1.How attractive is HPS as an investment opportunity? Areas such as business model (management, technology, etc.), power market and risks should be critically discussed. Other relevant areas of discussion will also gain marks.
HPS is an attractive investment opportunity because of its innovative technology, environmentally friendly and cost efficient nature. Furthermore, an almost infinite, untapped market exists in the rice belt of India which offers both, a significant supply of raw materials (rice husk and biomass) and enough demand for the firm to be able to utilize its full potential. Different aspects for the evaluation of the business model and investment opportunity in the light of key aspects are discussed below:
One of the key evaluation criteria, when considering investment in a business, is a management and key personnel who will be responsible for executing the idea. Key management personnel are the ones responsible for realizing what seems lucrative on paper. Husk Power Systems had a creative management team who innovatively solved the problems caused by the caste system when hiring manpower. Additionally, the partners took a personal interest in the business and visited the sites regularly to motivate the employees.
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In addition to management team, technology plays a vital role in the success of a business. Husk Power Systems has introduced an innovative technology to the market. Producing electricity from rice husk provides an innovative solution to a long existing problem as well as a substantial competitive advantage. On the supply side, there are 250 to 300 tons of rice husk produced for each 1,500 tons of milled rice, for a small village of 2,000 people, which is either burnt or left to rot in the fields. HPS can purchase this waste from the local people and convert each ton of rice husk into 760 kilowatts of electricity. On the demand side, there are 25,000 villages with 2,000 to 4,000 people each. As already mentioned, a small village of 2,000 people is large enough to support 35 kilowatts of electric supply which is the minimum capacity of a mini power plant. Furthermore, while businesses needed electric supply mainly during the day and households consumed more of it in the second half of the day, HPS was able to utilize the plant to its full potential and hence increase cost efficiency. Finally, HPS had established ten power plants of different sizes and its continuous technological innovation had resulted in decreasing the cost of installation by 22.8%.
Moreover, the market and industry analysis also show that HPS has a clear advantage over its competitors. As already mentioned, the supply side of HPS is intense. The mini power plant of Husk Power Systems will bring employment and a source of revenue for the villagers by purchasing rice husk from them in addition to supplying electricity at a reasonable price. It will be environmentally friendly in two aspects; preventing the production of harmful methane gas from the rotting of useless rice husk and reducing the amount of carbon dioxide in the atmosphere. When compared to other suppliers of power in the power industry, HPS technology provides evident advantages. For instance, HPS does not have to employ expensive and lengthy cables for reaching the villages because of its local production capability. Moreover, prepaid billing structure will enable HPS to have a much lower default and theft rate than its competitors. The price of electric supply by HPS is 20% to 30% lower than diesel-based engines that are used by businesses for irrigation. Most of all, innovative technology serves as an entry barrier for new entrants and saves HPS from direct competition.
Nevertheless, there are certain risks embedded in the business model. Firstly, the site of the business is very distant, and the chances of direct supervision are minimal. Although HPS has a very competent team, a partner who is responsible for the installation and operation of the plants is the one least competent of all academically. Moreover, as the price of HPS’s electric supply for the households is much higher than the conventional electricity. This can lead to potential resistance by the households towards HPS especially from the financially unfortunate people.
1.What concerns do you have about the company business model or expansion plan?
As an investor, the biggest concern that one would have about HPS is how much realistic its financial projections are. The founders of Husk Power Systems have great confidence in the technology and innovation of their business. In addition, they believe that the need for electric power that exists in the market is sufficient to drive demand for their product at the full potential of the mini plant. However, there are some factors that would concern a potential investor. Firstly, the market demographics of Indian rural area pose a significant threat to the expansion plan of HPS because lack of infrastructure can increase the installation cost and time. Furthermore, the time it takes each plant to breakeven will also depend upon income dynamics of target villages. The widening of the gap in infrastructural and economic growth between urban and rural India also suggest that the target market has worsened economically. All of the above factors suggest that the financial projections of Husk Power Systems might be too aggressive. Furthermore, the financial projections as shown in exhibit 8 project heavy losses for the first few years with continued injections of capital.
2.Describe the proposed financing structure. Evaluate the IRRs of the proposed investment and the founders implied equity stake under the following scenarios:
The financing structure proposed by Green Point is similar to a convertible note. In return for $2.5 million, Green Point will purchase a convertible note whose conversion is related to the next equity injection into the company. The note is a payable-at-maturity type. Hence, no interest payments will be due until the time of maturity. Consequently, simple interest at 11% will accrue annually on the outstanding balance. When HPS raises more capital through equity financing, the outstanding amount on the note will be converted into equity share in that financing.
Scenario 1: HPS follow-on equity financing round occurs in 2012; $5 million in equity capital is raised in return for a 17% equity stake after conversion of the convertible note.
For the purpose of calculating IRR of the investment, operating cash flows were calculated using information provided in the projected financial statement in Exhibit 8. By subtracting taxes and adding depreciation back into the earnings before interest and taxes (EBIT), operating cash flows have been calculated. Further the terminal cash flow has been found using 11% cost of funds and growth rate of 6.2% (projected GDP growth rate of India). Moreover, an injection of $2.5 million in 2009 and $5 million in 2012 has been assumed. The IRR of the investment based on the above assumptions is 74% which is fairly attractive.
Furthermore, in the current scenario $5 million have been raised in return for 17% equity stake in the firm. Since the market price and issue price depend upon the valuation of the firm and negotiation terms of the new financing in 2012. Using the given information, the implied equity stake of the founders has been calculated on the basis of following assumptions. The issue price has been assumed to be $1 per share. This assumption is valid because by changing the issue price per share; the percentage equity share does not change since that of the new investor is fixed (given). The number of shares of GreenPoint has been found out at the discounted issue price i.e. 25% discount. Finally, the number of shares of the founders has been worked back using the above mentioned information and the following formula:
No. of shares of new investor/Total No. of shares = 0.17
Where, the total number of shares is equal to 5 million shares of the new investor, 4.43 shares of GreenPoint and the number of shares held by the founders. The implied post-money equity share of the founders is 68% under this scenario.
Scenario 2: HPS follow-on financing round occurs in 2012; $5 million in equity capital is raised in return for a 38% equity stake after conversion.
Since the equity sharing of all of the investors will not affect the IRR of the company, the IRR remains 74% under this scenario, as well.
However, the equity stake of the owner will decrease. The equity stake of the founders has been found out through a similar approach as described in the previous section. By changing the post-money equity stake of the new investor to 38%, the implied equity stake of the founders falls to 28%.
Scenario 3: The firm fails to expand and has no prospects of raising additional capital. The founders agree to liquidate the firm assets in 2014 using a liquidation value of $3.5 million.
In this case, there will be no investment in 2012 and instead of the terminal value, liquidation value of $3.5 million has been used which gives an Internal Rate of Return of 27%. In 2014, the outstanding amount along with the accrued simple interest on the notes held by Green Point will be $3.875 million. According to the terms of the financing contract, 125% of this amount i.e. $4.844 million will be immediately payable to Green Point at the time of sale. The remaining $2.757 million will remain with the founders.
3.What are the advantages/disadvantages of convertible note financing as compared with traditional preferred equity?
A convertible note delays the valuation of the company to a later date and the whole process fundraising can be completely relatively quickly through convertible note as compared to equity financing. Using the conversion ratio that is fixed at the beginning of the note, the closing of the note is simple. Furthermore, a convertible note, being a debt instrument, puts the investor senior to shareholders in the event of liquidation. This increases the security for the investor should things go wrong. Similarly, convertible debt is cheaper and faster for the owners of the company as well. On the other hand, preferred equity does not have to be paid back as the convertible note. Consequently, convertible note comes with a relatively fixed cost for the company.
Under the current scenario, the convertible note offered by Green Point relies on the negotiations in the next round of equity funding and provides it with a discounted price at which the note will convert into equity. Such a financing provides downward protection to the investor. However, if the company performs exceptionally well, the note holder will only get the decided discount and will not benefit from the exceptional performance. As shown in the previous question, the investor gets a fixed return even if the company does not meet its aggressive goals as in scenario 3.
4.Would GreenPoint be better off using traditional preferred-equity financing?
When it comes to choosing between convertible debt and preferred equity, the potential growth of the firm plays a vital role. As already mentioned in the previous question, a convertible debt is better off when the risk associated with an investment is high. On the contrary, a convertible note will not enable the investor to realize the full performance growth of the business in case the investment outperforms the projections. In that case, the investor will only get a fixed return such as 8% annual return in the convertible note offered by GreenPoint. Furthermore, a convertible debt will save GreenPoint from the complex procedure of valuation. Given the uncertain nature of additional sources of revenue, the true value of the firm cannot be determined easily. A convertible note will save GreenPoint from getting into the hassle of valuation. Furthermore, it will also be able to enjoy a discount of 25% of the issue price at the second round of financing. This will also protect GreenPoint from dilution effects at the time of following financing round. Also, the term sheet includes clauses referring to voting right that the note holder will get. GreenPoint will get voting rights to elect two of the BOD members. Moreover, GreenPoint will get protection against another debt holder who gets a return more than GreenPoint because in such an event the rate of interest on GreenPoint’s note will either equate or be greater than subsequent debt investor. Given the above factors, GreenPoint is better off purchasing a convertible debt from HPS rather than a preferred equity investment.
5.What is the founders’ biggest concern in raising funds? Does the proposed financing structure mitigate this concern?
The biggest concern of the founders in raising funds is potentially unfair company valuation by the investors. Private equity investors were readily discounting any projected numbers due to a number of risky factors including distant and rural locations of India. In order to address these concerns, the founders reduced the financial projections down to only one primary revenue stream i.e. electric supply to households and businesses. By doing this, they avoided the argument of uncertainty of alternate revenue streams put forward by potential investors. In addition to this, another striking concern of the founders is whether the proposed financing structure and accompanying terms fit their business’s needs.
The financing structure proposed by GreenPoint resembles a convertible note. In return for capital investment of $2.5 million, GreenPoint will get a convertible note which becomes convertible at the time of the next round of equity financing at a discount. A concern faced by the founders of Husk Power Systems is whether undertaking the offer of the convertible note will result in dilution of their share out of their own business. Convertible debt financing provides a cheaper and quicker means of financing for the young business as compared to equity financing. This financing structure addresses the biggest concern of the founders stated above. By issuing a convertible note, they can postpone the extensive valuation until the next financing round and avoid the potential undervaluation at this point. This will be favourable for the founders because the valuation of the company will be much simpler in 2012 when the performance of the company and alternative revenue streams will be more certain.
Nevertheless, issuing a convertible note imposes a possible threat of call back of the note by the investor. However, according to the proposed term sheet, the note and accrued interest does not become payable until maturity unless the company is sold or liquidated before that. Hence, the proposed note does not pose this threat. Finally, the founders are concerned with the dilution effect of such financing. As depicted in question 3, the dilution effect of the convertible note depends upon the valuation of the company in that round which depends upon the performance of the company. A high valuation will result in greater pre-money price per share that will result in lesser number of shares being issued to both the new investor and GreenPoint. An illustration to this is presented in the following table. By taking the scenario 2 of question 3 as the base case, it has been shown that the share of the founders increase as the value of the firm and (hence) pre-money price per share (issue price) increases.
6.In conclusion, based on your analysis, how content will the investor, the entrepreneur and the firm be with the overall situation?
Investors: the investor will hold a convertible note that converts at the second round of equity financing. Although the initial investor, GreenPoint, is taking all of the risks by investing in the Husk Power Systems, a discount of 25% at the time of qualified financing provides a reasonable protection from the dilution effect. The note also provides fixed annual return until the note becomes payable or converts.
Entrepreneur: based on the above analysis, a convertible note postpones the difficult task of valuation by the investor. It also avoids immediate dilution of the founders’ share. A convertible note will also result in higher valuation of the company at the time of next equity financing if the company performs well. Finally, it will not cause over-dilution of the founders’ share in the business as compared to preferred equity financing.
Firm: the primary purpose of raising funds for the company is an expansion. The nature of the business model is such that growth is achieved by increasing the amount of mini-plants as it is only possible to reach a limited number of villages with each mini-plant. Installation cost of the plants induces a major fixed investment and capital is needed for such expansion on a timely basis. Through the convertible note, the company gets the required amount of financing under reasonable terms and without transferring control to the investors.
In conclusion, the above analysis depicts that the proposed financing structure fits the needs and satisfies the concerns of all; the investor, the entrepreneur and the company.
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