coba.belmont.edu

Private Equity and Debt AlternativesLinda Costello

Managing DirectorApril 27, 2006

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Private Equity and Debt AlternativesCommon Reasons to Seek Financing

Expansion – Growth in fixed assets or marketing expansion

Acquisitions

Founder/shareholder liquidity

Refinancing – Improvement of existing debt terms

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Private Equity and Debt AlternativesHow to Finance?

Available cash on the balance sheet

Operating cash flow

External financing

The principal consideration will be timing of the opportunity and

the alternative need for existing cash.

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Private Equity and Debt AlternativesCapital Structure Overview

Very generally, a company’s capital base is made up of debt and equity.

Common Equity

Capital Structure

Senior Debt

Subordinated (Mezzanine) Debt

Preferred Stock

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Private Equity and Debt AlternativesMaturity of the Business - Investor Types

Seed/Start-Up Stage

Individuals

Venture Capital

Corporations

Early Stage

Individuals

Venture Capital

Corporations

Growth Stage / Expansion Stage

Buyout funds

Mezzanine Investors

Stretch Lenders

Banks

Hedge Funds Financing Buyers

Corporations

Later / Mature Stage

Buyout funds

Mezzanine Investors

Stretch Lenders

Banks

Hedge Funds Financing Buyers

Corporations

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Private Equity and Debt AlternativesPrivate Equity Investor Universe

Private equity capital is provided by the following types of investors:• Private equity groups/buyout firms/financial sponsors• Venture capital firms• Management teams• Mezzanine funds• Wealthy individuals (“Angels”)• Investment arms of corporations

Most private equity firms target investments based on some or all of the following investment criteria:

• Specific industries • Maturity of the business• Size of the investment• Geography • Control or non-control investments

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Private Equity and Debt AlternativesMaturity of the Business

The maturity of the business is an important investment criterion most private equity firms use to make an initial investment decision.

Generally, the maturity of a business or its stage of development can be categorized as one of the following:

• Seed/Start-up Stage• Early Stage• Growth Stage/Expansion Stage• Later/Mature Stage

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Private Equity and Debt AlternativesSignificant Terms of Private Equity Investments

Significant terms in private equity investments include the following:

• Type of security– Almost always convertible preferred stock– Investors will sometimes also invest in the common stock

• Liquidation Preference– 1st money out in the event of any sale, dissolution, merger, consolidation,

or change of control– Typically 1x – 3x of capital invested plus accrued dividends with 1x being

the most common• Participation

– In addition to the liquidation preference, the investor “participates” with the other shareholders on an as converted basis

– Will sometimes be capped once a certain return has been achieved

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Private Equity and Debt AlternativesReturn Expectations and Investment Horizon

All private equity and venture capital investors have certain return on investment expectations which they use to evaluate their opportunities:

• Private equity firms are typically expecting annual returns of approximately 25%-35% on their investments.

• Venture capital investors are typically expecting annual returns of approximately 35%-45% on their investments although, they typically express returns as a multiple of capital invested.

– Assuming a 5 year time horizon this translates to a 3.0x – 6.0x multiple of capital invested.

Return expectations are also influenced by the investment time horizon of the investor.

• Most later stage private equity firms have a 4-7 year investment horizon.• Venture capital investors usually have a longer investment horizon.

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Private Equity and Debt AlternativesLiquidation Preference with Participation Example

The analysis below assumes the following:• Pre-money value = $50 million• Growth capital = $25 million• Post-money value = $75 million• Pro forma ownership = 66.7% common / 33.3% preferred• Liquidation preference = 1x

50.0$ 75.0$ 100.0$ 125.0$ 150.0$ Liquidation Preference 25.0 25.0 25.0 25.0 25.0 Residual Value 25.0 50.0 75.0 100.0 125.0

Residual Value to Common 16.7$ 33.3$ 50.0$ 66.7$ 83.3$ Residual Value to Preferred 8.3$ 16.7$ 25.0$ 33.3$ 41.7$

Assumed Exit Value ($ in millions)

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Private Equity and Debt AlternativesHow Do Debt and Equity Differ?

DEBT EQUITY

Generally the most senior obligation of a company after its accounts payable and other operating expenses.

The most junior layer of a company’s capital structure and, as such, has no claim on assets.

Contractual obligation and must be paid back on a schedule which is agreed to at the outset.

Generally has no fixed repayment schedule.

Often collateralized by a company’s assets and, as such, has a claim on those assets in liquidation.

Cash value only after all a company’s obligations, including debt, have been met.

Usually has an interest cost that is paid on a regular schedule from its incurrence until the final maturity payment.

Generally the riskiest investment made in the company, equity is generally the most expensive form of financing.

Debt is generally the lowest cost of financing.

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Private Equity and Debt AlternativesSenior Lender’s Approach

For middle market borrowers, senior debt is typically secured.

Availability (amount to be loaned) is often limited by hard assets for companies with EBITDA under $10-15 million.• A percentage of AR, inventory and fixed assets is the starting point for

determining revolving credit and term facilities • Uncollateralized term loans may be added at a higher cost • Some amount of the committed financing is generally held back as

“excess availability” at the time of closing

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Private Equity and Debt AlternativesSubordinated (Mezzanine) Lender’s Approach

Amount of the loan is typically determined by applying a multiple to historical EBITDA rather than by the company’s asset base.• The most significant measure of EBITDA is the company’s trailing

twelve months performance.• “Run rate” and projected results may also be considered.

Always behind senior lender in security and repayment.• Mezzanine is either unsecured or has a second lien on assets and

doesn’t amortize before senior term loan is repaid.• Interest rate is usually fixed, while senior debt is typically priced with a

floating rate.• Financial covenants are generally fewer and looser than those of

senior debt.

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Private Equity and Debt AlternativesSenior and Mezzanine Debt Comparison

Terms Senior Debt Mezzanine

Security First Lien Unsecured or Second Lien

Ranking Senior Contractual / Structural Subordination

Convenants Generally Comprehensive

Less Restrictive Mostly Financial

Term 3-5 years 4-7 years

Coupon Cash Pay - FloatingPrime or LIBOR + a spread

Cash Pay (Fixed) + PIK

All-in Rate 5.0% - 10.0% 12.0% - 18.0%

Warrants None Often

Prepayment Penalities

Minimal Moderate Via Prepayment Premium

Closing Fees Approximately 1% Approximately 2%

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Private Equity and Debt AlternativesThe Financing Process

Week 1 - Company selects placement agentWeek 1 - Company selects placement agent

Weeks 5-7 - Contact potential investors / lendersWeeks 5-7 - Contact potential investors / lenders

Weeks 8-9 - Interested investors / lenders submit term sheetsWeeks 8-9 - Interested investors / lenders submit term sheets

Weeks 2-4 - Private Placement materials assembledWeeks 2-4 - Private Placement materials assembled

Week 10-12 - Legal documentation and Closing

Week 10-12 - Legal documentation and Closing

Weeks 9-10 - Selected investor(s) / lender(s) complete on-site due diligence

Weeks 9-10 - Selected investor(s) / lender(s) complete on-site due diligence

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Private Equity and Debt AlternativesExpenses

Depending on the nature of the transaction, several types of fees and expenses can be incurred during the senior and mezzanine capital raising process:

• Legal

• Accounting

• Consulting

• Advisor

• Debt financing fees

• Travel

In most transactions, the company raising the capital will pay the fees and expenses incurred by the capital providers.

The total fees and expenses incurred in senior and mezzanine capital raising transactions are generally between 3%-5% and are paid out of the proceeds.

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Private Equity and Debt AlternativesHow Can an Advisor / Agent Help?

Knowledge of most likely financing sources developed over years of experience.

Advice regarding structure, pricing and covenants.

Ability to generate increased competition among investors and negotiate most attractive terms.

Shouldering the burden throughout the entire financing process to allow management to devote more time to day-to-day business.

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Private Equity and Debt AlternativesCase Study

A steadily growing, seven-year old company was interested in buying a competitor that had announced it was for sale.

The company’s passive shareholders also had interest in getting some liquidity for their initial investment made seven years earlier.

Financing Requirement

• Purchase of competitor’s equity

• Refinance existing debt

• Shareholder liquidity

• Transaction expenses

Total Requirement

$ 38 million

$ 5 million

$ 5 million

$ 2 million

$50 million

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Private Equity and Debt AlternativesHistorical Financial Performance

2001 2002 2003 2004 2005E

Revenues 29.0$ 32.0$ 37.0$ 43.0$ 51.0$ Growth Rate 10.3% 15.6% 16.2% 18.6%

Cost of Goods Sold 21.0 23.4 27.4 31.4 37.2

Gross Profit 8.0 8.6 9.6 11.6 13.8

SG&A Expenses 4.4 4.8 5.6 6.5 7.7

EBITDA 3.7$ 3.8$ 4.1$ 5.2$ 6.1$

Historical Income Statement

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Private Equity and Debt AlternativesTarget’s Historical Financial Performance

The $38 million purchase price yields an EBITDA multiple of 6.9x.

2001 2002 2003 2004 2005E

Revenues 22.0$ 25.8$ 28.4$ 31.8$ 36.4$ Growth Rate 17.3% 10.1% 12.0% 14.5%

Cost of Goods Sold 15.4 18.1 19.9 22.3 25.5

Gross Profit 6.6 7.7 8.5 9.5 10.9

SG&A Expenses 3.3 3.9 4.3 4.8 5.5

EBITDA 3.3$ 3.9$ 4.3$ 4.8$ 5.5$

Target Income Statement

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Private Equity and Debt AlternativesAcquirer’s Balance Sheet

ASSETS LIABILITIES AND EQUITY

Current Assets Current LiabilitiesCash 1.1$ Accounts Payable 6.5$ Accounts Receivable 5.9 Accrued Expenses 3.0 Inventory 3.5 Current portion of long-term debt 0.8

Total Current Assets 10.5 Total Current Liabilities 10.3

Property, Plant & Equipment (net) 8.9 Long-term debt 4.2

Shareholder Note Receivable 1.6 Members' Equity 5.2 Paid-in capital 1.3

TOTAL ASSETS 21.0$ TOTAL LIABILITIES AND EQUITY 21.0$

Acquirer's Balance Sheet

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Private Equity and Debt AlternativesDebt Capacity – Acquirer Only

EBITDA 6.1$ Accounts Receivable 5.9$

Senior Debt Multiple 3.0x Advance Rate 85%Senior Debt 18.4 Availability 5.0

Subordinated Debt 6.1 Inventory 3.5 Total Debt 24.5$ Advance Rate 50%

Total Debt Multiple 4.0x Availability 1.8 Total Availability 6.8$

Cash Flow Approach Asset-Based Approach

Senior Debt Capacity is between $6.5 and $18.4 million.

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Private Equity and Debt AlternativesCombined Financial Performance

Lenders will take the target company’s EBITDA into account when analyzing debt capacity.

Synergies and cost reductions post closing will also be examined and incorporated into the analysis.

2005E 2006ERevenues 88.4$ 97.2$ Cost of Goods Sold 63.4 69.8 Gross Profit 25.0 27.5

SG&A Expenses 12.3 10.0

EBITDA 12.7$ 17.5$

Combined 2005 and 2006 Income Statement

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Private Equity and Debt AlternativesDebt Capacity Pro Forma for Acquisition

The combined company has debt capacity ranging between $18 and $70 million, therefore the $50 million requirement can be accomplished solely with debt financing.

• “Run rate” EBITDA is probably the most important number in determining debt capacity.

Acquiror's Target's BS Combined AdvanceBalance Sheet Balance Sheet Balance Sheet Rate Availability

AR 5.9$ 4.0$ 9.9$ 85% 8.4$ Inventory 3.5 2.4 5.9 50% 3.0 PP&E 8.9 6.0 14.9 50% 7.5

18.8$

Combined Senior Debt Total Debt Total Senior Total DebtYear EBITDA Multiple Multiple Capacity Capacity2005 12.7$ 3.0x 4.0x 38.1$ 50.8$ 2006 17.5 3.0x 4.0x 52.5 70.0$

Balance Sheet Analysis

Cash Flow Analysis

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Private Equity and Debt AlternativesLikely Covenants

Limitations on:

• Senior debt

• Total debt

• Capital expenditures

• Sales of assets

• Dividends Measurement of:

• Interest coverage

• Fixed charge coverage Reporting requirements:

• Monthly financials (30 days)

• Quarterly financials (30 days)

• Annual financials (120 days)

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Private Equity and Debt AlternativesConclusion

The debt market has been active and aggressive for the last several years, making possible increasingly leveraged financings.

The large second lien market in which many institutions are willing to buy junior bank loans has resulted in favorable terms for borrowers.

More mezzanine lenders have emerged, raising funds that must be put to work, and this increased competition for junior loans has resulted in attractive mezzanine terms for borrowers.

These factors have fueled an unprecedented level of middle market borrowing which, while potentially moderating somewhat, is expected by most to continue into 2006.

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Technology Venture Segment of Private EquityGary A. Peat

PartnerApril 27, 2006

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Private Equity OverviewVenture Capital – “State of the business”

$-

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

$7.00

$8.00

Q195

Q395

Q196

Q396

Q197

Q397

Q198

Q398

Q199

Q399

Q100

Q300

Q101

Q301

Q102

Q302

Q103

Q303

Q104

Q304

Q105

Q305

Seed, Startup & Early Stage Venture Capital Invested1995 through 2005

(Source: PriceWaterhouseCoopers - M oneyTree Survey)

$ billions

Netscape IPO

Yahoo IPO

Amazon IPO

Earthweb IPO

$2.4 million revenue$850 million market cap1st day price appreciation

Peaked at 900%+

Consistent Rate of Investment,“post-bubble” steady state

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Private Equity Overview

Venture Capital today? Steady pace, competitive, healthy A strategy and a “real plan”

• A real leader is a must• Capable team must be built to formulate and execute plan• Experience matters, but optimized when in concert with

entrepreneurship

A real market, with real customers, paying real prices• Where this exists, there is still real opportunity

– Examples today: Ecommerce, mobility, software as a service, etc.

Reasonable Expectations: 10X is great again

Exit environment:• IPOs are expensive and difficult and will stay that way• Strategic buyers only “pay up” for results or strong IP or both• Private equity buyers are not material in overall tech M&A (yet…)

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Council Ventures $52 million Fund I

• 3 partners, Gary Peat, Katie Gambill, Denny Bottorff

• Leveraged by CEO Council

– Directorships, Chairmanships, Mentorship, Rolodex, etc. Early stage tech focus

• 10 deals thus far, 1 or 2 more with this fund

• 2 seed (no revenues)

• 6 startup (less than $2 million run rate)

• 2 early stage (under $10 million run rate, still not profitable) Business models:

• 5 tech enabled service (a/k/a software as a service)– EVault, Marketworks, NotifyMD, Advanced Academics, Benefit Informatics, iKobo

• 2 enterprise software– Lancope (network security), AppForge (mobility)

• 1 Healthcare financial services– Senior Whole Health

• 1 rocket science (microelectromechanical systems—a/k/a MEMS)– MEMX, Inc.

Actively seeking new investments

Private Equity Overview

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Venture Capital and Healthcare

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Nashville…Healthcare “Silicon Valley”

Over 200 healthcare companies with multi-state, national or international presence

More than 130 professional service firms support Nashville’s healthcare community

21 public companies - $25 billion revenues

More than 100 companies have been spun-off from HCA, HealthTrust and Hospital Affiliates

More than $750 million in venture capital invested in Nashville healthcare companies from 1995-1997 (this accounts for 25% of all venture capital invested in healthcare services in the U.S. during that time)

Source: Nashville Healthcare Council

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Nashville…Healthcare Family Tree

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Invested in Medcast in July of 1998

- Proven management team

- Opportunity to create value in emerging industry

- Clayton Associates brought knowledge and contacts to the transaction

Merged with WebMD in November of 1999 for $250 million

Shows proactive nature of investing with a proven management team and unique business opportunity

WebMDAn Early Winner

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Invested first seed equity in 1998

Developed strategy to own and manage non-rural hospitals

Clayton Associates and FCA assisted in recruitment of senior management

Recruited Joseph Littlejohn & Levy’s $285 million equity investment to acquire 15 hospitals

Top 10 for-profit hospital management company in the U.S.

Iasis Healthcare

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Invested first seed equity in 1998

Developed strategy to own and manage behavioral healthcare physician practices and facilities

Clayton Associates assisted in recruitment of senior management

Through acquisition, became a publicly traded company

Today, one of the top for-profit behavioral management companies in the U.S.

Psychiatric Solutions

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Clayton Associates participated in the first seed funding with New York-based, Welsh, Carson, Anderson and Stowe

Premiere provider of healthcare services throughout U.S.

Divested their behavioral healthcare hospital holdings and focusing on urban acute care

Today, over a $1 Billion revenue business

Ardent Health Services

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Provided growth capital in September 2002

CEO is a respected executive in the international healthcare industry. HCA Alumni.

HCCA is a recognized leader in global healthcare management, operations, recruitment and staffing services since 1973

Operates through offices and staff in the U.S., Canada, United Kingdom, India and the Philippines

HCCA International

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Relationships, relationships, relationships

Leverage resources

Do the right thing

The next 10 years