Capital raising alternatives

Malcolm McBratney – Partner

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Summary• Overview.

• Funding purposes.

• Options and alternatives.

• Capital raising life cycle.

• Positioning for capital raising.

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Everyone needs capital

• Particularly relevant for rapid growth or capital expenditure intensive companies.

• Challenges:– access to capital; – managing control and dilution.

• Important for clients to have a capital raising management / strategy: – understand the options and alternatives.

• Even income producing companies need capital injections to expand, manage debt, etc.

• Limited alternative strategies.

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Alternatives to pure capital raising• Income free cash flow.

• Organic growth (from within business).

• Strategic partnership.

• Joint venture.

• Licensing Agreement.

• Franchise arrangements.

• Purpose of the alternatives is to limit the need to source capital, share or shift cost, or defer timing point.

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Alternatives to pure capital raising cont’d

• Rationale – internally generated capital is the ‘easiest’ and cheapest way to fund growth.

• In practise – growth cannot be achieved without capital injection at some stage.

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Funding purposes• Common capital requirements:

– Supplement cash flow / working capital;– Growth;– Acquisitions;– New product / service or market development;– Capital expenditure e.g. plant and equipment, property; – Restructuring.

• Suitable types and sources of funding depend on:– Stage of business development** (risk influences what

capital is available and on what terms);– Amount required;– Type of business and market characteristics;– Timing of business cash flow.

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Funding purposes cont’d

• ‘One of the most common reasons for insolvency is poor cash flow as opposed to poor profitability. During the initial stages of growth, businesses are cash hungry and consume large amounts of cash flow.’

• Sounds basic but biggest cause of business failure.

• Once the preferred type and source determined, client must understand the capital raising process (e.g. what info is required?).

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Capital raising life cycle

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Capital raising life cycle• Pre seed and seed phase – idea stage; funding

required for R&D.

• Start up phase – product development completed; funding required for production capacity and sales.

• Growth phase – funding for expansion. Debt and equity may be sourced.

• Maturity phase – stable sales, strong profits and established market.

• Decline phase – sales and profitability decline as competition increases and consumers choose alternative products. Business requires product diversification / improvement.

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Pre seed: Friends, Family and Fools

• Initial phase funding / capital raising - <$100K.

• “Sweat equity”.

• Founders and their immediate network.

• Important because usually one of the only available sources of funding.

• Generally sympathetic to founder’s vision and less intent on rates of return.

• Pre-existing relationship can create a risk.

• Low formality and documentary requirements.

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Pre seed: Friends, Family and Fools cont’d• s708 exception to disclosure document requirement in

s706:– (Small scale offer) 20 issues in 12 months of $2 million.

– (personal offer) may only be accepted by person to whom made and person is likely to be interested.

– (Sophisticated) total investment of $500,000 or certificate from accountant that $2.5M of net assets or gross income for each of the last 2 financial years of at least $250,000.

– (Professional) person controls assets of $10 million, holds AFSL, listed entity, etc.

– (Offshore) offers received outside of Australia.

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Seed capital: angel investment

• Invest during the early development phase.

• Business angels are generally high net worth individuals with cash reserves to invest in high risk / high growth businesses.

• May require involvement in the business, are active in development and bring skills, contacts, experience and personal branding.

• Informal investment process (e.g. subscription).

• Long term investment – 3-7 years / $100K-$2M but represents approx. $1B per annum in Australia.

• Not easily accessible – found through business contacts though increasingly marketing themselves.

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Seed capital cont’d

• Other seed capital sources: – Employees;

– Suppliers / customers;

– Incubator funds.

• Government grants (limited since 14 March Budget).

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Start up, growth, expansion, maturity• Varied capital funding sources:

– Venture capital;

– Trade investor;

– Public float (IP0);

– Debt.

• Toward maturity, investors may seek capital funding by way of an exit strategy:– Private equity / trade sale;

– Public float (IP0).

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Venture capital• Specialist financial intermediaries who seek high

return from high risk industry specific ventures.

• Usually active involvement with influential role (i.e. board position and decision making authority).

• Act as mentors – management and technical advice.

• Generally require a predetermined exit mechanism within a set timeframe (e.g. IPO or 3 years).

• Investment ($1-$10M) staggered across the achievement of agreed milestones.

• IRR dependent upon stage of development. Usually expect higher return at start-up than expansion. 25%-40% p.a is normal IRR over the life of the investment.

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Venture capital cont’d• More formal investment process (e.g. pitch, IM,

MOA/CA, due diligence, legal agreement).

• Factors that increase attractiveness to VC:– Significant barriers to entry – IP protection;– Competitive advantage – IP protection;– Sale history / customer commitments;– Experienced management;– Growth sector / potential;– Strong business model;– Strong financial returns;– Replicable business model;– Market knowledge and distribution systems;– Exit strategy.

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Exit strategies - Trade investor

• Competitor company in the same industry – contribute skills to development and roll-out.

• Usually expect a dominant role in decision making and have an ultimate objective – takeover.

• Common model in pharma industry where R&D intensive.

• Examples:– ChemGenex – Mercke Sante + Stragen;

– Psivida – Pfizer;

– Avexa – Shire Biochem.

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Exit strategies - Trade sale / Private equity• Successful exit.

• Subject to earn-out.

• Key management retention.

• Best price?

• Suitable for business market / retail investors don’t understand.

• Enhanced privacy.

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Exit strategies - Public float (IPO)

• Initial public offering vs compliance listing.

• Significant time and cost commitment, esp. due diligence readiness (IP, IT, IR contracts).

• Exit mechanism and a liquidity event for investors (i.e. VC).

• Must satisfy exchange rules (e.g ASX Listing Rules).

• Offer of securities requires prospectus – s706.

• Continuous disclosure requirements apply – Corporations Act and Listing Rules.

• Escrow can be a big issue.

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ASX Listing Requirements

Profits Test

OR

•Aggregate $1 million for last 3 full financial years.

•Consolidated profit $400,000 for last 12 months.

*NB. review half year accounts if full year ended >8 months before IPO application.

Assets Test

AND

•NTA $2 million after IPO costs.

•Market cap $10 million at issue price.

•Commitment to spend half of the cash and have assets readily convertible to cash.

*NB. review half year accounts if full year ended >8 months before IPO application.

Spread Test At least 500 investors holding $2,000 of shares or 400 investors with at least 25% of shares on issue are held by non-related parties (excl escrow).

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Assessing IPO

• Advantages– Access to capital.

– Enhanced profile / credibility.

– Higher valuation + PE ratio.

– Increased efficiency.

– Continuous disclosure for shareholders.

– Liquidity / exit.

– Employee commitment.

• Disadvantages– Subject to market

performance.

– Greater scrutiny.

– $$ accountability.

– Potential loss of control / dilution for founders.

– Risk of public failure.

– Liability for directors.

– Ongoing costs.

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Once listed - Secondary capital raising• Funding required following listing:

– Retire debt / debt event (e.g. Trinity).– Acquisition (IP, assets, etc.) (e.g Ausenco, GBST).– R&D Clinical trials (e.g. Tissue Therapies, ChemGenex).– Commercialisation. – Ramp up (e.g QGC).

• Funding alternatives:– Loan / debt – query in the current market.– Rights issue:

• Traditional prospectus;• Non-traditional Rights Issue Cleansing Notice.

– Share Purchase Plan (SPP).– Institutional Placement (Placement).

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Loan

• Debt funding usually from banks.

• Difficulty satisfying lending criteria:– Low revenues;

– Low asset valuation;

– Securitisation restrictions (contract, Listing Rules);

– Default risk.

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Rights Issue

• Means an offer of securities to all registered shareholders on nominated Record Date who have a registered address in Aust or New Zealand.

• May be shares (and can be offered with options).

• Usually pro-rata – same percentage interest held before the offer (e.g. 1:3 ratio).

• LR7.7 – if pro rata offer, not required to extend offer to other jurisdictions if unreasonable to do so.

• NZ relief exists for offers to NZ residents (e.g. Exemption Notice regime or mutual recognition laws).

• Usually issue price is at a discount to the market price.

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‘Traditional’ Rights Issues

• s706 – offer of securities requires disclosure.

• Prospectus: – s712 - short form: incorporation by reference;

– s713 - continuously quoted: information not previously disclosed (Note: 3 months not 12).

• May be renounceable or non-renounceable – renounceable means ‘rights’ can be sold.

• Must be at least 1:1 ratio.

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‘Non-traditional’ Rights Issue

• s708AA Cleansing Notice provisions adopted in the Corporations Legislation Amendment (Simpler Regulatory System) Bill 2007 (Effective 1 July 2007).

• In place of a prospectus currently required for a ‘rights issue’, issuers are able to lodge a ‘rights issue cleansing notice’ with ASX.

• Lodge within 24 hours before the offer is made.

• Streamlined document – lower content requirements.

• Time and cost efficiencies.

• Potential risk – no due diligence defence because not a disclosure document.

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Using a Cleansing Notice • s708AA – securities to be offered must:

– be quoted class of securities at the time of offer;

– be offered in proportion to the existing holdings;

– have not been suspended from ASX for more than 5 days (total) in 12 months prior (et al).

• ‘Excluded information’ must be set out in the Cleansing Notice.

• May be renounceable or non-renounceable offer.

• Options may not be offered unless they are quoted.

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Cleansing Notice vs Prospectus

• Form and content of Cleansing Notices will evolve with market practice.

• Content will depend on:– information previously announced to market;

– the purpose of the capital raising;

– potential effect on control.

• Disclosure regarding the effect of the raising would be information that investors and their professional advisers would ‘reasonably require’ to make an informed assessment (Quasi-prospectus test).

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Share Placement Plan (SPP)

• Offer of a maximum of $5,000 of shares to current shareholders at a discounted issue price.

• Total number of shares issued must not exceed 30%.

• SPP offer can only be made once in any 12 month period.

• Limited total quantum that can be raised - discounted issue price and the cap on the number of shares.

• Exemption to the prospectus requirements – s706.

• Time and cost efficiencies.

• Examples: Tissue Therapies and ChemGenex.

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Placement

• Placement of securities to ‘sophisticated’ and ‘professional’ investors.

• No prospectus required – s708.

• Facilitates cross-border investment.

• Time efficiencies – can be effected within a few days with minimal documentation.

• Example: ChemGenex.

• Can follow on with SPP or Rights Issue.

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Positioning for capital raising• Companies must plan for capital raising.

• Cost of accessing capital too early and too often:– Interest;– foregone equity / dilution.

• Appropriate management of risk lowers the cost of capital.

• Appropriate management of business and founder expectations increases capital options.

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Positioning for capital raising cont’d

• Principle considerations for proper positioning:– Raise when can;

– Credibility;

– Use of funds well enunciated;

– Quality product - de-risked technology;

– Pricing;

– Volume;

– Anchor investors.

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Summary

• Capital raising planning.

• Amount to be raised – purpose, pricing (discount) and ratio?

• Capital raising life cycle.

• Primary form – FFF, seed / angels, govt. grants, VC, IPO.

• Secondary form – Rights issue, Placement, SPP.

• Exit strategies.

• Tax implications.

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Contact details

Presenter: Malcolm McBratney

Direct line: 07 3233 8878

Email: mmcbratney@mccullough.com.au