Financing Corporate Growth & increasing Shareholders’ value

Financing Corporate Growth & increasing Shareholders’ value Presented by: Moazam Ali Shah ICAP KSA Chapter 24 February 2014

Bird’s eye-view: • The Cash flow Pie- Two basic approaches for using finance to increase the value of the pie. • Slicing the pie. • When would the investor pay more. • Using the financial policy to increase the cash flow pie • Three sources of conflict related to financial policy • Using capital structure as a conflict management tool • The special features of “growth companies” • Financing “growth companies” • Critical importance of financial flexibility for growth companies • Conclusion

Introduction: • Rapid growth poses special problems for Financial Managers. They must raise large amounts of cash to fund this growth • Ultimate goal of Financial Policy, whether the firm is growing or not is to maximize the value of shareholders’ equity. • Let’s examine the financial tools available to all firms to boost market value before talking about the appropriate financial strategies for growing firms.

2 basic approaches for using Finance to Increase the Value of the Firm: • Think of the firm as producing a cash flow “pie”, which is distributable to all investors (debt holders, stockholders and others) • There are two basic approaches for using finance to increase the value of the firm:

First approach: Considers the size the cash flow pie to be independent of financial policy, so that the principal role of finance is to divide the pie into slices and distribute among the various stakeholders.

Second approach: focuses on ways in which financial policy can be used to increase the size of the value pie by affecting operating and investment decisions. • underlying this approach is the view that a company is a complex web of “contracts” tying together disparate corporate stakeholders such as investors, management, employees, customers, suppliers, and distributors. This approach assumes that the firm’s future operating cash flow may depend significantly upon the perceptions and incentives of the firm’s non-investor stakeholders. Financial policy can be used to increase the size of the cash flow pie by strengthening stakeholder relationships – for example, by improving management incentives or increasing the confidence of suppliers and customers.

Slicing the Pie: • The firm needs money to finance Future Investment Projects. • Instead of selling some of the existing assets to raise funds, it will Sell Rights to Future Cash Flows generated by its current and prospective projects. • Total revenue from the sale of rights to the pie can be increased if financial security (shares or debt) is devised in a way that the investor is willing to pay a higher price.

When would the investor pay more…. • There are three circumstances in which investors may pay more in the aggregate for claims to the cash flow pie: • The securities are more liquid • The securities reduce transaction costs • The security structure reduces the “credibility gap” between management and potential investors that exists whenever companies raise capital from outside sources.

Increasing Liquidity: • There is a substantial empirical evidence that investors are willing to accept lower returns on more liquid assets. Other things being equal, therefore, a firm can increase its market value by increasing the liquidity of the claims it issues. • Ways of increasing liquidity of claims: • Going public • Underwriting new public issues • Buying insurance for a bond (debt) issue • Listing on organized stock exchanges

Reducing Transaction Costs: • By reducing transaction costs associated with raising money, the firm can increase its net proceeds • Similarly, the use of secured debt can reduce enforcement costs by giving a lender or lessor clear title to the pledged or leased assets.

Bridging the Credibility Gap: • One of the key costs associated with issuing new securities arises from the financing problem caused by so-called “informational symmetries” i.e. corporate management having “inside information” about the company’s prospects that it can use to exploit potential investors by issuing overpriced securities. • Recognizing managements’ ability and incentives to exploit them by issuing overvalued securities, rational investors will revise downward their estimates of the company’s value as soon as management announces its intent to issue new securities.

Companies can overcome the credibility problem by raising funds in accordance with what Stewart Myers calls the financing “pecking order” i.e. use the least riskier source first (retained earnings) and then use progressively riskier sources such as debt and convertibles; common stock offerings are typically used only as a last resort. • By using internal funds, companies avoid the credibility problem altogether.

Using Finance to Increase the Cash Flow Pie • The modern corporation is an interrelated set of contracts among a variety of stake holders: shareholders, lenders, employees, managers, suppliers, distributors, and customers. Although these stake holders have a common interest in the firm’s success, there are potentially costly conflicts of interests. To the extent that financial policy can reduce these conflicts, it can enlarge the cash flow pie and thereby increase the value of the firm.

Three sources of conflict related to Financial Policy: • Stock holder – Manager conflict: • Stems from the separation of ownership and control. • Managers are concerned with maximizing their own utility • Management’s tendency to consume some of the firm’s resources in the form of various perks. • Managers have an incentive to expand the size of their firms beyond the point at which shareholder wealth is maximized. The problem of overexpansion is particularly severe in companies that generate substantial amount of “free cash flow” i.e. cash flow in excess of that required to undertake all economically sound investments. • Maximizing share holder wealth dictates that free cash flow be paid out to share holders. The problem is how to get managers to return excess cash to share holders instead of investing it in projects with negative NPVs or wasting it through inefficiencies.

Stock holder – Debt holder conflict: • Debt holders have prior but fixed claims on a firm’s assets, while stock holders have limited liability for the firm’s debt and unlimited claims on its remaining assets. • In case of high leveraged firms, shareholders may pass up projects with positive NPV that involve added equity investment because most of the pay offs go to the debt holders. • The failure to invest in such projects reduces the value of lenders’ claims on the firm as well as the total value of the firm.

Non-Investor - Stake holder Conflict: • The potential conflict between a company and its non-investor stake holders can best be understood by viewing stake holders as buying a set of implicit claims from the company. For example: the manufacturer of a car, a pump, or a refrigerator is implicitly committed to supplying parts and service as long as that product lasts. • Financially healthy firms typically have a strong incentive to honor their implicit claims, whereas, for financially distressed firms, the long run value of a strong reputation may be less important than generating enough cash to make it through the next day.

Using Capital Structure as a Conflict Management Tool: • Unfortunately, a financial policy designed to reduce one source of conflict often opens the door to other conflicts. For instance, one way to lessen the opportunity of management to waste the firm’s free cash flow is to reduce the scope of management discretion by issuing additional debt. Issuing more debt, however, increases potential stock holder – debt holder conflicts and also raises the probability of financial distress. • In short, any change in capital structure is likely to mitigate some problems and aggravate others. • It makes sense to first discuss the distinctive features of a growth company and then to suggest how these features affect the choice of financial policy.

The Special Features of Growth Companies: • The most obvious sign of a rapidly growing company is its large appetite for cash. • Even though profit rises along sales, cash flow is generally negative because the investment required to finance the growth in sales typically exceeds the current net operating cash flow. • Therefore, the ability to locate potential sources of external funds and to arrange them in an attractive financial package are major factors affecting corporate growth. • For a company to grow in value, not just in size, it must have access to investment opportunities with positive NPVs. These opportunities are thought of as “growth options”. Growth options are typically the primary source of value in rapidly expanding firms.

Another key aspect of growth companies is that the market is likely to have a particularly difficult time in establishing their values. • The CREDIBILITY GAP between management and investors is likely to be most pronounced in the case of growth companies because management in such cases will often have far better information about the future profitability of undeveloped products and untapped market niches. • Investors must also cope with the problem of uncertainty about management’s abilities and commitments. • Debt holders’ fears of being exploited are also magnified in the case of growth companies. • Non – investor stakeholders such as customers and suppliers must make “firm-specific investments” whose returns depend on management’s ability to exploit growth options effectively. If the firm fails to expand and develop new products, those parties that chose to do business with the firm will suffer.

Financing Growth Companies: • In an attempt to make financial choices to finance growth companies, the Financial Managers design financial instruments in such a way to solve specific incentive problems and resolve potential conflicts. • Because of the LARGE CREDIBILITY GAP that faces growth companies, investors are likely to be especially wary of new financial instruments from such companies that promise unique risk/ return trade-off. • Increasing LIQUIDITY and reducing TRANSACTION COSTS are probably less useful ways to increase the value of the firm. The reason being, that growth companies are likely to attract investors who are more interested in LONG TERM CAPITAL APPRECIATION. • Measures designed to bridge credibility gap are likely to be particularly valuable for growth companies. • Both investor and non-investor stakeholders will be more uncertain about the future prospects of a growth company than about the prospects of a more mature firm.

Example: Suppose the growth option is to invest in the development of new software package for word processing…… • All else being equal, therefore, the high costs of financial distress together with the costs associated with resolving the conflicts of interest between shareholders and debt holders, reduce the optimal amount of debt in a growth firm’s capital structure. By contrast, established firms operating in stable markets can afford more debt since their competitive stance will be less compromised by the restrictions and delays associated with high financial leverage.

The Role of Bank Loans in Financing Growth Companies: • A banking relationship may solve many of the problems associated with public debt. • The advantages of a banking relationship to a growing company stems from the personal nature of the relationship between borrower and lender. • Banks play the role of delegated monitors who check on the behavior of the firm’s managers. • When a firm is unable to make interest payments on time or when its financial statements indicate problems, the banker’s first response is to examine the firm’s conditions more closely. On the contrary, if the banker finds that the firm’s prospects are promising, he can reschedule the firm’s payments, waive a covenant, or even increase the loan.

The loan approval process by the bank conveys two pieces of positive information about the borrowing firm to outside investors: • The bank believes the firm is sound, and • The bank will supervise corporate management to ensure that it behaves properly However, despite the advantages of bank debt, banks cannot supply all the financing required by growth companies.

The Role of Venture Capital in Financing Growth Companies: In the case of start-ups, whose assets are comprised primarily of growth options, bank loans are virtually unobtainable. Venture capital has evolved as a solution to these problems. In effect, venture capitalists provide private equity. But in return, they demand a much closer relationship, more control, and a significantly higher expected rate of return. Venture capitalists also typically demand a financial structure that shifts a great deal of risk onto company management. The financial structure also motivates management to work harder and thereby increases the probability that a favorable outcome will occur.

To further limit their downside risk, venture capitalists also rarely give a start-up company all money it needs at once. Typically there are several stages of financing. At each stage, the venture capitalist will give the firm enough money to get to the next product or market development milestone. The use of this staged capital commitment can be seen as a mean of overcoming the “credibility gap” that confronts all growth companies in raising capital.

Critical Importance of Financial Flexibility for Growth Companies: • Availability of substantial financial resources also signal the competitors, actual and potential, that the firm will not be an easy target. • A firm that is highly leveraged, with no excess lines of credit or cash reserves, a competitor can move into the firm’s market and gain market share with less fear of retaliation. In order to retaliate – by cutting prices or by increasing advertising expenditures, the firm will need more money. Because it has no spare cash and can’t raise additional debt at reasonable price, it will have to go to the equity market. But we have already seen that firm’s issuing new equity face a credibility gap.

Thus, firms with valuable growth options should place a high priority on financial flexibility. • In an attempt to preserve financial flexibility, corporate managers have a strong preference to fund new investment with the least risky sources available i.e. retained earnings and then debt capital and in the last, common stock. By adhering to this PECKING ORDER and overcoming one problem, however, management may well be creating another. The reason: a firm that issues debt today thereby increases the probability that it “must” raise equity tomorrow – perhaps on a very unfavorable terms.

Financing Growth Firms – Conclusion: • For a rapidly expanding company, the primary role of finance should be to PRESERVE THE GROWTH OPTIONS that are its principal source of value. • One way to improve the financing trade-off is to develop a close working relationship with the providers of funds. This means that a BANKING RELATIONSHIP or some other source of “PRIVATE DEBT” may be particularly important for those growth companies with enough tangible assets to support moderate amount of debt. • In the case of start ups, VENTURE CAPITAL, most likely will be the principal source. In such cases, the credibility problem is partly resolved by the close relationship between management and the provider of funds that allows for the exchange of information on a confidential basis.

Moreover, these funding sources can negotiate financing terms which offer management considerable financial and operating flexibility. • Finally, a growing company cannot make financial policy without considering its non-investor stakeholders. If customers, suppliers and distributors feel that the firm is so financially weak that it longevity is in question, they will not make the investment required to develop a relationship with the firm. • For this reason, a growing firm must demonstrate that it has financial flexibility and strength. • All this analysis points to one avoidable conclusion: a growth company needs a good deal of equity upfront; debt is to be used with care and moderation.

Thank You!

Financing Corporate Growth & increasing Shareholders’ value