Monday, September 19, 2011

When a Commitment May Not Be a Commitment

This prospect story is worth telling you about. One of BH Capital Ltd’s 25 affiliates made arrangements for a conference call. These calls are designed to more fully investigate the prospects’ opportunity and usually a chance for the prospect to convince me to take him on as a client. At this point we have usually reviewed a mountain of documentation. We have a pretty good idea of what the project holds. We just want to hear from the horse’s mouth the finer details of the project/engagement and what kind of financing structure the prospect has in mind. This was a real head turner.
Commitment Letter? Foreign Bank?

The prospect pontificated for about twenty minutes when he made a U-turn. He said he had been talking to a foreign bank and that they were willing to issue a commitment letter for long term financing. All I needed to do was lend him money for six months to build a power plant. Six months? Power plant? Commitment letter? Well he mentioned the name of the institution and where it was located…a half a world away. I said that I was not familiar with the bank and that the commitment letter, although it may be real, I could not count on it. He became argumentative and said it is the Bank of America of… I responded and said that that may be true but as the lender taking the biggest risk, and the lender having to rely on a bank I have never heard of, that I felt there was another way to meet his needs without the reliance of the third party. I went on to say that there were a couple of dozen American banks that I would not accept a commitment letter from now for various reasons. Basically he said he wanted to do it his way or no way at all and then he promptly hung up.
Banks Unable to Honor Their Commitment

Over my thirty years in structured finance I cannot tell you how many times I have been on the short end of the commitment letter. In my book The Obstacle Course I told a story of how a banker welched on his commitment. It has happened time and time again. I have seen banks unable and or unwilling to honor their commitments literally dozens of times. Sometimes the bank was financially incapable of funding as prescribed. In other cases they just changed their mind for no good reason. In yet other cases the internal consensus of a transaction shifted and they just pull out and leave you in the breach right at the closing table. After some research the picture was very clear. The prospect was naive and convinced with his own BS that this was a real bank with real capability. After some research the picture of the bank was quite different than he knew.
The bank was facing huge current losses. Their recent attempt to float new equity had failed. Even more recent their attempt to float new debt had failed. They were facing huge projected losses because they had acquired companies that were bleeding at a very rapid rate. In short they were in very poor condition and on top of that fact they had no experience in the energy field. They were just another bank on my list that I would not deal with.
Behind Commitment Letters Are People

So many people think a commitment letter will solve everything. It is the Holy Grail to completing andy kind of project. Frankly it is not. Behind commitment letters are people. Sometimes those people do not do what they say. Also things change and so goes the commitment letter. Banks just like businesses can fall the way of Lehman Brothers. They can fail too. And with the failure so goes the outstanding commitments that the bank has made.
The Deal is Closed When the Cash Shows Up

The rule for commitment letters is who is behind it? Do they honor their commitments and do they have experience in the area the project is situated? Look at who and what is behind this Holy Grail of letters. Remember the deal is closed when the cash shows up. A commitment letter is only a piece of paper.

Monday, September 12, 2011

A Business Valuation is Critical to Raising Capital

When raising capital for a business or business venture, most do it yourselfer’s leave out several key tools that drastically increase their chances of obtaining capital and making their dream a reality. Why? I ask myself that every time a client says “I don’t need a business valuation to raise capital”. Or they say, “I’m not paying for that,” they do it their way and a year later are still in the same rut when we first met. One thing I’ve learned from this business, the really successful entrepreneurs know there are costs to raising capital. As a result, they hire the right team of professionals and surround themselves with advisors to drastically increase their success rate.
Mistake #1 – Valuing Your Business Too High

One of the biggest mistakes many business owners or would be business owners make is valuing the business too high. As a result, when they try to sell the business, they find out it’s not anywhere near what they think it’s worth. They use wrong criteria for evaluating it’s value. This is a very general description of what a business valuation is, what is involved in valuing a business and some common mistakes many business owners or entrepreneurs make when starting a new business venture or trying to sell a business. I’ll also discuss possible solutions to increase your chances of a successful capital raise.
What is A Business Valuation?

‘Shark Tank’ is a TV show in which budding entrepreneurs take their ideas to a panel of Venture Capitalists (VC’s) and “pitch” them on investing in their business. One of the biggest reasons the entrepreneurs fail to gain capital is common, “I can’t get my hands around the valuation” one of the sharks states. The entrepreneurs have not properly done their homework, and most of the time, overvalue their business. A typical request would be to give up 20% of the business for $50,000. Simple math tells us they are valuing their business at $250,000 (20% x 5 = 100% // 5 x $50,000).
The panel asks the potential partner – “Do you have any patents? Do you have any orders to fill? How much revenue did you generate last year and through this year? Where are your sales coming from? Do you own any assets? How is your business structured (LLC, Partnership etc.)” and many other questions designed to determine a value of their business, their market and reason for the request. Most contestants fumble through this questioning because they don’t have solid proof what their business is truly worth, they guessed.
A business valuation is not an appraisal. An appraisal involves physical or tangible elements, jewelry, real estate, a classic car or inventory – something that can be touched. An appraisal can be part of a business valuation, the physical assets, but there is more to the value.
Three Common Methods to Value a Business

1) The Income Approach: Also known as a valuation approach, this method takes into account the annual income a property or business generates to produce revenue. Revenue or Net Operating Income (NOI) is determined by adding all the revenue a business generates minus all operating expenses. However, income taxes, interest and servicing debt are not deducted. Many models may call this EBITA – Earnings Before Interest, Taxes and Amortization expenses.
In the simplest form, the process works like this – assume our business is an antique store and has EBITA of $1,000,000 annually. A valuation multiple is applied to the EBITA. Many times it’s based on the discretionary earnings of the business. Assume that after interest, taxes and depreciation there is $500,000 profit. The sales price would be calculated on that amount – a common factor is 2 ½ times earnings or $1,250,000. Of course there are other things taken into account the inventory, furniture, fixtures or equipment, accounts receivables or the real estate (if we own the building) – but you get the idea.
2) The Market Base This approach looks at comparable sales of similar businesses in your area. Every industry is classified into a Division, then a Major Group, and finally a class. This is known as the Standard Industry Code or SIC. The Bureau of Labor and Statistics is a great resource for this information
Using our Antique Store, we are grouped in with Retail Stores, under Retail Trade and Used Merchandise. Comparable stores would be Second Hand Stores, Pawnshops, used Furniture even used book stores. The value is based on how these businesses sold for in our community or a general geographic area. This is not an apples to apples comparison – it’s similar to a home appraisal. If a comparable business or a home, was sold due to illness or some other issue where the owner was forced to sell below market value, that affects the sales price of your business, or how much an investor may be willing to invest in your endeavor.
3) The Asset Base This approach bases the value of the business on the overall assets that are in inventory when the business sells.
For our antique store, that could be a pretty good deal – especially if we are selling high end antiques or old jewelry. If we have $5,000,000 worth of inventory at wholesale and the retail value was $10M, we would anticipate a sales price somewhere between the two. If we own the building and real estate, that could be a nice thing for us.
Which Method is Best?

So which one is best? A combination of all three. Together, they look at ALL aspects of the business – not just the assets or the revenue. But there is one element many entrepreneurs forget to take into account when valuing a business – the key people running the operation. Does that team come with the sale of the business? If the answer is yes – that can add a tremendous value since those folks know the client’s, they understand the market and were most likely instrumental in making the business what it is today. If not, then you need to rely on the above.
Mistake #2 – Why Not To Do it On Your Own

Another mistake when selling a business or seeking funds for a venture is trying to do it on your own. A project I recently reviewed was amazing. The conservative numbers show a great return on investment, there is a need for this service, the client has the market locked up and has created a virtual monopoly. He did his own market research, he’s buying the primary business asset at a great discount – so in his mind there is equity and he thinks this deal is a no brainer. Here is the problem, he refuses to accept anyone’s word that the money sources need an independent third party valuation and market study done for his business. He comes back with “The asset is worth X but I’m only paying Y” – exactly, if that’s what you can buy it for, that’s all it’s worth. “But I’m insuring it for X” That’s nice, how much did you pay for it?
Here is the dilemma, the capital sources are impressed with his credentials, he’s extremely qualified to run this operation. He’s recognized as one of the top 5 professionals in his field in the world and is uniquely qualified to provide all this information – for someone else. The capital sources could care less who he is – they won’t “take his word for it” – they want an independent study conducted to verify the information on their own. So here we are, a client who refuses to pay for an independent study and money sources refusing to give him a dime until he does. So next year, I’ll let you know that someone else paid for a study, took his business idea and is making millions, while this “expert” is sitting in the wings.
Mistake #3 – Why Do I Need a Market Analysis?

Which leads me to another major mistake – many entrepreneurs don’t understand why they should have a Needs and Necessity Study /a Market Analysis done. This is probably the most critical piece of the business valuation. If the person putting a value on your business does not know what the local market is doing, how can they provide a legitimate value? If you are getting into an industry that is in a downward spiral, who is going to invest in it?
Doing It Right The First Time Saves Money and Time

So what does all this mean? Hire a qualified source to help you raise capital. Make sure it’s a reputable institution or individual with a proven history that will require a market study and a valuation done on your venture. This protects you both – the entrepreneur won’t get stuck giving away more of the company then they should. The investor is going to know the value of the company and the market is there so you both have a legitimate chance at success. Yes, it is going to cost you some money you may not have been expecting to spend right now. It’s important to understand, a group that works with you to raise capital is going to do the majority of the work for you now, so in the future, when you come back – the paperwork and bulk of the work will be done for future equity raises, it won’t take as much to do it again.
Many budding entrepreneurs are not willing to spend the money to do it right the first time; they are looking for “the deal” and want immediate satisfaction. They don’t consider the long term consequences of their decision or the additional time and money it’s going to take to achieve success. It’s like the man who was aimlessly wandering through the desert, dying of thirst. He came across a shack, upon entering, sees a sealed glass container of water on a shelf. Next to it is an old fashion water pump secured to the floor and a sign above the water container saying “Don’t drink the water – unscrew the cover, prime the pump and you’ll get all the water you want – Don’t forget to put a full jar back for the next guy”. Do you want to drink the water? Or prime the pump?
Jim Alafat, CMPS

Thursday, September 1, 2011

The Cost of Capital Formation

Recently I gave my ten thousandth explanation of why it costs money to form capital. Most entrepreneurs do not understand the process of capital formation. If it is borrowed money or an equity infusion there are a host of costs associated with capital formation. So let’s talk about the costs.
Lawyers Cost Money

The client is always responsible for the costs of capital formation. First is legal. Lawyers cost money. The client will have to have a good general corporate lawyer on hand to read and interpret contracts, loan documentation and various agreements associated with a loan transaction as well as review and assist in the preparation of due diligence documentation. Also if the transaction involves the infusion of equity then the entrepreneur will need a top flight securities attorney. These are a special breed of lawyer. If they are worth their salt they will bring capital resources to the table as well. These lawyers are a bit more expensive than the corporate lawyer. So be prepared for the bill to be larger and more extensive. However if they are good they will be well worth the cost.
Accountants Cost Money

Lenders and investors want the most up to date financial statements and also desire as much disclosure as possible. Enter the accountancy costs. Accountants also charge by the hour. Getting your most up to date financial statements prepared or for that matter a full blown audit will cost you a pretty penny. The fact is the “numbers” as we say will tell the story and are a requirement. Don’t balk at the need for the preparation of financial statements. If you need capital you are required to provide disclosure. This one of the first steps you need to take.
Professional Reports Cost Money

Appraisals, Valuation Reports and Feasibility Studies are a fact of life. Even the Need and Necessity study is now par for the course in required documentation. If it is real estate or asset based financing these reports are a must. They can get quite expensive. Third party opinion reports are now the second set of eyes on almost every transaction. The lender or investor uses them as a touchstone to test their own impressions of value and need. Appraisals are usually accompanied by a Feasibility Study or at the very least a Need and Necessity Study. Equity or convertible debt transactions now require a Valuation Report. There is less reliance on the appraisal then before. That is why you see the Feasibility Report as the second requirement to real estate documentation requests. Hold on to your wallet because these reports are costly and getting the highly experienced and recognizable firms will cost even more.
Professionals Do Not Work For Free

The due diligence process takes not only time but money. Structuring a transaction should be done by the pros. Hiring a corporate finance consultant is a must. Get your own private banker to ply his skills during this phase of the process. A surgeon does not perform surgery on himself. Therefore the entrepreneur should let the professional step in and guide this part of the process. Getting the entrepreneur ready for the dance takes time and money as well. Preparing the documentation in an acceptable format takes time and money. Presenting the deal the entrepreneur seeks costs money. Presenting to the reliable sources takes time and money. Determining the final appropriate source for financing takes time and money. Your accountants, lawyers and corporate finance consultants will all have to pitch in to make the transaction a go for the entrepreneur. Even the final documentation will need all hands on deck for review and final negotiation. This costs money. Professionals do not work for free.
There are a host of other costs such as entitlement expenses, master planning costs, forecasting and budgeting, title searches, litigation and background checks. The list really does go on and on. Suffice to say that if you do not have this money in the bank when you start the process don’t start. No one worth his salt is going to work for free of put it all on the line for the entrepreneur when the entrepreneur can make or break the entire transaction. You need money to form capital. This is not a process where everyone around the entrepreneur is expected to take all the risk when there is little to gain.
Money Begets Money

I always get a kick out of the prospect that says if you charge “upfront fees” I am not interested. First of all BHCL does not charge “upfront fees”. But after I am done explaining to the prospect the aforementioned his tone changes. It’s easy to spot the guys with just an idea looking for a free ride as opposed to the serious entrepreneur who knows what he is facing to reach for the brass ring. In short money begets money. You have to have it to get it. Be prepared. It can be very expensive. But when the end goal is reached and the entrepreneur gets the capital he needs, then he understands it has been worth every penny he has spent.