-20% of the initial shares of the company are kept in the employee option pool, and
these are awarded to the key management personnel (such as the CEO, Research Head, Product
Development Head etc.) over a period of time to retain them and on achievement of milestones such
as development of prototype, signing first sales agreement etc.

MATHEMATICS OF A PE/VC DEAL


Valuation of a private company, especially a new venture (in the VC context) is fraught with
assumptions. The cash flow projections themselves are very uncertain. Hence, in general the
following methodologies are used in tandem to come to a specific valuation figure:
Precedent Transactions & Multiples
If there are analogs for the private company that are publicly traded, then standard multiples
such as P/E or EV/EBITDA can be used to arrive at an estimate valuation. Further, sometimes
industry specific multiples are also useful.On the other hand, if there are no publicly traded
analogs for the private company, a useful method is to use the multiples in the transactions
(mergers, acquisitions etc.) that have happened in the sector. However, the danger with using
precedent transactions is that they may also include other factors such as control premium.
Venture Capital Method (using DCF)
This method uses the cash flow projections of the private company and discounts them by using
a discount rate commensurate with the stage of investment. Higher the concept and the
execution risks, higher is the discount rate applied.

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Hence, a bridge financing, which is done just some time before an IPO, would use a low interest
rate of 20%, while a seed stage (angel) investment with high concept and execution risk (i.e. the
product is new and the team also does not have any prior entrepreneurial experience), the
discount rate would be very high (to the tune of 80% in some cases). All other stages of financing
would lie somewhere in between. These discount rates do not have any theoretical justification
but are based on empirical evidence in the VC industry. The following table gives the range of
discount rates typically used for each round of financing. (Adapted from A Method for Valuing
High-Risk, Long-Term Investments: "The Venture Capital Method" by WA Sahlman)

Stage of Financing
Seed Stage
Start-up
First Stage
Second-Stage
Bridge

Range of Discount Rates used


Up to 80%
50-70%
40-60%
30-50%
20%

The First Chicago Method


In this method, instead of using the actual cash flow projections, cash flows in various scenarios
are projected and the probability of each scenario occurring is considered. This is then used to
estimate the expected cash flows. Since the cash flows have already been penalized for their
uncertain nature, the high discount rates used in Venture Capital Method are not used in this
case. The expected cash flows are discounted back using the average portfolio discount rate of
the PE/VC investor. (Adapted from A Method for Valuing High-Risk, Long-Term Investments:
"The Venture Capital Method" by WA Sahlman)
The value of the private company before the PE/VC fund decides to invest is known as the pre-money
valuation. Pre-money valuation when added to the investment that the PE/VC fund makes gives the
post-money valuation of the company.
Thus,

Post-Money Valuation = Pre-Money Valuation + Investment by PE/VC Fund


The pre-money and post-money valuations are subjects of great negotiations between the
entrepreneur/promoter and the VC/PE Fund.
The promoter wants the pre-money valuation to be as high as possible because it leads to lower
dilution in his own stake post the investment by the PE/VC Fund.

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The share of the PE/VC Fund after making the investment is given by:

PE/VC Share (%) = [Investment by PE/VC Fund] / [Post-Money Valuation]


The above concepts of pre-money valuation and post-money valuation can also be extended easily
for multiple rounds of financing. For each round of financing, the number of shares outstanding
before the round when multiplied by the price per share for that round of financing gives the premoney valuation. Using this pre-money valuation and the investment being made by the new
investor, the post-money valuation can be calculated, which can then be used to calculate the %
stakes of each of the investors after the round of financing is complete.

As an example, consider a company A, which has 1,000 shares outstanding, all held by
the promoters currently. In the first round of financing, the company raises INR 500 at INR 1 per
share from investor X (i.e. 500 shares).
Thus, Pre-money Valuation for Round 1 = INR 1 x 1,000 = INR 1,000
Post-money Valuation at the end of Round 1 = INR 1,000 + INR 500 = INR 1,500
Hence, % stake of Investor X at the end of Round 1 = 500/1,500 = 33%
And, % stake of Promoters at the end of Round 1 = 1,000/1,500 = 67%
Now, suppose the company does a second round of financing wherein it raises INR 10,000 at INR 10
per share (i.e. 1,000 new shares) from Investor Y.
Then, Pre-money Valuation for Round 2 = INR 10 x (1,000 + 500) = INR 15,000
Post-money Valuation at the end of Round 2 = INR 15,000 + INR 10,000 = INR 25,000
Hence, % stake of Investor Y at the end of Round 2 = 10,000/25,000 = 40%
% stake of Investor X at the end of Round 2 = 500 x 10/25,000 = 20%
% stake of Promoters at the end of Round 2 = 1,000 x 10/25,000 = 40%
As a closing comment, one must remember that in the case of PE/VC investments, it is as much about
the team and the management of the private company as it is about the idea and its potential. A
great idea but a bad management team means high execution risk, which means that the idea might
never see the light of the market. Hence, a PE/VC Fund invests as much time in evaluating the
management team and the promoters as in evaluating the potential of the product/service idea.

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WHAT IS PROJECT FINANCE?


When organizations seek investments in projects which can have a material impact on its finances,
they follow the project financing route to isolate the risks from the corporate balance sheet. Such
projects generally require higher leverage which reduces the financial flexibility that a corporate
requires to cash in on future profitable opportunities.
These projects are then structured as an independent company which raises debt on the assets of the
project and pays off the debt from its cash flows. The company structuring the project is called the
project sponsor and makes the initial contribution to its equity as well as negotiates for numerous
performance and supply contracts. Financial institutions extend debt depending on the quality of the
contracts, the reputation of the sponsor and the project proposal, besides other factors.
Project Financing has the following characteristics:
The project company seeking finance is a legally independent entity although it can have equity
sponsorships by one or more sponsors
The project company can be visualized as a management of various commercial contracts e.g. A
power project company in India can have the following contracts
o Turnkey construction agreement with L&T
o Operation and Maintenance agreement with Tata Power
o Coal Supply agreement with Coal India Ltd.
o Power Purchase Agreement with the Maharashtra State Electricity Board
Based on the quality of the contracts, the company can raise debt to finance the project and pay
off the debt from the cash flows of the project.
The debt to the project company is a non-recourse debt. Sponsor is not liable to payment of debt
obligations. All debt obligations are to be paid from the cash-flows from the project.
Project financing includes both industrial and infrastructure projects and is generally of two
types.
o Flow-Type Projects: These projects have an infinite life. e.g. power projects, road
infrastructure projects
o Stock-Type Projects: These projects have a limited life. e.g. Resource extraction projects
like coal mining, oil etc.
In the context of India, a toll-road project awarded by the government on a B-O-T (Build,
Operate and Transfer) contract should be considered a stock-type project.

Cash Available for Debt Servicing (CADS) : It includes the pre-tax cash operating income
plus the interest income from the debt reserve account minus mandatory expenses (working capital,
maintenance and infrastructure improvements). This cash does not include the debt reserve account.

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Debt Service is the debt liability, including the principal and interest payment, due for
the year.

Debt Reserve is an account maintained to cover for the shortfall in future in payment of
debt obligations. This is generally a percentage of the revenue or any other parameter. A larger debt
reserve affects the Equity IRR by building up a buffer for future debt payments.

Debt Service Coverage Ratio (DSCR): This ratio is an indicator of the capability of the
project to pay its debt obligations, both interest as well as principal, for a particular year. Thus,
project financing institutions demand a minimum level of DSCR over the loan period which reflects
the risk-profile of the project.

Example: DSCR is typically 1.3x for an independent power project with PPA (Power
Purchase Agreement) as almost all risks have been mitigated. However, DSCR for a merchant power
plant ill typically be 2x because of exposure to market risks.

Equity IRR: Cash flows to equity investors (or project sponsors) happen after all
mandatory expenditures, debt service and payment to debt reserves is done. The IRR of these set of
cash flows is the return that sponsors get on their investments.

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