Husk Power Systems is a well-established firm in India providing electricity in 25 isolated villages through its 10 "mini power plants" with rice husks as a fuel source. It is seeking $1.5 million to $2.5 million capital needed for its expansion to reach 350,000 to 400,000 consumers in 400 villages by the end of 2011. With an offer from a private equity of a convertible note, it is assessing whether to accept such offer based on the company's and founder's interests.
Elena Loutskina; Manoj Sinha; Chip Ransler
Harvard Business Review (UV5625-PDF-ENG)
October 28, 2010
Case questions answered:
- How attractive is HPS as an investment opportunity?
- Do you have any concerns about the company’s business model or expansion plan?
- What is the proposed financing structure? Please evaluate the IRRs of the proposed investment and the founders’ implied equity stake under the following scenarios:
• HPS’ follow-on equity financing round occurred in 2012; $ 5 million in equity capital was raised in return for a 17% equity stake after the conversion of the convertible note
IRR=28%
• HPS’ follow-on financing round occurred in 2012; $5 million in equity capital was raised in return for a 38% stake after the conversion
IRR=28%
• The firm fails to expand and has no prospects of raising additional capital. The founders agreed to liquidate the firm’s assets in 2014 using a liquidation value of $3.5 million
IRR=24% - What is the most crucial risk factor the investors have to assess in this deal? What are the advantages/disadvantages of “convertible note” financing as compared with pure (preferred) equity?
- What is the founders’ biggest concern in raising the funds? Does the proposed financing structure mitigate this concern?
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Husk Power Systems: Financing Expansion Case Answers
This case solution includes an Excel file with calculations.
1. How attractive is Husk Power Systems as an investment opportunity?
As an investment opportunity, Husk Power Systems seems to be quite attractive based on the analysis of the following points.
- HPS is going to cater to a unique, untapped market with high growth opportunities. In India, about 125,000 Indian villages consisting of over 30 million people did not have any electricity access. Electricity consumption in India has more than doubled since 2000, and it is the single largest consumer of capital, drawing more than one-sixth of all Indian investments. The power sector has consumed more than 70% of coal use by 2008. The Indian rural power market is of the size of $102 billion, with more than 350 million consumers growing at the rate of 10% annually.
- Power sources available in rural areas are relatively costly, with portable diesel generators costing around $0.3 to $0.35 per kWh. With their unique technology, HPS provided power at $0.15 per KWH for households and $0.25 per KWH for commercial purposes and still made a profit out of it.
- The main raw material for the technology implemented by Husk Power Systems is rice husk, which is available in India’s abandon.
- HPS has also developed the idea of using by-products like rice husk ash generated from the gasification process to be used for generating an alternative source of income. They can sell the rice husk ash to the cement factories, and the estimated revenue comes out to be around $ 2 billion. (Though it is doubtful how much they would be able to generate, there is still an idea.)
- There is less chance of new entrants as most Indian villages are located in isolated areas, which will cause enough trouble in transporting equipment. The lack of infrastructure created an entry barrier for new competitors. On the other hand, this also acts as a disadvantage for HPS as it takes a longer duration to transport equipment, set up plants, and recruit competent employees from the villages.
2. Do you have any concerns about Husk Power Systems’ business model or expansion plan?
- One of the biggest challenges for Husk Power Systems would be to recruit competent employees from the villages to work in the plant. As most of the villages are located in remote places, it is facing a problem in attracting people to install and manage the plant.
- Another big issue can come from the social caste system in Indian villages. Such a system stifled any sense of ownership among employees.
- They have an estimated power supply of 10 hours to village households with a plan that can cost the villagers around $2 per month. Considering Indian village conditions, $2 per month can be substantial, and villagers may want to spend less. In that case, HPS’s financial projections need to be re-evaluated.
- Another major issue is the estimation of additional revenue streams. The revenue generated is quite uncertain, and even the partners are not confident enough to include them in the financial projection presented to the investors.
3. What is the proposed financing structure? Please evaluate the IRRs of the proposed investment and the founders’ implied equity stake under the following scenarios:
- Husk Power Systems’ follow-on equity financing round occurred in 2012; $ 5 million in equity capital was raised in return for a 17% equity stake after the conversion of the convertible note.
IRR=28% (refer to the attached spreadsheet)
- HPS’ follow-on financing round occurred in 2012; $5 million in equity capital is raised in return for a 38% stake after conversion
IRR=28% (refer to the attached spreadsheet)
- The firm fails to expand and has no prospects of raising additional capital. The founders agreed to liquidate the firm’s assets in 2014 using a liquidation value of $3.5 million.
IRR=24% (refer to the attached spreadsheet)
4. What is the most crucial risk factor the investors have to assess in this deal? What are the advantages/disadvantages of “convertible note” financing as compared with pure (preferred) equity?
The most crucial risk for the investors is to validate the assumptions of various factors made in the financial projections. The factors include growth in the no. of power plants, each plant’s profitability, the time it would take for each plant to break even, increase in energy consumption in villages, monetization of by-products, CER pricing, and chances of Govt. subsidies or international partnerships.
The main advantage from the HPS’s point of view of using convertible notes is that it will delay the dilution of common stock or ownership. Investors were demanding more equity stake in the firm due to the uncertainty of additional revenue stream and the aggressive growth plan of Husk Power Systems.
The convertible note would give the partners time to organize their business and solidify their position without losing ownership.
From the investor’s point of view, they will earn interest on the convertible notes for the period till conversion, and in case of any default or bankruptcy, they will be paid first. It can also act as a tax shield for investors.
5. What is the founders’ biggest concern in raising funds? Does the proposed financing structure mitigate this concern?
The main concern is raising the funds for the partners to sell a part of the company’s ownership. Investors were asking for more equity stakes on account of the uncertainty of revenue streams and an aggressive growth plan.
They were afraid that they were on their way to diluting themselves out of their own business. Convertible notes would delay the dilution process and give them sufficient time for the firm’s fair valuation.
Additional File:
Excel Spreadsheet. Download here.
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