Example of a Financing Plan

Contact: Mike Volker, Tel:(604)644-1926, Fax:(604)921-7810
Email: mike@risktaker.com

A Fine Example of a Financing Plan

Let's now take a look at an actual financing plan to understand how a technology company approached its financial requirements. This company is a young company, but one which is beyond the start-up stage. It has modest sales ($2m/year), a growing customer base, and a line of computer peripheral products. It is based in Vancouver and is incorporated in British Columbia under the entirely fictitious name of MTI (any resemblence to an actual company is completely intentional). As will be demonstrated, there are numerous options available to MTI, but its ultimate ability to raise the required capital will depend primarily on the tenacity and integrity of its management team.

The "PLAN"


MTI requires new capital investment of $1,300,000 in order to meet its business plan goal of attaining at least $10 million in sales within 2 years. The financial plan proposed herein assumes that MTI will become a public company. It is the intent of MTI's founding shareholders, and the objective of this plan, to secure new investment capital directly into MTI. We start of with some fairly esoteric and innovative financing concepts involving tax schemes and government sponsored programs (the idea being to reduce MTI's "cost", i.e. dilution).

The proposed MTI financial plan, in time sequential order, may be summarized as follows:

  1. MTI LP - Raise cash in the current year for MTI via a Marketing Limited Partnership (for approximately $500K)
  2. Investment directly into MTI in Jan/Feb via a VCC (Venture Capital Corp) within 6-9 months
  3. Private Placement prior to a public listing next year
  4. IPO - public offering and listing
  5. Exchange Offering Prospectus and/or private placements following a public listing (in subsequent years)
  6. MTI LP II (second LP in the year following the first LP offering)
Additional sources of funding, not involving investors per se, which can also be considered are:
  1. Bank lines - a new bank line of up to $150,000 can be negotiated after an initial infusion of capital
  2. Government programs - R&D tax credits, Industry Canada Programs, BC Science Council
  3. Private buy-out - a back-up plan would be to find a buyer who could take over MTI (e.g. a strategic partner like a supplier or major customer)

Discussion of Funding Alternatives

MTI Marketing Limited Partnership I

The Limited Partnership ("LP") concept combines an equity investment with a tax shelter vehicle to offer additional benefits (tax savings or tax deferrals) to investors while postponing an equity dilution for the company. MTI would organize and establish the LP and choose a General Partner to manage the LP on behalf of the investors in the LP. The basic concept of such a tax shelter is relatively straightforward. It entails investors putting their money into a partnership fund which is managed by a general partner. The partnership then spends money on behalf of MTI for the purposes of marketing MTI's products (includes salaries, trade shows, advertising, packaging, etc). In return for spending this money, the partnership will be entitled to a cut (say 1 or 2%) of future revenues realized by MTI as a result of the marketing expenditures. However, the investors get to write off, i.e. expense, almost their entire investment in the year in which the investment is made thereby reducing their net taxable income. By using this approach, investors in the top tax brackets, can effectively double their investment (or looking at it another way, get a return on their investment of almost 50% immediately).

The costs associated with an LP, especially the legal and accounting costs, can run up to $75,000 regardless of the size of the LP. Hence, the LP fund should be sufficiently large to justify this fixed overhead. An LP in the $500,000 to $1,000,000 range would be appropriate. However, the funds raised by the LP must be expended in accordance with GAAP (Generally Accepted Accounting Principles) prior to the current calendar year-end. Therefore, even if more than $500K could be raised, the LP could likely only spend this amount for reasonable and justifiable marketing related purposes. If successful, MTI would be well positioned to offer MTI LP II in the following year and would be able to raise a larger amount at a lower cost (percentage-wise) since most of the legal structures would already be in place.

Conceptually, the LP serves two purposes: for the investor it combines an investment with a tax deferral and for the company it is essentially a deferred private placement. The LP would appeal to an investor who is both interested in MTI and who is in a position to benefit tax-wise. The LP allows the investor to write-off over 90% of his investment in the current year, giving a high-tax bracket British Columbian approximately half of his investment back within a few months as a tax saving. In the following year, the LP investor is bought-out by the company at a premium. The premium is approximately 25%. This is an arbitrary limit put on the value of the LP. In fact, in order for the buy-out to take place, MTI when it is public would make a takeover bid for the LP. This bid would have to be supported by a business valuation opinion and it is expected that this valuation would be greater than 125% of the original LP investment - hence limiting the return to 25%. The investor would then receive shares in the public company, at share prices prevailing at that time, for 125% of his original investment. Premiums are based on market conditions (i.e. supply of and demand for tax shelters) and generally run in the 25% to 50% range. At the time of the buy-out, the company would experience an equity dilution, but likely at higher market prices (because the company is then reporting high earnings due to the reduced expenses that were incurred by the LP).

The buy-out of the LP, and the timing thereof, is at the sole option of MTI. MTI's Board would exercise this option so as to be most favorable to its shareholders. In the event that the LP is not successful, the Board would not be able to justify a buy-out based on a proper valuation opinion on the LP. One could regard the extra legal and accounting costs associated with the structuring of an LP as a form of "insurance" cost to the public company, i.e. to ensure that any pubco dilution occurs only if the LP is successful and at such a time that pubco's shares are trading at reasonable prices.

In summary then, a successful LP has the same outcome as a private placement except that the investor has enjoyed a tax benefit and the public company has deferred and decreased an equity dilution.

The process can be summarized as follows:

a)MTI sets up the LP (i.e. lawyers obtain the tax shelter number and structure the legal entity)

b)MTI solicits interest using a preliminary "Term Sheet"

c)MTI recruits a GP to manage the LP

d)MTI sells the LP to investors using an Offering Memorandum

e)the LP spends the funds on behalf of MTI for marketing purposes before 1995 year end

f)in the following year, MTI makes a take-over bid for the LP

g)LP investors receive shares (they get 125% of their investment in shares at market price)

h)LP is wound up (i.e. dissolved)

A "Term Sheet" (investment summary and highlights) which is used to sell the LP to prospective investors can also be used to solicit expressions of interest before any significant sums are expended on the legal set-up and offering memorandum costs. The terms are set out such that the company will offer to buy-out the LP investors in the following year based on the unit value as determined by an independent valuator. The LP's revenue sharing agreement is set forth in such a way that the valuation will produce a value greater than the pre-defined buy- out limit of 125% of the original LP investment. This serves the purpose of reducing the risk to investors.

A formal "Offering Memorandum" must be prepared before LP units can be sold to investors. Securities regulations require that a formal document known as an Offering Memorandum be prepared in order to fully inform potential investors about the LP and the opportunity. An Offering Memorandum is not required if the LP offers its units only to insiders of MTI or to "sophisticated" investors. The latter would save considerable legal expense. The Offering Memorandum approach is being suggested herein, with the understanding that one of the Offering Memorandum could be abandoned by relying on one of the securities exemptions in the event that sophisticated investors are identified.

Use of proceeds of a $500,000 LP (based on the Offering Memorandum approach):

  Overhead Costs:	
    Legal Set-Up costs  $20,000 to $25,000
    Accounting Fees       5,000 to  10,000
    GP Fees (6 months)   15,000 to  30,000 (over 6 months)
    Printing, mailing,etc 2,000 to   5,000
    Legal Take-Over Bid  10,000 to  15,000
    Valuation Opinion    15,000 to  20,000
  Total Overhead Costs:	$67,000 to $95,000

  Broker's Commission:(10%) $30,000

  Marketing Program:
    Trade Shows            $125,000
    *Marketing Fees/Wages   100,000
    US Marketing plan       150,000
    Advertising, brochures   25,000	
    Marketing Expenses:     200,000

  TOTAL:                   $500,000(approximately)	

(*MTI could charge marketing fees for services to the LP which MTI would take into general revenues, effectively increasing MTI's working capital by the amount taken in.)

Whereas an LP is attractive to investors and the company for the affore-mentioned reasons, it should also be noted that, in the fiscal period during which the LP funds are expended, the company enjoys an abnormally high profit because its expenses have been substantially reduced. The higher earnings should yield a higher share price. However, it must also be noted that in the period when the LP is bought out by the company, the company will have an asset on its books (valued at 125% of the original LP investment) which it will have to write off in one to five years. This is often referred to as the "hang-over" effect. This write-off will be mitigated by the increased sales and profits arising from the LP investment.

Venture Capital Corporation (BC Equity Capital Program)

The Province of British Columbia through its Equity Capital Program, provides a tax credit to venture capital investors willing to invest in B.C. eligible small businesses through a Venture Capital Corporation (VCC). Investors receive a 30% tax credit on funds which they invest through a VCC. The tax credit is refundable for individual investors. This program is almost identical to the very popular Small Business Development Corporation (SBDC) program offered by the Province of Ontario during the late seventies and eighties but recently discontinued.

The B.C. Government makes an annual allocation to this program early each calendar year. Investments are typically approved in the January/February period until the provincial allocation is used up. Therefore, a VCC investment in MTI should be planned almost immediately.

The VCC program guidelines are summarized as follows:

A VCC investment would work well for MTI because MTI would easily qualify as an eligible small business. Because the VCC would invest in a private company, MTI, the VCC investors could obtain up to 49.9% without having to obtain a valuation opinion since the deal would be negotiated at arm's length. The prospect of future liquidity with possible up-side potential through a public company is appealing to VCC investors. Many VCC investments do not also offer their investors liquidity through a public company.

The VCC money can be raised throughout the calendar year. Hence, some form of staging couId be permitted, e.g. use a minimum-maximum range. If the VCC sells well early in the year, a minimum sum could be raised immediately and the VCC it could be kept open with additional funds to be raised later in the year. If successful, this form of financing could preclude some of the other vehicles. However, due to the competitive nature of the VCC program, the registration application should be prepared and submitted to the BC Government as early as possible.

Private Placements in MTI

A private placement, i.e. issuance of shares and warrants for cash, into MTI is possible given that MTI will be a publicly traded entity. It is actually a very "easy" means of raising capital because typically investors expect to receive a short-term gain, at least on paper, by investing into a company just before it becomes publicly traded. Without the prospect of liquidity through a publicly-traded MTI, a private investment into MTI would appeal only to investors who are very patient and who are familiar with the principals of the company. Such an investment could also be of interest to those who see a strategic or business fit with MTI, such as suppliers or resellers. It could also appeal to individuals who might take an active management role in MTI and want equity participation. If such an investment were to involve the sale of a controlling interest in MTI, it should be considered as a take-over or buyout. This is discussed under its own heading ("Private Buy-Out").

One might question if it is possible to obtain direct investment into MTI if MTI remains as a private firm, i.e. with no immediate intention of becoming a publicly traded company. In this example, we will assume that such financing took place at the earlier, start-up stages in the life of MTI by angels and well-heeled technology financiers.

In general, investments made into privately-held firms are done at valuations far lower than those for comparable public companies. Also, for any investor to make a private, minority investment into MTI, that investor would basically be backing the MTI team and become a part of that team. Usually the management team consists of the founding shareholders which is a main criterion for an investor.

Public and Private Placements in MTI as Public Company

This section deals with the selling of securities by MTI as a publicly traded company. Once a company is publicly traded, it can raise capital from time to time through either private placements of stock or through public offerings of shares. See section titled, "Going Public".

Private placements are very straightforward and rely on regulatory exemptions from having to prepare complete disclosure documents such as a Prospectus or Offering Memorandum. This is one of the main advantages to being a public company - the ability to raise new capital efficiently through private placements. The cost of doing a private placement is minimal, consisting mainly of legal and filing fees. A private placement in the range of $500,000 can be completed for less than $10,000 in costs. However, if the placement is made by an underwriter, a commission of at least 10% would be charged by said underwriter. Additionally, the underwriter may request broker's warrants as an additional bonus. Private placements generally consist of units in which a unit is equivalent to a common share plus one common share purchase warrant (or some fraction or multiple of a share purchase warrant).

After a company is listed and is trading publicly, the only way in which it may sell its securities (issue new shares), by law, is through an Exchange Offering Prospectus or through a private placement relying on one of the Securities Act's exemptions from having to issue a prospectus. The Exchange Offering Prospectus (EOP) has recently replaced the "Statement of Material Facts (SMF)" form of offering which was popular on the VSE. EOPs (formerly SMF's) must be used when a listed company wishes to distribute new securities to the general public.

MTI Marketing Limited Partnership II

A new LP could be structured by MTI for the subsequent taxation year. All of the comments relating to the MTI LP I above are applicable here. If the first LP is pursued and given the outcome, a second such partnership, i.e. MTI LP II, could be considered. In the event that it is too late to do the first LP in the current year, preparation for such an offering in the following year could commence much earlier in that year.

Bank Financing

MTI has had a normal operating line of credit in place from the Royal Bank of Canada to a maximum amount of $200,000 by margining its accounts receivable (75%) and inventory (50% of inventory value to a maximum marginable value of $175,000). A condition imposed by the Royal was that MTI maintain its Debt-Equity at 2.5:1.0. Because of MTI's losses reported in the current fiscal year, the Royal has asked that an additional $150,000 in working capital be obtained by MTI within 3 months in order to maintain the Bank's credit facilities. A new credit line will have to be negotiated and put into place after new equity has been placed either with the Royal or another bank.

Government Programs

In the past, MTI has been the recipient of various government incentives. These included non- refundable grants under the NRC's IRAP program (modest funding of $5,000) and a non-interest bearing term $120,000 loan from the Western Diversification Office (WDO). MTI will also apply for an investment tax credit under the SR & ED program of Revenue Canada. In future years, R&D funding will increase as MTI raises its value-add component and hence its margins. This has been factored into its financial pro-formas. Funding under other programs has not been specifically included in this plan although MTI will, from time to time, apply to any such funding programs as it considers appropriate.

Private Buy-Out

MTI is in a business which could be attractive to other firms in the same industry and market.There are also a number of US firms which might find MTI attractive as a springboard into the Canadian market. It is suggested that this approach be used both as a back-up funding alternative if the other financing options prove difficult in providing the required funding and as a future goal insofar as MTI should be operated and managed so that it is always attractive to a potential suitor.

Going Public

The plan is for MTI to become a public company. This can be accomplished in one of two ways:
  1. Initial Public Offering (IPO)
  2. Reverse Take-Over
An Initial Public Offering (IPO) is the best understood, most traditional way for a company to go public and in the process, raise new equity capital. It is a very straightforward exercise, involving an underwriter as a sponsor and financier, an application to the stock exchange, e.g. to the VSE for a smaller company like MTI, and the preparation of an Offering Memorandum which is a complete disclosure document. This process can realistically raise new equity from $750,000 to $1,500,000 for MTI through the facilities of the VSE. The costs and expenses consist of legal fees for the Offering Memorandum, agent's legal fees, accounting fees, regulatory filing fees, listing fees and expenses which will generally be in the $150,000 to $200,000 range. There would also be underwriting commissions amounting to 10% of the equity capital raised. This process can take anywhere from 3 months to 1 year with 6 months being the average time required.

A reverse take-over involves the use of an existing publicly traded company which is inactive, i.e. a "shell". Reverse takeovers have been popular because they can be used to take a company public without having to simultaneously sell shares to the public. A good example of a company that went public in this manner is Magna International. This method is also popular because it can be done more quickly. Reverse takeovers fall under the jurisdiction of the VSE, whereas IPOs require both VSE and BC Securities Commission approvals. Reverse take-over disclosure requirements are similar to those of an IPO. Legal and other expenses would run in the $75,000 to $125,000 range. An additional cost consists of the actual price paid to the current majority owners of the shell. Clean VSE shells cost between $125,000 and $150,000 to purchase a large control block of shares around 75%. However, the purchase price is offset by the fact that a shell usually has some net assets in it - cash, properties, shares etc. Then, there is also the "cost", or dilution associated with the other 25%. Once a take-over has been completed, this 25% is reduced to less than 10% by way of dilution of the public shareholders of the shell.

It appears that, regardless of the route chosen to become public, the total costs, excluding any financing commissions, are all in the $100,000 to $200,000 range. It is not possible to directly compare these approaches since there are so many unique factors and considerations pertaining to each case (e.g. how "clean" is the shell? what roadblocks might the regulators impose?).

To become public on the VSE, a company must meet the following listing criteria:

  1. have expended $300,000 on developing the business
  2. have unallocated working capital of $100,000
  3. have at least 300,000 publicly held free-trading shares
  4. have a minimum of 300 public shareholders each holding a board lot (500 shares)

Conclusion and Outstanding Issues

Raising capital is an exercise in marketing and selling. Results cannot be guaranteed. Creativity, flexibility and commitment will assist in getting MTI funded in a competitive financial marketplace. Timing is a critical issue. Capital of at least $150,000 is required immediately by MTI in order to maintain its current bank credit facility. Banks do this to make life interesting!

Hopefully, this real-life example has illustrated some ways for a company to raise money. Some of these ways are simple and straightforward. Others are more esoteric and complex. Such is Life!

Copyright 1996, All Rights Reserved, M.C.Volker.