WEEK 1: RAISING FINANCE - EQUITY
Equity, venture capital and accountability
We shall look at financing of a business in the context of the limited liability company. This is the primary legal form of businesses (other than small businesses) in the U.K.
The characteristics of a limited company
Corporate entity - it can sue in the courts
Limited liability - how much they lose is limited to the amount they have invested
The first of these characteristics is describes how a Limited Company is a legal personality (or "legal entity") which is separate and distinct from its members. This means that the company can enter into contracts in its own name, and can sue and be sued in the courts.
The second characteristic means that the liability of the members (shareholders), or 'how much they stand to lose', is limited to the amount they have invested. Consequently if a Limited Company is sued or liquidated in order to settle debts, it will only pay out to the value of its current worth - the investors cannot be made to pay any more. This has serious risk implications for those who trade with a company – particularly suppliers, and the investors themselves.
Sources of long-term finance
These split into equity (the issuing and selling of shares) and debt (borrowing, for example from banks). The remainder of this lecture will deal mainly with equity. The next lecture looks at debt more closely.
The creation (‘incorporation’) of a company – ‘seed-corn’ finance
‘Seed-corn’ describes initial funding up to approx. £500k in most cases
Concerns pre- commercial launch R & D funding
Founder management team (FMT) may have savings of their own
There may also be friends and family who wish to invest
Beyond this the FMT need to look externally (business angels (e.g. Dragons Den)or Venture Capitalists –see below)
Let us now turn to the mechanics of share issues
Ordinary Shares (equity)
When a business takes on Company status (‘Ltd.’ or ‘Plc’), its owners become known as shareholders. The capital of a company is divided into shares. These can be of any denomination (named value).
Example: Ms A and Mr B and their associates wish to create a company with ordinary share capital of £10,000 total. This could be made up of (say):
1,000,000 x 1p shares; or
100,000 x 10p shares; or
20,000 x 50p shares; or
10,000 x £1 shares; or
A combination of different types
Any denomination can be used for a share – this is known as the nominal value or par value and remains constant (although the ‘book’ value and 'market' value may go up or down).
All shares are ordinary shares (also known as ‘equities’) unless specified otherwise. The essential feature of ordinary shares is:
They carry voting rights - (one vote per share) therefore:
Any person or party owning (50% + 1) of the issued equity controls the company - referred to as a takeover
Authorised and issued capital
The share- capital of a company may be expressed in different ways;-
i) authorised capital - this is:
The maximum amount a Co. is allowed to issue
………under its `Memorandum of Association' (a document drawn up by the founders upon incorporation). It does not reflect the actual capital raised (unless the maximum has been reached).
ii) issued Capital - this is:
That part of the authorised capital of which share certificates are in circulation.
The total issued capital may be the result of one or several issues.
Example: Ms C and Mr D are the sole Directors of Y Ltd. and decide on an authorised capital of £200,000, of which £40,000 will be issued upon incorporation in 10p shares. If they decide to be the only shareholders and have equal share – holdings:
How many shares will they each buy upon incorporation?
£40,000 split equally = £20,000 each
10p shares so (£20,000/£0.10)
= 200,000 shares each
Why might they have opted for an authorised capital which is greater than the current issued capital?
To leave room for future expansion.
Share Premium
The nominal value is not necessarily the same as the issue price of the share.
If a £1 share is issued for £1.20 then:
The nominal value is £1.00
The share premium is £0.20
Making an issue price of £1.20
Why are shares sometimes issued at a premium?
Remember that the nominal value remains constant but over time the market value (i.e. the value a buyer is prepared to pay) may well rise. In future years there may well be new issues of shares with a nominal value that is no longer realistic. Such shares are therefore likely to attract a premium (higher price). The excess monies collected by the company constitute a capital reserve.
Under the Companies Act 1985 a capital reserve:
Can be used for re-investment in the company
Cannot be used to pay dividends
Reserves and dividends
If a company makes a profit it can do one of three things with it:
Give a cash reward to the shareholders (known as a dividend)
Retain it for future internal investment (expansion)
Make a ‘bonus issue’ of new shares (‘free’ shares to existing shareholders).
Only current years profits or prior years’ revenue reserves can be used to pay dividends. Capital reserves (such as share premium) can never be used to pay a dividend, although they can be used to make bonus issues.
An early stage NTBF is unlikely to return a profit – hence dividends are unlikely in early years. Investors in NTBF’s seek to gain from their investment in other ways such as a long-term growth in the market value of the shares.
‘Bonus issues’ and ‘rights issues’
Bonus issues
Occasionally a company will convert reserves into ‘free’ shares for existing shareholders. Shareholders receive these ‘pro-rata’ (in the ratio of) to the number of shares they already hold.
Worked Example 1
Rockford Ltd has the following capital structure on its balance sheet (in £’s)
Ordinary Shares of £1 each 2,000,000
Share premium 600,000
Revenue reserve 350,000
The Directors of Rockford decide to make a “one-for-four” bonus issue, and to use the share premium for this purpose
This means one new share for every four existing shares.
Thus there will be 2,000,000 x (1/4) new shares = 500,000 new shares.
Thus the Share premium will need to be reduced by this amount, giving:
Ordinary Shares of £1 each 2,500,000
Share premium 100,000
Revenue reserve 350,000
It should be noted that in a bonus issue no new cash is introduced to the company
Therefore it is not a method of raising finance.
Rights issues
This is a method of raising new funds for a company. In common with bonus issues, new shares are issues to existing shareholders on a pro rata basis. The key difference is that they are not free, in other words the shareholders pay for them (although they usually receive a discount on the market price).
Worked Example 2
Paynter plc has the following capital structure on its balance sheet (in £’s)
Ordinary Shares of £1 each 3,000,000
Share premium 400,000
Revenue reserve 580,000
The Directors of Paynter decide to make a “one-for-three” rights issue of further £1 shares at a price of £2.50p per share.
Thus there will be 3,000,000 x (1/3) new shares = 1,000,000 new shares.
Because the nominal value of the share is £1 only:
1,000,000 X £1 = £1,000,000 can be added to the ordinary shares account.
The remainder (£2.50 - £1) x £1,000,000 will be added to the share premium account giving:
Ordinary Shares of £1 each 4,000,000
Share premium 1,900,000
Revenue reserve 580,000
Types of Share
As we have seen, Ordinary shares – (‘equities’) carry one vote per share.
A company can create many different types of ordinary share, some with more rights than others. Usually these ‘rights’ refer to who-gets-paid-first if the company is distributing a limited amount of limited dividends, or if it is being wound-up (liquidated).
It is not uncommon for a company to have ‘Type A’ and ‘Type B’ ordinary shares. The meaning attached to these names is a matter for the company to determine. There can be as many ‘types’ as the company sees fit.
It also possible for a company to have preference shares. If so, such shares:
Have priority over equities in the allocation of profits
Have a fixed dividend each year (as long as there is enough profit
Do not carry voting rights
Venture capital
When companies are young and require more money than their existing owners can provide – or borrow – to expand, but they are not necessarily large enough to sell their stocks publicly, they may seek venture capital.
Definitions:
“A source of finance for new businesses or turn-around situations in which high returns are offered but high risks are expected.” (Roger Hussey, Oxford Dictionary of Accounting, 1999:350.)
“Finance provided by a specialized institution to an entrepreneur, start-up or developing business where a fairly high degree of risk is involved. The term is also used in a wider sense to include the provision of finance for management buy-outs and refinancings. In this wider sense the correct term is private equity [which refers to institutional investment in unlisted companies]. (Graham Bannock & William Manser, 1999: 281.)
Providers of venture capital are likely to come to share ownership with the founders of a company, at least for a period. Providers of venture capital may seek to overcome the ‘principal-agency problem’ (whereby the FMT look after their own best interests at the expense of other shareholders), by:
demanding a specified level – perhaps even majority – of representation on board;
structuring rewards so that the founders work hard – for example, specifying moderate salaries for the founders, so that they can only realise large rewards from appreciation of the value of their own stock, which will mean that the venture capitalist stocks will also rise;
provide venture capital in stages, with interim audits taking place to confirm that earlier funds have led to the specified levels of progress of the firm;
What do investors want from their investment?
Cornwall et al state (p5) that investors prefer:
Less risk to more risk
More return to less
The return sooner rather than later
More liquidity to less liquidity
It follows that a request (from a company) for funds “must appear to offer less risk, (or) more return, (or) a faster return, (or) more liquidity than other requests” (ibid. p5)
Therefore in order to attract external investors early stage companies need to:
Assure investors of the quality of the management team
Offer potential super-normal profits and high capital gains
Offer potential liquidation of the investment
Inform and involve investors regularly (the accountability issue)
So, what do VC’s look for when choosing their investments?
Lang (2002: 66) cites the following criteria are in order of importance:
Global sustainable under served market need
Strong management team
Defensible technological advantage
Believable plans
60 per cent internal rate of return
An exit route
Accountability
It is clear that investors in growth companies want to be regularly informed and involved at Board (of Directors) level. The following quotes from Senior Executives in established Biotechs illustrate:
“It was important from the beginning to recognise that you need large amounts of capital to continue building a biotech enterprise, and that the CEO must spend quite a bit of time with the investment community, answering their questions, keeping them up to date on the results of the company ….especially in the difficult early stages”
James L. Vincent, CEO, Biogen Inc, (in Jones 1992, p141).
“After gaining initial government support we raised another £7m from British & Commonwealth, the Prudential, Midland bank and 3i. Directors of B & C and the Pru joined the Board as Non-Executive Directors; a B & C Director was a member of Celltech’s organising committee, and acted as the Company’s Chairman for its first two years”.
Gerard Fairtlough, founder of Celltech, Britains first Biotech enterprise (ibid, p144).
“In financing Centocor’s ambitious strategy my major concern was the cost of capital. If you have good products, good ideas, good technology and good people, you ought to be able to raise money. The only question is how much equity in the company you will have to give up to secure it ….. with venture capitalists putting up, in some cases all the money and taking up to a 40% equity stake”.
Hubert Schoemaker, Chairman of Centocor Inc. (ibid, p141-2).
Liquidation of investment
Shareholders will want to realise a ‘capital gain’ on their investment. This occurs when the shares substantially increase in value; they can then be re-sold to a third party. A buyer of these shares is therefore needed. The easiest way for a growth-stage firm to try to seek buyers for its shares is by stating in its’ business plan that it will seek a listing on of the equity markets of the London Stock Exchange (LSE),such as
Official List (largest co.'s)
Alternative Investment Market (medium sized co.'s)
OFEX (smaller co.'s)
These markets offer different degrees of regulation and entail companies in varying levels of costs and so are each suited to companies of different size. The AIM is the less expensive to join and least regulated (therefore being suitable for smaller firms). At the other extreme the ‘main market’ entry requirements are prohibitive for all but the largest firms).
These markets offer the existing shareholders the opportunity to sell their shares. But they also offer the company the chance to issue and sell new shares to a wider audience. The AIM is a common next-step for NTBF’s seeking expansion finance.
Short term finance for established companies
All of the above refers to long-term finance. Established companies who are seeking to make a short term improvement in their cash position often try one or more of the following methods:
Tighter credit control; offering settlement discounts, debt factoring
Moving to a 'just-in-time' inventory system
Tighter creditor management
References:
Cornwall et al (2004): “Entrepreneurial Financial Management – an Applied Approach” Pearson Education, US
Hussey, R. (1999) Oxford Dictionary of Accounting
Jones, S (1992): “The Biotechnologists” MacMillan, London.
Lang, J. (2002): “The high-tech entrepreneur's handbook - how to start and run a high-tech company” Pearson Education, London
Lorenz (1989): “Venture Capital Today: A practical guide to the venture capital market, 2nd edition, Woodhead-Faulker Limited, Cambridge
