Double Bottom Line Investing:

An Introduction to
the CDVC Approach

A workshop presented by the

Community Development
Venture Capital Alliance

March 26, 2008

New York, NY
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 Deal Structuring:
Equity and Near-Equity
Investments

Alan Bernstein
Carter Ledyard & Milburn LLP

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 Session Goals

„ Clarify distinctions between debt

and equity investors
„ Introduce key equity terminology
„ Briefly describe several equity or
near-equity investment structures

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A great training tool appropriate for staff, board
members, state and local economic development
officers, lenders, and community leaders.

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 Debt Equity
Objective Limit downside risk Maximize upside
reward
Decision Credit-worthiness, Business value,
historic and future future potential and
Process cash flows, risk
collateral value
Return Limited, even if Depends on company
company performs performance,
well Potentially high
Cost of Low w/ fixed or High. Percentage of
variable coupon company value
Capital

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 Debt Equity
Investor Minimal: review Significant:board seat
of financial and involvement in
relationship position and day to day operations
w/entrepreneur loan covenants Less Adversarial – “on
More Adversarial the same page”

Repayment or Exit through Exit through source

repayment of other than current
exit debt from cash income: sale to 3rd
flow party, management,
etc.
Dependent on growth

Complexity Boilerplate, less Customized, more

complex complex

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 Objective
„ Debt
ƒ Limit downside risk
• Unsecured: Senior debt or subordinated debt
• Secured debt: senior secured debt or senior
subordinated debt (collateralized or guaranteed)
ƒ Fixed or floating interest rate – No upside
ƒ Convertible debt
„ Preferred Stock
ƒ Higher earning potential
ƒ Convertible preferred stock
„ Equity
ƒ Common stock
ƒ Upside potential
ƒ Risk of loss
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Decision Process Is Based On
„ Debt
ƒ Creditworthiness
ƒ Historical and future cashflow
ƒ Collateral value
„ Equity
ƒ Valuation: what is the business worth?
• Comparables businesses: thumb rules
• Discounted cashflow analysis
• Recent sales of similar businesses
ƒ Future potential/growth
ƒ Risk
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 Return: Debt

„ Debt
ƒ Limited, even if company performs well

„ Equity
ƒ Depends on company performance
ƒ Potentially high

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 Cost of Capital: DEBT
„ Debt
ƒ Entrepreneur – how much does it cost
you to finance your business?
ƒ Fund – PRI for Ford, Heron &
MacArthur at 3% to 5%, a fund can
put that money to work for 8%, 10%,
12% or 14%.

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 Cost of Capital: EQUITY

„ Equity
ƒ Entrepreneur – High: giving up
ownership and potentially control

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 Investor Relationship with
Entrepreneur: DEBT
„ Debt
ƒ Minimal: review of financial position
and loan covenants
ƒ Lender Liability

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 Investor Relationship with
Entrepreneur: EQUITY
„ Equity
ƒ Significant: board seat and
involvement in day to day business
operations
ƒ Investor brings more than money to
the table

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 Repayment or Exit

„ Debt
ƒ Exit through repayment of debt from
cash flow
„ Equity
ƒ Exit through source other than
current income: sale to 3rd party,
back to management, or IPO (rarely)

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 Complexity

„ Debt
ƒ Boilerplate, less complex
„ Equity
ƒ Customized, more complex,
more flexibility

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 Equity Investing Offers an
Opportunity to Focus on
Community Development
Issues
„ Local revitalization
„ Jobs
„ Job quality
„ Low-income

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 Debt vs. Equity: Debt
„ Debt
ƒ Capital supplied in form of loan [as claim
against company assets]
ƒ Fixed time period, interest rate and fees
ƒ Investor focus on predictability of
repayment through cash flows
ƒ Borrowers pledge assets as collateral in the
event cash flow is insufficient to retire debt.
ƒ Lender more interested in repayment than
business growth

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 Debt vs. Equity: Equity
„ Equity
ƒ Capital is supplied as investment in
exchange for ownership in the
company
ƒ Returns derived from growth and
increased value of company which
translates into higher equity value to
investor
ƒ Investors seek to “exit” investments
by selling their equity at higher value

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 The Power of Equity:
Financing Business Growth
Year 1 2 3 4 5 6 7 8 9 10 11

Positive 4th Stage

Growth
Cash
Flow Startup
Expansion Stage
1st Stage
Negative 2nd Stage

s s ily d t P
n g rd m a n l bt en ack O IP
O
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cem y
B ES
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&
n ge Cap Pl
a
Bu
ona C re nd A re te gt
s ie tu a M
er r n iv
P F
Ve Pr
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 Business Risk

„ Management risk
„ Market risk
„ Technology/production risk
„ Financial risk
„ Exit risk
„ Policy risk

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 Business Value
„ What is the value of the intellectual
property, patent, customer base, etc.?
„ What is the size of the market and what
percentage can the company capture?
„ What is the upside opportunity and on
what is it based?
„ Does the company have access to
production facilities?
„ Does the product have component parts
of interest to a third party?
„ What other intangible assets values
does the company have?
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 What is Value?
„ Value is a long-term concept
ƒ Value may not be realized in the immediate
term
ƒ Valuation analysis should cover several
years
„ Value may not, and often does not,
equal price
ƒ Like beauty, value is in the eye of the
beholder
ƒ Creates opportunities for transactions
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 Method of Valuation
„ Multiple of Sales
„ Earnings Multiples
„ Replacement Value
„ Discounted Cash Flow
„ Weighted Average of Different
Methods

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 Forecasting is the nuts
and bolts of the analysis

Prediction is very difficult, especially about the future.

Niels Bohr (1885 - 1962)

„ Projections should be as detailed and

as granular as possible
ƒ Creates more robust models
ƒ Aids sensitivity analysis
ƒ Permits more rigorous verification of
assumptions

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 Risk/Return Tradeoff

Risk

Near Equity
Low Debt Equity High
Products

Return

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 Near Equity Structures

„ Debt with Royalties – a loan with

the right to a percentage of
company sales or profits
„ Debt with Warrants – a loan with
the option to purchase equity at a
pre-negotiated price
„ Convertible Debt – a loan that is
convertible to equity
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Mechanics of Equity Investing

„ Screening and Due Diligence

„ Negotiating the Investment
„ Making the Investment
„ Managing the Investment
„ Exiting the Investment

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 Equity Specific Issues

„ Value a company and calculate

appropriate financial return
„ Negotiate the fund’s protective
provisions and rights
„ Confront issues of relationship and
control with management
„ Make provisions for liquidating the
fund’s interests
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 Debt with Royalty
Participation
„ Participation Agreement is
governing document and defines:
ƒ Whether royalty amount is based on
profits or revenues
ƒ Whether royalty is tied to the total
amount or to incremental growth in
profits and revenues
ƒ Due dates for sales or profit
statements, as well as royalty
payments
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 Advantages of
Debt with Royalty Structure
To the Fund To the To Both
Company
Debt protections No equity Avoid
to mitigate risk dilution complicated
valuation
exercise
Exit Tax deductible Debt-like
predetermined Interest and structure
royalty easier to
payment understand
Reliable income
from interest &
royalty payments 30
 Debt with Warrants

„ Warrant to Purchase Securities is

the governing document which
ƒ Spells out the terms and conditions
governing stock purchase
ƒ Governs the process of exercising and
registering the warrants
ƒ Identifies the restriction and
notification requirements of both the
fund and the company

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 Key Terms:
Warrant Document

„ Warrant or Exercise Price

„ Exercise Period
„ Legal Protections
„ Number of Shares
„ Triggering Events
„ Put/Call Options
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 Advantages of Debt with
Warrants
To the Fund To the Company
Low-cost access to upside Minimizes and delays
with security of debt dilution of ownership
Current & regular income May get lower interest rate
from debt component thru safer structure
Put agreement provides easy No impact on cash flow
exit and boosts returns which can fuel future growth
Exercise of warrants
provides additional cash
Interest expense is tax
deductible

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 Convertible Debt

„ Loan Agreement/Securities
Purchase Agreement is governing
document
ƒ Spells out terms and conditions
governing both the loan and its
conversion to equity
ƒ Details the rights, restrictions and
notification requirements of both the
fund and the company

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 Key Elements of
Loan/Securities Purchase
Agreement
„ Conversion time frame
„ Conversion price
„ Conversion product (common or preferred)
„ Triggering events
„ Put options
„ Legal protections
„ Adjustments
ƒ Performance
ƒ Anti-dilution
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 Advantages of
Convertible Debt
To the Fund To the Company
Lower initial risk May give up less
profile, fund has time equity than immediate
to decide whether to equity investment
convert would require

Interest payments on
loan are tax deductible

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 Risk/Return Tradeoff

Risk

Low Debt Royalty Warrants Convertible Equity High

Return

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 Equity Investment

„ There are three types of ownership

shares
ƒ Common Stock
ƒ Preferred Stock
ƒ Convertible Preferred Stock

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 Key terms of
Convertible Preferred
Investment
„ Dividends
„ Liquidation Preference
„ Voting provisions
„ Redemption/ Put and Calls
„ Adjustments
ƒ Performance
ƒ Anti-dilution

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 Dividends

„ Mandatory vs. “As declared”

„ Cumulative vs. Non-Cumulative
„ Rate and Timing

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 Liquidation Preference

„ Ranks ahead of junior stock

„ Sale of company is “liquidation”
„ Participating preferred
„ Multiples and caps

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 Voting
„ Right to Director(s)
„ Can’t change terms
„ Control provisions
ƒ Sale of company
ƒ Budget
ƒ Hiring
ƒ Other

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 Redemption

„ Investors have “liquidity” if no sale

„ Price and timing
„ Control provisions on default

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 Anti-dilution
„ “Price dilution” vs. “Percent
dilution”
„ Includes all capital events
„ Price protection
„ “Weighted average” vs. “Ratchet”

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 Other Rights
„ Co-sale (“tag-along”)
„ “Drag-along”
„ “Pay or play”
„ Phased Investments

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Advantages of Preferred Equity
To the Fund
If regularly paid, dividends
provide current income
In liquidation event, preferred
has preference over common
shareholders
Redemption feature may
provide viable exit
Structure offers flexibility in
defining control over major
decisions
Conversion to common stock
allows participation in upside
To the Company
Equity shores up balance
sheet allowing greater
leverage of debt
Protective features of
preferred may permit
concession by fund on level of
equity ownership
Fund management devotes
time and expertise to building
company value
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 Conclusion: Equity Investing
„ Successful deal structuring involves
balancing returns – whether social or
financial – with the risk presented by a
company
„ A well-structured and documented deal
affords the fund legal protection and is
a critical step in the investment process
„ There is no substitute for a good
screening process, a complete and
thoughtful due diligence review, and a
monitoring program that tracks investee
operating and financial performance 47
Thank you
and
Questions?

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