The 30 Day MBA (14 page)

Reserves, a typically misleading term in all accounting, means profits of various kinds that have been retained in the company as extra capital. Also important is what the term reserves does not mean. It does not mean actual money held back in reserve in bank accounts or elsewhere. Reserves come from retained profits over many years but are reinvested in buildings, equipment, stocks or company debts, just like any other source of capital, and are rarely held in cash.

The main categories of reserves are as follows:

• Profit and loss account, ie cumulative retained profits from ordinary trading activities.
  
• Revaluation reserves, being the paper-profit that can arise if certain assets are revalued to current price levels without the assets concerned being sold.
  
• Share premium account, ie the excess over the original par value of a share when new shares are offered for sale at an enhanced price. Only the original par value is ever shown as issued share capital.
  

Sources of equity capital

There are two broad sources of equity: private equity, usually put in by individuals or small groups of individuals who for the prospects of greater returns will take on greater risks; or public capital through a share issue on a stock market.

Private equity

There are three main sources of private equity: business angels, venture capital firms and corporate venture funding.

Business angels

One likely first source of equity or risk capital will be a private individual with his or her own funds, and perhaps some knowledge of your type of business. In return for a share in the business, such investors will put in money at their own risk. They have been christened ‘business angels', a term first coined to describe private wealthy individuals who back a play on Broadway or in London's West End.

Most angels are determined upon some involvement beyond merely signing a cheque and may hope to play a part in your business in some way. They are hoping for big rewards – one angel who backed Sage with £10,000 ($15,700/€11,230) in its first round of £250,000 ($392,000/€280,800) financing saw his stake rise to £40 ($63/€45) million.

These angels frequently operate through managed networks, usually on the internet. In the UK and the United States there are hundreds of networks, with tens of thousands of business angels prepared to put up several billion pounds each year into new or small businesses.

Finding a business angel
The World Business Angels Association (
www.wbaa.biz/?page_id=58
) provides links to angels and angel associations around the globe. The UK Business Angels Association (
www.ukbusinessangelsassociation.org.uk
) has an online directory of UK business angels. The European Business Angels Network (eban) has directories of national business angel associations both inside and outside of Europe at (
www.eban.org
> About EBAN > Members Directory) from which you can find individual business angels.

Venture capital

Venture capital (VC) providers are investing other people's money, often from pension funds. They have a different agenda from that of business angels, and are more likely to be interested in investing more money for a larger stake.

In general, VCs expect their investment to have paid off within seven years, but they are hardened realists. Two in every 10 investments they make are total write-offs, and six perform averagely well at best. So, the
one star in every 10 investments they make has to cover a lot of duds. VCs have a target rate of return of 30 per cent plus, to cover this poor hit rate.

Raising venture capital is not a cheap option and deals are not quick to arrange either. Six months is not unusual, and over a year has been known. Every VC has a deal done in six weeks in its portfolio, but that truly is the exception.

Finding venture capital
The British Venture Capital Association (
www.bvca.co.uk
) and the European Venture Capital Association (
www.evca.com
) both have online directories giving details of hundreds of venture capital providers. Ernst & Young (
www.ey.com/GL/en/Services/Strategic-Growth-Markets
) provide an overview of the risk capital market on this website. The National Venture Capital Association in the United States has directories of international venture capital associations both inside and outside the United States (
www.nvca.org
> Resources).

You can see how those negotiating with or receiving venture capital rate the firm in question at The Funded website (
www.thefunded.com
) in terms of the deal offered, the firm's apparent competence and how good they are managing the relationship. There is also a link to the VC's website. The Funded has 2,500 members.

Corporate venturing

Venture capital firms often get their hands dirty taking a hand in the management of the businesses they invest in. Another type of business is also in the risk capital business, without it necessarily being their main line of business. These firms, known as corporate venturers, usually want an inside track to new developments in and around the edges of their own fields of interest. For example, Microsoft, Cisco and Apple have billions of dollars invested in hundreds of small entrepreneurial firms, taking stakes from a few hundred thousand dollars up to hundreds of million.

And it's not just high-tech business that takes this approach. McDonald's held a 33 per cent stake in Prêt à Manger while it worked out where to take its business after saturating the burger market. British sugar and artificial sweetener maker Tate & Lyle launched a £30 million venture capital fund in January 2013 to help develop food science start-ups and develop new ingredients, as well as opening a Commercial and Food Innovation Centre in Chicago. HM Revenue and Customs (
www.hmrc.gov.uk/guidance/cvs.htm
) has a useful guide entitled ‘The Corporate Venturing Scheme', explaining the scheme, tax implications and sources of further information.

Recent research into corporate venturing by Ashridge (
www.ashridge.org.uk
> Research and Faculty) Business School concluded that less than 5 per cent of corporate venturing units created new businesses that were taken up by the parent company. Moreover, many failed to make any positive contribution whatsoever.

CASE STUDY
  
Meraki: Corporate venture multi-million dollar pay day

Meraki (may-rah-kee), a Greek word that means doing something with passion and soul, could soon stand for how to make a billion in under a decade. Meraki was formed in 2006 by three PhD candidates from MIT, Sanjit Biswas, John Bicket and Hans Robertson, all currently on leave from their degree programme.

Meraki, according to its website, ‘brings the benefits of the cloud to edge and branch networks, delivering easy-to-manage wireless, switching, and security solutions that enable customers to seize new business opportunities and reduce operational cost. Whether securing iPads in an enterprise or blanketing a campus with WiFi, Meraki networks simply work'. With over 10,000 customers worldwide ranging from the English public school Wellington College to fast-food chain Burger King, Meraki was initially backed by Californian venture capital firm Sequoia Capital and Google, two early venture investors. Rajeev Motwani, the Stanford University professor who taught Google co-founders Larry Page and Sergey Brin made the necessary introductions.

Payday came on 19 November 2012 when Cisco, who had been in exclusive talks since September with Meraki bought the company for US $1.2 billion (£754 million). The founders had been considering a flotation and at first rejected Cisco's overtures. Analysts think Cisco has overpaid, but with their greater market presence and cash resources the company is confident it will be able to expand Meraki's technology using their global networks. Cisco has included a retention package to keep Meraki's co-founders at Cisco to consummate the deal. Sujai Hujela, an executive at Cisco, also stated: ‘We are making sure we want to preserve and pollinate the culture (at Meraki) into Cisco.'

Private capital preliminaries

Two important stages will be gone through before a private investor will put cash into a business. The emphasis put on these stages will vary according to the complexity of the deal, the amount of money and the legal ownership of the funds concerned. For example, a business angel investing on their own account can accept greater uncertainty than, say, a venture capital fund using a pension fund's money.

Due diligence
Usually, after a private equity firm signs a letter of intent to provide capital and you accept, it will conduct a due diligence investigation of both the management and the company. During this period the private equity firm will have access to all financial and other records, facilities, employees etc to investigate before finalizing the deal. The material to be examined will include copies of all leases, contracts and loan agreements in addition to copious financial records and statements. It will want to see any
management reports, such as sales reports, inventory records, detailed lists of assets, facility maintenance records, aged receivables and payables reports, employee organization charts, payroll and benefits records, customer records and marketing materials. It will want to know about any pending litigation, tax audits or insurance disputes. Depending on the nature of the business, it might also consider getting an environmental audit and an insurance check-up. The sting in the due diligence tail is that the current owners of the business will be required to personally warrant that everything they have said or revealed is both true and complete. In the event that proves not to be so, they will be personally liable to the extent of any loss incurred by those buying the shares.

Term sheet
A term sheet is a funding offer from a capital provider. It lays out the amount of an investment and the conditions under which the new investors expect the business owners to work using their money.

The first page of the term sheet states the amount offered and the form of the funds (a bond, common stock, preferred stock, a promissory note or a combination of these). A price, either per $/£/€1,000 unit of debt or per share of stock, is quoted to set the cost basis for investors ‘getting in' on your company. Later that starting price will be very important in deciding capital gains and any taxes due at acquisition, IPO (initial public offering) or shares/units transferred.

Another key component of the term sheet is the ‘post-closing capitalization'. That is the proposed cash value of the venture on the day the terms are accepted. For example, investors may offer $/£/€500,000 in Series A preferred stock at 50 pence per share (1 million shares) with a post-closing cap of $/£/€2 million. This translates into a 25 per cent ownership stake in the firm ($/£/€500,000 divided by $/£/€2 million).

The next section of the term sheet is typically a table that summarizes the capital structure of your company. Investors generally start with preferred stock in order to gain a priority of distribution, should the enterprise fail and the liquidation of assets occur. The typical way to handle this is to have the preferred stock be convertible into common stock on a 1 : 1 ratio at the investors' option, such that the preferred position is essentially a common stock position, but with priority of repayment over the founders' own common-stock position.

Other terms included on the sheet could cover rents, equipment, levels of debt vs equity, minimum and maximum time periods associated with the transfer of shares, vesting in additional shares, and option periods for making subsequent investments and having ‘right of first refusal' when other rounds of funding are sought in the future.

Public capital

Stock markets are the place where serious businesses raise serious money. It's possible to raise anything from a few million to tens of billions; expect
the costs and efforts in getting listed to match those stellar figures. The basic idea is that owners sell shares in their businesses that in effect bring in a whole raft of new ‘owners' who in turn have a stake in the businesses' future profits. When they want out, they sell their shares on to other investors. The share price moves up and down to ensure that there are as many buyers as sellers at any one time.

Going public also puts a stamp of respectability on you and your company. It will enhance the status and credibility of your business, and it will enable you to borrow more against the ‘security' provided by your new shareholders, should you so wish. Your shares will also provide an attractive way to retain and motivate key staff. If they are given, or rather are allowed to earn, share options at discounted prices, they too can participate in the capital gains you are making. With a public share listing you can now join in the takeover and asset-stripping game. When your share price is high and things are going well you can look out for weaker firms to gobble up – and all you have to do is to offer them more of your shares in return for theirs. You do not even have to find real money. But of course this is a two-sided game and you also may now become the target of a hostile bid.

You may find that being in the public eye not only cramps your style but fills up your engagement diary too. Most CEOs of public companies find that they have to spend up to a quarter of their time ‘in the City' explaining their strategies, in the months preceding and the first years following their going public. It is not unusual for so much management time to have been devoted to answering accountants' and stockbrokers' questions that there is not enough time to run the day-to-day business, and profits drop as a direct consequence.

The City also creates its own ‘pressure' both to seduce companies onto the market and then by expecting them to perform beyond any reasonable expectation. There have been a number of high-profile examples of companies that have floated their shares on a stock market then changed their minds and withdrawn, buying out all outside shareholders. The rationale for taking a company private is that the buyer feels that they can run the company better without the need to justify their decisions to other shareholders, or the complex and burdensome regulations that public companies must comply with.