Leisure Wallet Report 2012 Zolfo Cooper Industry insight How to bring private equity to the P-A-R-T-Y Patrick Marrinan | Zolfo Cooper, Corporate Advisory Services Zolfo Cooper has advised the boards of Pho, Be At One and Blanc Brasseries on recent fundraisings. In this article Patrick Marrinan, an experienced corporate finance professional at Zolfo Cooper, outlines some of the key considerations for entrepreneurs who are contemplating going to market to seek funding from professional investors. Five steps to the private equity P-A-R-T-Y What often separates the great deals from the less successful ones is planning and preparation. Having a concept that has the potential to attract the interest and wallets of private equity (PE) is a tremendously exciting prospect, but the capital raising process represents a momentous journey, and entrepreneurs are faced with a significant number of difficult decisions along the way. The aim of this article is to demystify the PE capital raising process, and to outline the key issues that should be at the forefront of an entrepreneur’s thinking when embarking on a process. In my view, the primary considerations for most capital raisings can be encapsulated in five points, which are discussed over the following pages. “It is common for young or fast-growing companies to discover a disconnect between the quality of their financial information and the quality of the data that is required by an investor during due diligence.” Preparing your business for market P There are some fundamental questions that all owner-managers need to ask themselves when they first consider bringing in new investors. The opening and most critical question concerns the quality of the business, because without a strong consumer proposition and financial model you are unlikely to be a viable PE investment option. Ask yourself — is the business sufficiently differentiated, niche or special, when compared to the competition and in the context of the market in which it operates, and have you perfected the financial model to deliver an attractive return on investment? From a financial perspective, investors are drawn to businesses that can demonstrate a track record of generating profits, the potential to improve profitability going forward, and high levels of return on capital employed. If the consumer proposition and financial characteristics are sound, the next consideration is management — is the business run by quality operators and, importantly for PE, how strong is the accounting function? In most cases, the pedigree of the operations team is known to the investor community and is evident by the success of the business to date. What is often not so obvious to the outside world is the degree of in-house professionalism that exists in the finance department. In our experience, a full time, permanent Finance Director (FD) is crucial to a successful capital raising and serves to provide investors with confidence in the historic financials. Ultimately, the worst thing that can happen is for a potential investor to question the numbers in the business plan because of a ‘nasty surprise’ that emerges in the course of due diligence. It is common for young or fast-growing companies to discover a disconnect between the quality of their financial information and the quality of the data that is required by an investor during due diligence. Once they are satisfied about the concept, financial investors scrutinise the accounts at a detailed level to help them get comfort that they really know what they are investing in. The process can be intense and I am never surprised when management teams speak of the stress heralded by the PE due diligence process. This is where a seasoned FD can add significant value to the process, both in the preparation and presentation of the financial information. Continued overleaf  Tourism, Hospitality & Leisure 01 Zolfo Cooper Leisure Wallet Report 2012 Industry insight How to bring private equity to the P-A-R-T-Y ...Continued from page 25 Aggressive but supportable business plan A When working with entrepreneurs, we often talk about the need to present an aggressive but supportable business plan. The business plan has to show a sensible balance between offering attractive returns to investors at exit and a realistic rate of growth. As a general rule, PE firms like deals that return at least 2.5 times their original investment. If the business plan shows that this level of return is only achievable by opening ten sites per year in central London, the plan will most likely be viewed as overly aggressive. Where the appropriate returns can be achieved by opening, say, three sites per year, the plan becomes entirely believable. The team is all about having the right people, in the right roles, to deliver the plan. Investors will review the current head office cost with interest and interrogate the business plan for the timing and cost of future hires. We are frequently asked how investors treat a business that has invested in head office infrastructure ahead of a planned roll out. Overall, most investors prefer that the owners have invested in experienced management, and any downside from the higher costs is generally offset by the higher level of comfort the investor has in the delivery of the plan. The key is to get the right balance. Management remuneration will be based on a reasonable market salary, with the potential for some modest annual bonus for exceeding the business plan. This can be a significant change for an entrepreneur used to taking dividends as well as a salary to fund a lifestyle. Going forward, your new partner will understandably want to see every spare penny reinvested into the expansion plan. The focus is on creating the value at exit, and growing EBITDA is the primary objective. Realise your go-to-market strategy R Selling a business (or part of it, at least) is not like selling a house, and due consideration needs to be given to the go-to-market strategy. One of the key questions is: do you set your target deal structure prior to launching the process and request offers based on that structure; or do you let the prospective investors propose a deal structure and select the one that is most attractive? 02 Tourism, Hospitality & Leisure Whatever the chosen strategy, it is imperative that you have an open dialogue with your advisor about your objectives from the transaction. Your advisor can explain the pros and cons of the different potential structures and financial instruments, as well as the impact and consequences of the various structural options, in terms of both risk and return. Traditionally, PE money comes in via a new company specifically set up for the transaction. The majority of the capital is usually invested in the form of loan notes, which attract an interest rate (coupon) that rolls up until exit or some future date. This approach helps de-risk the investment for the investor, as loan notes are paid out prior to any equity distributions. Similarly, for entrepreneurs who have invested many years of toil in building the business, loan notes help to lock in most of the value that has been created to date. For example, if you have a business worth, say, £10 million that receives a new cash investment of, say, £5 million, then a standard deal structure, assuming no senior debt, would have around £14.5 million of loan notes and £500,000 of ordinary shares. In this structure most of the current value is locked up in the loan notes and the equity takes the upside above the value of loan notes. However, the key issue in any structure with significant amounts of loan notes is the interest rate rolling up on those loan notes. Loan notes typically attract annual compound interest of between 5% to 12%, and can materially increase in value through the course of the investment period. In the earlier example, if the loan notes have a 10% coupon rate and the investment ran for five years, the value of the loan notes and rolled up interest on exit would be £23.4 million. In this situation, management would have to increase the value of the company by almost 60% before their equity had any value. Of course, some entrepreneurs are more focused on the potential equity upside and are willing to forgo some or all of their founder loan notes in favour of retaining more equity. This structure reduces the amount of loan notes that rank ahead of the equity pot but is a riskier option for the entrepreneur. In return for adopting this ‘equity’ investment approach, an entrepreneur should be able to demand a bigger slice of the equity pie, particularly if the investor has loan notes in the structure. This approach also sends out a clear message to the prospective investor that management are highly confident that they can deliver the business plan. Leisure Wallet Report 2012 Zolfo Cooper Industry insight Tax and legals: seeking specialist advice T You could write a book on the subject of tax when it comes to M&A, especially in relation to ownermanager deals. There are multiple technical issues which require expert input to successfully navigate, however, in my experience there are a few straightforward pointers that entrepreneurs should take on board early in the process. Fundamentally, entrepreneurs should engage a credible, experienced and proactive tax advisor early in the process to help navigate the tax minefield. A single capital raising process can touch on tax issues relating to income tax, capital gains tax, entrepreneurs relief, EIS investments, VAT, corporation tax and stamp duty to name just a few. The rules, and some of the treatments of certain issues, are not intuitive, so specialist help is required. The ultimate objective of the process is to deliver an amount of money, whether today or at exit, into the entrepreneur’s bank account, and tax will play a huge part in determining that final figure. With this in mind, a specialist can deliver extraordinary value, and it is money well spent. From a legal perspective, the biggest issue that entrepreneurs face is loss of control. Recognising the difference between economic ownership and control is important and entrepreneurs need to go into legal negotiations with their eyes open. In exchange for investing a significant amount of capital into the business, investors will typically require several key elements of control. These include: Drag rights: the investor’s ability to ‘drag’ other shareholders into a transaction to sell the business at some point in the future. In the unlikely scenario that the founder does not want to sell the business, the contract dictates that the founder can be compelled to sell his/ her stake alongside the PE house. Leaver provisions: clauses that set out what happens to the shares of key managers who leave the business for a variety of different reasons. These are often classified as good leavers (retirement or illness) and bad leavers (eg gross misconduct). These provisions impact how the value of the founder manager’s shares are treated at the time of leaving the business and require careful negotiation to protect the founder manager’s rights. Investor consents: an investor will expect to have consent rights on the big decisions such as site selection, significant spending, any key personnel appointments (above a certain pay grade) and approval of the annual budget. You need to ensure you use a lawyer who is experienced in private equity transactions. A commercial lawyer can expedite the process by striking a good balance between protecting the entrepreneur’s interests within the legal documents and adopting a pragmatic approach to negotiations by avoiding indulgence in extreme hypotheticals. It is important for entrepreneurs to remember that while the contract is important, the investor is reliant on the management team to deliver future value and is keen to maintain a strong relationship. This generally means that these types of protections are rarely contentious. Continued overleaf  Tourism, Hospitality & Leisure 03 Zolfo Cooper Leisure Wallet Report 2012 Industry insight How to bring private equity to the P-A-R-T-Y ...Continued from page 27 Y Your choice of partner Put simply, this is the most important consideration when raising PE capital. The type of investor you select should be driven by the needs of the management team and the business. Entrepreneurs should ask themselves whether they are looking for an active investor that has been there, done it, and can add material value. On the other hand, you may feel that too many cooks spoil the broth and just want the cash. If you are in the market for a PE partner with genuine sector expertise, it may well prove to be more expensive compared to other investors. After all, sector-focused investors have worked to develop niche experience, and this may come at a price. The quid pro quo for this is that a sector specialist should help the management team deliver, or even exceed, the business plan forecasts. For many entrepreneurs, the experience, knowledge and contacts that a specialist can bring to the board room is a big draw. If you fall into the other camp and just need the funding, it may be that Enterprise Investment Schemes (EIS) or Venture Capital Trusts (VCT) are more cost-effective solutions. These vehicles appeal to retail investors because of favourable tax incentives, and individual companies can raise up to £5 million per year through an EIS or VCT. The required return of EIS and VCT investors is generally lower than the standard PE hurdle, which means that they may be able to pay a little more for a business on the way in. On the other hand, the business is unlikely to get the same added value from an EIS or VCT fund, versus an investor that specialises in a particular sector. A successful capital raising process may result in multiple proposals from the investor pool and the advisor will negotiate with the serious parties to deliver the optimum financial terms. Quite often, at the end of the negotiation process, the difference between the best offers can be negligible. At this point, the strength of relationship between entrepreneur and investor becomes the deciding factor. Entrepreneurs often talk to me about issues such as trust, support and respect when considering the best partner. Inevitably there will be some difficult and challenging conversations with your new investor partner during the investment period and the strength of the entrepreneur-investor relationship is key to fostering an environment that allows the management team to deliver value for all shareholders. 04 Tourism, Hospitality & Leisure Bringing private equity to the P-A-R-T-Y Bringing external professional investors into a fast-growing company often takes owner-managers way beyond their comfort zones, and is plainly not for everyone, or every business. But, for the right concepts, it can deliver game-changing growth. Following the steps set out in this article will help you deliver the right deal for you and your business. Patrick Marrinan is a senior associate in the Corporate Advisory Services team at Zolfo Cooper, specialising in tourism, hospitality and leisure “The entrepreneur-investor relationship is key to fostering an environment that allows the management team to deliver value for all shareholders.” Industry insight Leisure Wallet Report 2012 Zolfo Cooper Tourism, Hospitality & Leisure 05 Zolfo Cooper 10 Fleet Place London EC4M 7RB t:+44 (0) 20 7332 5000 f:+44 (0) 20 7332 5001 Follow our Twitter feed: @ZolfoCooperLLP This publication does not constitute professional advice. Whilst every care has been taken in its preparation please note that it is intended as general guidance only. Before acting upon any information provided within this publication you should consult with a suitably qualified professional advisor. Zolfo Cooper accepts no liability for any loss sustained by any person who chooses to rely on this publication. Copyright © Zolfo Cooper 2012. All rights reserved. www.zolfocooper.com