Monday, September 02, 2019

If not debt, then equity?

Given that my last post discourages entrepreneurs from raising debt apart from a few specific cases namely:-
1. Very high ROCE low risk businesses - (P.s. Tell me if you are in one of these)
2. Quick Flip businesses where you are adding value to an asset,

Let us go to what then an entrepreneur needs to do to get his business adequate capital. If not debt, then the corollary is essentially Equity capital. Equity capital is where an investor invests capital and in return takes ownership of a chunk of the business - e.g. 1mn USD for 30%. Now debt is a simple proposition - most entrepreneurs understand that if they were to borrow from a private individual the rate of interest would probably be higher as compared to the rate of interest were they to borrow from a financial institution and likewise an investor would also intuitively guess that if a bank were to give him x % per annum for his money, he should get x+++% for his money were he to lend to a business. However, this intuitiveness usually breaks down when it comes to discussing an equity investment. Both investors and entrepreneurs seem to not have a clear sense of how equity should be valued.

So here are some of my thoughts on the same:-
Firstly, I feel eventually all businesses tend to be valued based on the DCF method. Of all the methods that I have found this is effectively the method I feel is logical, scientific and pretty much accounts for most things I feel should be accounted for.

For the sake of my analysis, let us assume that you were in a zero risk business that would with clockwork precision every year keep paying you 100$ on the anniversary of that year. It would pay you this forever - How much would you sell this business to me for? To answer this question, you would need to know the prevailing bank interest rate - because effectively the only other investment that would be comparable would be a term deposit. So if the bank interest rate was 10% - you could tell me that this is a great alternative to putting 1000$ in a term deposit. If the bank interest rate was  1%, you could justify selling it to me for 10,000$ as a replacement for a 10,000$ term deposit. However, there is no way that I would pay 1010$ if the bank interest rate was 10% or 10,010$ if the bank interest rate was 1% if I was a logical thinking person.

To keep it simple, let me now touch on the reason behind the discount in the DCF. Essentially money today is worth more than the same money if given to me in the future as if I had that money today, I could put it to work - at the worst case by putting it in a bank and in the best case by putting it into other speculative investments. As such, I would discount next years earnings by a %age - minimum the return I would get from a bank - and I would discount 2 years forward earnings by the same %age compounded twice and so on so forth.

To complete this simplistic analysis of DCF we have to factor in that businesses grow or decline - so for instance if a business was growing - the earnings shareholders would benefit from would grow and if it was declining the earnings available to shareholders may decline or else they might have to put in further capital if it were to incur losses. Either ways, we have to factor in the growth or decline in future cash flows.

Lastly, businesses are always uncertain and are affected my many external factors - as such both entrepreneurs and investors have to look at the probability of the business reaching a particular scale and then maintaining that scale for a significant amount of time.

Now coming to valuation - to figure out valuation let's take a live example -
A young company requires 1mn USD. It's cash flows are projected to look like below:-

Y1 - -500,000$
Y2 - -300,000$
Y3 - -200,000$
Y4 - 50,000$
Y5 - 100,000$
Y6 - 200,000$
Y7 - 500,000$
Y8 - 500,000$
Y9- 500,000$ and so on so forth.

On the face of it, this is a great business - the company has consumed only 1,000,000$ in capital and is throwing out 500,000$ in cash per year. However, let's look at it from the view point of the investor who is being asked to invest 1,000,000$
Step 1:- What is the prevailing interest rate? If the interest rate is 10% - the maximum that he could value the business throwing out 500,000$ in cash in perpetuity is $5,000,000.
As such, the first call the investor should make is how long he expects this 500,000$ to last - so let's say if he had a crystal ball - and could look sitting in year 0 as far beyond as Y 15 - he could say that the company would generate 500,000$ for 6 more years so till Y15.
Now he would have to calculate the present value of these cash flows discounted by at least the interest rate - 10%. This would look like this
Giving a value of $1.8mn for these cash flows.
Put in another way - for investing 1mn $ - the investor should own 1/1.8 or at least 55% of the business. This is only if he is 100% certain that the business will generate such cash flows as per the projections. In life nothing is certain and so it's wise to discount by 25% - and so the investor would reach a valuation of 1.35mn USD or to put it differently - his stake for investing 1mn USD should be a minimum of 75%.

Remember that we have here discounted by 25% for all risks such as:-
1. The product not having a market.
2. Competitive forces outgunning the business.
3. Economics of the business degrading.
4. Management and litigation risk.
5. The business raising further capital diluting the investor and thus diluting his share of future cash flows.
6. Team friction and other reasons why the business could implode.

As such, in general it is apt to discount by 75%.

Given all of the above, it is the responsibility of the entrepreneur to first introspect if his business firstly has the potential to generate the sort of cash flows that account for a brutal valuation exercise as given above. If he feels so, it is his responsibility to then construct a deal that leaves enough on the table for the investors. How can he do this?

Rule 0: Do detailed math and raise with some margin of safety. All projections go haywire if your investors get diluted in a distress situation.
Rule 1: Be Frugal and capital efficient. This will ensure that the profits are significant in comparison to capital invested.
Rule 2: Focus on speed. Remember the discount is compounded by the number of years. Time will kill investor returns if you are not mindful.

So having said this what do you value a business at - I like to think of the following as a typical example of cash flows:-
Y1-  -400,000$
Y2 - -400,000$
Y3 - -200,000$
Y4 - -200,000$
Y5 - 100,000$
Y6 - 500,000$
Y7 - 1000000$
Y8 - 1000000$
Y9 - 1500000$
Y10 - 1500000$

A business like this I would typically take the positive value of 10 years of cash flow - so in this instance Y5-10 (6 years) - and calculate the NPV of the same - and assign that as the valuation of the business - In this case it would be 2.5mn USD - If I felt the business was highly probable to not meet the projections - it would be a no go. As such my advice to an entrepreneur who arrived with the above projections - 1. Do more with less capital. Try to burn less money in the initial days. 2. Try to innovate so that Y10 cash flows remain steady and growing for maybe another 15 years - giving both him and me more upside given that we both would make very limited money in the present construct.

I hope this has been useful.

Some Thoughts on Debt

Remember as an entrepreneur the music stops if you don’t have access to cash so in general, you must always ensure that you have cash on hand - whether that cash is equity or debt makes no difference - the only two areas that it makes a difference are in figures of IRR and in taxation. Taxation is real and IRR is virtual.

However the basic principle is for every business venture you have to measure ROCE - Return on Capital Employed - ROCE for startup businesses is essentially profits divided by the total capital required - debt + equity. In general, you must have ROCE very quickly - ie within 3-4 years touching 40-50% for a startup to be viable. Of course the trick here is that many startups will use very little capital and so 40-50% is no big deal so if you want to think big you have to look at trying to create a business which will have ROCE of 40-50% while using at least 1cr and then moving to 5cr and then going onwards to 30-40cr in capital. This is the first place where many entrepreneurs fumble - they are able to create ROCE of 40-50% but at a very small scale. Their abilities and management skill don’t allow them to imagine how to employ larger amounts of capital with sustained ROCE.

Now onto debt and why it is interesting. Debt is interesting as it is essentially someone’s else’s money and so if you have a high ROCE business you can expand your capital employed by using other people’s money and supercharge the return on your money. Let me give an example - if you had a business with ROCE 30%. Let’s assume the business was able to employ 3cr. If you put 1cr if your own money and borrowed 2cr at 15% per year - the business would turn 3cr into 0.9cr in profits and you would pay interest of 30L in interest on the 2cr and so you would have made 90L -30L = 60L on your 1cr in that year - a whopping 60% return on equity.

Note that if you could borrow at 10% per year your interest payable would be 20L and your return on 1cr would become 70L or 70%. If you could borrow at 5% you would make 80L on your 1cr.

So effectively for a business person, your aims have to be:-
1. Find businesses that have high ROCE
2. Design them to be where they can employ larger and larger amounts of capital as they scale and you are confident of the results.
3. Ensure you can borrow at the lowest possible rate so as to supercharge the return on your equity capital.

1 and 2 are an art in themselves and require luck and persistence in seeking opportunities. 3 let us analyze in some more detail:-

Kinds of debt:-
1. Secured against liquid capital. I would call this more of tax planning - the lowest I have been able to get is 1 month ago at 7.9%. I doubt if anyone can get a lower rate.
2. Mortgages - typically you can get 8.75% with a very strong credit rating.
3. Personal loan - 11%
4. Business loan - 11-14%
5. Real estate loans - 15-18%
6. Unorganized sector loans - 24%

What are low ROCE businesses:-
1. Real estate / hotels
2. Capital goods
3. Finance businesses

As such entrepreneurs who get into above businesses with debt - esp high-cost debt are dead in general unless they are very lucky. Even then they are enriching the bank. So in general taking on debt to deploy into such businesses is a bad idea. The only way in which the above businesses are viable is if you are into flipping the capital asset and you have a very strong thesis for why it will appreciate. Even then, you have to be able to flip fast or else the debt overhang in my opinion will kill you.

So bottom line:-
Whenever you design a business, do the math on what ROCE you expect.
Build reputation, credit worthiness, relationships where you are able to get debt at the cheapest possible interest rate.
Only take on debt if you are confident of high ROCE. Even then balance it with equity.
Be very conscious of time when debt meter is ticking.

If not debt, then equity?

Given that my last post discourages entrepreneurs from raising debt apart from a few specific cases namely:- 1. Very high ROCE low risk bus...