The investment banker has to educate the client on the linkage between these three parameters.
- The resource mobilisation that the business needs depends on the project size and structure. A project to manufacture 1mn units of a product will obviously cost lesser than a project to manufacture 2mn units of the same product. Since the latter project cost will be less than twice the project cost for the former, there are economies of scale involved in going for the larger project. However, larger the project, higher the resources that need to be mobilised. From a technical stand point there is a minimum economic size for the project; below this size, the cost of production will not be viable in the market. Businesses need to freeze on an optimal size for the project, depending on factors such as industry demand, trajectory of industry growth, current capacity, time required to set up a new project, new capacity expected to come up during the project set-up period, availability of raw materials and other factors of production and overall economics of cost of production.
- A financial model is discussed in the next chapter. Valuation comes out of the financial model and various subjective factors. There are two kinds of valuation associated with an investment transaction – pre-money and post-money. Suppose a PE investor decides to invest USD10mn for a 20% stake in the business. This means:
- Post-money valuation of the business is USD10mn ÷ 20% i.e. USD50mn.
- Pre-money valuation is Post-money valuation minus the Proposed investment i.e. USD50mn – USD10mn = USD40mn.
- If the company has already issued 800,000 shares before the investment, it will now issue 200,000 shares to the PE. This will lead to a 20% stake in the revised total shares issued viz 800,000 (existing) + 200,000 (new) i.e. 1,000,000 shares.
- An alternate approach to the calculation is that the 800,000 shares already issued will represent (100% – 20%) i.e. 80% stake in the revised capital structure. Therefore, the revised capital would have 800,000 ÷ 80% i.e. 1,000,000 shares. This can be achieved by issuing 1,000,000 – 800,000 i.e. 200,000 shares.
- The cost of each share for the PE will be Investment of USD10mn ÷ 200,000 shares received i.e. USD50.
- If the face value of each share of the company is USD1, then the shares will be issued at a premium of USD49.
- Post-money valuations are done on a fully-diluted basis. In the above example, suppose the company had the following elements in its capital structure:
- Loan of USD1mn, which is convertible into shares at USD40
- Warrants attached to an issue of debentures, which entitle the holders to 120,000 new shares at USD60 each
- Employee Stock Option Plan under which employees have an option to acquire 100,000 new shares from the company at USD30 each.
- The fully diluted number of shares in the company is the sum of the following:
- 800,000 i.e. the existing number of shares
- 200,000 i.e. the number of new shares being issued to the PE at USD50 each
- 25,000 (USD1mn ÷ USD40) i.e. the number of shares that will be issued on conversion of the loan
- 0 towards warrants since these are out of the money, being exercisable at a price higher than the current price of USD50
- 100,000 towards ESOP shares
- Thus, the fully diluted number of shares is 1,125,000. This gives a post-money fully-diluted and converted valuation of 1,125,000 X USD50 i.e. USD56.25mn
- The money to be received in the net worth (share capital + reserves) of the company is the sum of the following:
- USD10mn from the PE
- USD1mn as part of the loan conversion
- USD3mn being USD30 X 100,000 ESOP shares
- Thus, the money to be received on full conversion and full dilution is USD14mn.
- The revised pre-money valuation is USD56.25mn – USD14mn i.e. USD42.25mn.
- Before the PE investment, the original promoters had 100% of the company. After the PE investment, their holding comes down to 800,000 ÷ 1,000,000 i.e. 80%. Thus, the PE investment had led to them diluting 100% – 80% i.e. 20%. On fully-diluted and fully-converted basis, the promoter share-holding would be 800,000 ÷ 1,125,000 i.e. 71.11%. Thus, their dilution will be 100% – 71.11% i.e. 28.89%. The point to note is that higher the valuation, lower the dilution for the same resource mobilisation. Suppose, the company needs USD10mn to implement its project, but the PE investor is prepared to buy only at USD40 per share. This means that, the company will have to issue USD10mn ÷ USD40 i.e. 250,000 shares. This will take the total shares issued to 1,050,000.=
The promoters’ stake will become 800,000 ÷ 1,050,000 i.e. 76.19%. Thus, the dilution would be 23.81%, instead of the 20% calculated earlier. It can be similarly reasoned that for the same price per share, a higher resource mobilisation will entail greater dilution by the promoters.
Promoters need to internalise this connection between resource mobilisation, valuation and dilution. An implication is that at times, the promoter may choose to implement the project in phases. This may allow him to do a subsequent dilution for the next phase of the project at a higher valuation. There is however a risk that at that stage, the markets may be weak. This may lead to a lower valuation for the subsequent dilution, despite the value created in the company as part of the first phase of the project.
Each stage of financing is called a “round”. Thus, there will be first round of financing, second round of financing etc. So long as each round of financing happens at higher valuations, the previous investors benefit. In the previous example, let us ignore the loan conversion, warrants and options. In the first round, a PE investor invested USD10mn for a 20% stake. Suppose that in the second round, another PE investor invested USD15mn for a 20% stake. This means that post-money valuation of the business is now USD15mn ÷ 20% i.e. USD75mn – up from USD50mn calculated earlier.
The new PE investor will be issued 250,000 new shares. This will be 20% of the revised total shares issued by the company of 1,250,000.
The earlier PE investor was allotted 200,000 new shares. Its stake is now 200,000 ÷ 1,250,000 i.e. 16%. On the post-money valuation of USD75mn, its stake is valued at USD12mn – an appreciation of 20% on the USD10mn that it invested.
