The Magic of Debt and Equity Finance

Paul A. Zaman shares insights on the importance of a company choosing the right capital structure to enhance shareholder value … the alchemy of debt and equity

One of the key ways for a company, small or big to improve long term shareholder value is by having the appropriate mix of debt and equity and making good investment choices. Even a seasoned executive director often misunderstands this aspect. Lets first explore the history of equity and debt.

The Dutch started joint stock companies, which let shareholders invest in business ventures and get a share of their profits. In 1602, the Dutch East India Company issued the first shares on the Amsterdam Stock Exchange. It was the first company to issue stocks and bonds. This was a massive investment aimed at building the biggest merchant fleet to break the monopoly the Portuguese held. At its peak the company paid a dividend of 40% and had 50,000 employees worldwide, trading from Europe, Peru, China, Japan and Batavia. In 1798, after 196 years it failed financially due to funding its army and fighting wars with other countries to protect its business franchise.   Other stock exchanges were set up after the Amsterdam exchange such as London in 1697, New York 1817, Bendigo in Australia 1860 and Bombay in India 1875, which is the oldest in Asia.

The history of debt, that is money lending goes back to Biblical times. The ascent of Christianity in Rome meant that interest was usury and so immoral. This created the opportunity for others to fill the space and become moneylenders. Ironically centuries later it was Pope John XII whom created the Italian–French banking system. There was a hierarchical order among banking professionals; those who did business with heads of state to fund palaces and wars, the city exchanges for business trade, and at the bottom were the pawnshops or “ Lombards”. Most European cities today have a Lombard street where the pawnshop was located. As merchant shipping grew in importance money lending was closely linked to the major trading ports of London, Amsterdam and Hamburg.  It was in coffee shops that the investment opportunities and loans were discussed and traded, such as Jonathon’s Coffee House and Edward Lloyd’s in London In 1698. John Castiang began publishing a twice-weekly newsletter of share and commodity prices, which he sold at Jonathan’s, and which led to the formation of the London Stock Exchange. Lloyd’s shipping list led to the establishment of the famous insurance company Lloyds of London.

Most of us have experienced a bank loan or mortgage. The lender provides cash, called the principle and receives an agreed interest return and an agreed date when the principal will be repaid in full. There is no upside on the return to the lender if the borrower uses the funds and makes good profits. However if the borrower does badly then the lender risks the return of the principle. A lender is risk averse and usually secures the loan against a tangible asset, like land and property so they only loose the principle principal loan amount if the asset turns out to be inferior and not worth as much as initially expected. Usually lenders get a majority of their investment money returned

A share investor invests by buying a company’s shares and so the company receives cash. A company in law is set-up to be eternal with an ongoing sustainable business. The investor does not therefore expect to get their investment returned unless the company decides to change its business or close down. The investor does expect to get a share of the profits each year as a dividend.  Investors can also sell their shares to other individuals at a gain or a loss. Selling at a higher price means that the new buyer expects to see further increased long-term shareholder value that is increasing dividends. The down side risk, is that if the company does badly it makes losses and all the investment may be lost. In a closedown situation the tax office, lenders, employees, and suppliers get paid first and if there were any money left over this would be distributed to the shareholders. Usually shareholders loose all their invested money.

Shareholders are owners and have a long-term commitment and wish to see the company do well.  Lenders wish to protect the money lent and monitor for the risk of default.

Shareholders have upside potential from ever increasing dividends and so also the ability to sell the shares at a higher price. Lenders have no upside potential.

Shareholders can lose all and often do. Lenders usually can recover their principle funds by grabbing and selling a tradable asset such as property.

Therefore due to the different risk-reward profiles, the cost to the company in terms of paying ongoing dividends to an investor is higher than the cost of paying the interest on debt and repaying the principle.

Lenders will assess the credit rating by the ability to pay the interest each period without defaulting on these payments. The minimum comfort level if to have enough cash income is to cover the payment of the interest three times over. Another factor is the quality and sustainability of the cash income. If the source of the income varies widely from period to period, there is more chance that in a low-income period the business or person may default. So a Company and a person with steady income can get better credit ratings then those with volatile and uncertain income.  How does a lender deal with this aspect? Simply they increase the interest rate payable so that on average across a portfolio of similar credit risk some default others pay. On average the portfolio of loans delivers the yield the lender wants.

Throughout the history of stock trading, the focus has been on dividend payments. It has only been in recent years a prolonged focus upon trading for capital gains. There have been some speculative periods, where investors focussed just on capital gains from shares that had the promise of delivering great wealth in the future. Such as the Compagnie du Mississippi and the South Sea Company, both merchant-shipping lines which traded on multiples of around 100 Price/sales and over a year the investment gain was ten fold. The crash of these companies triggered London, Paris and Amsterdam market collapses in September 1720.  More recently the stock market crash of October 24th 1929, known as Black Thursday was when the Dow Jones Industrial average dropped 50%.  It also was a global stock market effect. The succeeding-years saw the Dow Jones drop-a-total of over 85%. This event preceded the great depression.

Bringing this together with some everyday examples. Debt costs less than equity so depending upon the quality of income and level of income, the most wealth is created by having the right mix of debt and equity.  If you invest in property, a high quality house in a high quality area will yield stable rent and stable capital appreciation – you can afford and will be able to get higher gearing that is more debt. A low quality house in a low quality area is likely to have a volatile rent profile and large cyclic changes in its capital value – you may be unable to get much debt unless there is additional external income guarantees. For instance retail banks in Melbourne, Australia in the last few years changed their mortgage policy from lending 80% to only 60% of City centre property valuation to protect themselves from downside asset revaluation. For instance, traditionally the listed public utility companies such as telephone, electricity, water and gas generated steady income and offered steady high dividends and modest capital growth. Whereas a high technology company paid no dividend and instead offered the promise of fast increasing growth giving income in the future and future dividends. The privatisation and deregulation of the telecommunication sector meant that new players using new technology competed against utility telecommunication companies. The sector became overnight “high technology” which resulted in disastrous decisions. Many of these companies core business are once more behaving like utilities.

Returning to the executive director, one indicator of the long term health and wealth of a company can be seen by simply looking at the financial statement in the annual report of a company and seeing the trend in the return on equity and the return on assets. If it is around 9% or under and with a falling trend then the historic investment decisions made by the Board of Directors have and are continuing to destroy shareholder value. If the level is around 15% and increasing then the Board of Directors have made fantastic decisions, which create value.  These figures need to be adjusted to reflect of the company is more like a utility with stable business or a high technology growth company. A company’s share price will ebb and flow based upon market sentiment.  At some time the collective equity market intelligence will understand the performance of the Board of Directors, via their historic choices of the debt & equity mix and their choices of investment opportunities. The equity market will then reward or punish the share price. Good quality companies with good governance and proven business models often deliver the best long-term investment performance.

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Entrepreneurial business, start young!

Corporate Social Responsibility – entrepreneurial business, start young!

Paul A. Zaman explores how triple bottom line reporting pays dividends for start-up and small business.

Some may be thinking that CSR reporting is only form multinational corporations and they would be wrong. A study in Canada of ten entrepreneurial businesses whom engaged in pro-active CSR reporting and strategy execution found that all grew strong and established themselves in the community. Start young and grow.

So how does an entrepreneurial company embrace and execute corporate social responsibility. There are two major global initiatives on CSR reporting, also known as triple bottom line reporting. The Global Reporting Initiative (GRI) sponsored by the United Nations and the Institute of Social and Ethical Accountability (AccountAbility) a not for profit institution set up in 1995. The GRI focuses on a process of identifying and reporting upon key relevant CSR issues. The GRI has a scheme for small business called High Five; AccountAbility focuses upon assurance, which means the process of reporting and the audit role. GRI has over 600 users and AccountABility over 300 users. Each is growing fast and is just the tip of the iceberg.  There are many more companies that use the guidelines yet do not formally submit reports back.

Dr. Anwar Ibrahim, the former Deputy Prime Minister of Malaysia was on 30th March 2006 appointed Honorary President of AccountAbility. AccountAbility says that Dr. Anwar is a prominent advocate for democracy, freedom, responsible business and the rule of law.

In my view, GRI has a focus on the financial, management and operational key performance indicators that make it easy for a business person to get great results. Whereas AccountAbility has a focus on auditing the process and dialogue with the stakeholders to verify the voracity of the data.  I like to stay focused upon creating shareholder value, which means the GRI five step process is a great starting point.

STEP 1: Get Board and Senior Management and owner sponsorship.

STEP 2: Using the business vision, objectives, strategies, activities and plan identify the stakeholders and map out the company relevant key interest areas.

STEP 3: Identify from the GRI the relevant type and nature of indicators to report upon that match to the key interest areas. Collect and collate historic data on these areas and candidate indicators. Identify the historic relevant management activities in these areas and determine what enhance and new activities could be done.

STEP 4: Verify data quality, with internal and external stakeholders. Engage in dialogue with key external NGO whom are respected surrogate representative of the external stakeholders. Set targets, management activities and accountabilities for the forward-looking years of the CSR. Write, finalise and distribute the first CSR report.

STEP 5: Collect feedback from the CSR report in areas of improvement in CSR performance. Plan the next steps of the CSR strategy and execution. Get recognition from management, staff, suppliers, and customers for the CSR awareness and commitment.

Developing a corporate sustainability report is like most business wide projects requires the support and commitment of top management and in a small business the entrepreneur owner and founder. Much of the information will already be in the company it just will be in different areas awaiting collation. Companies as small as five employees have created CSR reports.

An initial step is setting the context and significance of CSR reporting for the company. There must be real benefits in reporting such as enhanced reputation. increased profit, improved access to capital, improved access to information, new market opportunities, improved relationships and increased staff motivation. Reviewing CSR reports on other companies available at GRI or via sustainability reports on corporate web sites, in your industry and peers will help. This will help identify what are the major environmental sustainability and integrity issues and the social welfare and human rights issues affecting your industry sector and specific to your company. These are then listed, profiled and ranked for importance.

Like an annual report and financial statement there are a few guiding principles on what to report such as: materiality, comprehensiveness, inclusiveness and transparency. The quality and reliability of reporting is based upon reproducibility and accuracy. The CSR report is intended for senior management to make informed decisions about how to improve the CSR report, the economic benefit, strategy and execution plans. The CSR reporting must therefore also be timely and relevant for management action. Lastly, the process for data gathering should be auditable to demonstrate that the underlying information and report is fair and true.

One of the initial dilemmas is identifying whom your company’s key stakeholders are. Candidates include employees, family, community leaders, owners and equity investors, banks, financial analysts, suppliers, customers, end users, NGOs, labour associations, licensing bodies and environmental inspectors.  Once established map the key CSR issue areas to each stakeholder and rank the level of  stakeholder’s interest.

The next stage is dialogue with a representative set of stakeholders to verify their level of interest and understand their expectations for your business. This could be by a town hall meeting, one on one meeting or even an email questionnaire. With this feedback you can gauge if you are satisfying the key stakeholders interests.

The CSR report areas can now be formulated along three themes. The economic theme impacts typically affects customers, suppliers, employees and owners. The Environmental theme impacts typically on materials, energy, water, pollution, compliance, transportation, and your products and services. The social theme relates to labour practices and conditions, human rights, community at large, product responsibility.

The next step is to start collecting the core performance indicators. Again the GRI, AccountAbility and peer CSR reports will guide you into the selection. It is key to select the core indicators relevant to your business and your CSR areas of interest. Formal sources of information are the financial accounts, utility bills on water, electricity and waste quantity, staff turnover and sick leave.

The focus is on setting CSR objectives, strategies and action for improvement. In doing this like all planning iteration and consultation is required.

To capture the economic benefits the CSR initiative the results need to be published and disseminated. For small business this could be via notice boards, web page, newsletters, meetings, press releases, presentations, industry conferences. The communication method should be matched to the stakeholder groups identified to ensure you get your company’s message out there. Naturally the senior management needs to do a final review before distribution of the CSR report.

What small companies, 5 to 100 employees have done CSR reporting? All types such as advisory services like consulting, training and financial planning; business services like printers and waste management; hospitality, food and beverage outlets. Plus many large multinationals in every sector including Sony, Canon, Microsoft, McDonalds, Telstra, Heineken, Hewlett Packard, Lend Lease, Phillips, TNT, Westpac

Another benefit of the CSR Report is making corporate social initiatives more meaningful. Corporate social initiatives differ from corporate philanthropy in that it is aligned with the company’s vision and the CSR strategic issues. This means your company’s social sponsorship affects the key community stakeholders that your company is involved with and they recognize the power of your intention and commitment.

The CSR Report is a critical window on management’s claim of being socially responsible. It means that corporate sponsorship makes sense to all that witness it and becomes justifiable and sensible to owners and beneficiaries.

The three-minute elevator chance to fund your idea!

Corporate Governance: the three-minute chance to fund your idea

Innovation needs investment funds. Entrepreneurs need investment funds. Entrepreneurs inside corporations, sometimes called intrepreneurs need investment funds. The process of research, development, product design and finally commericialisation is the end-to-end innovation process. The costs are incurred before the sales revenue is earned. Entrepreneurial spirit is required in all businesses. P.F Drucker thought that innovation and selling where the two critical management processes and capability for survival and growth. So how does an entrepreneur get the investment funds?

The venture capital (VC) approach is the easiest to describe and the principles apply everywhere. A VC wants a single page summary followed by a 5-page business and financial plan. If after they screen this plan they are still interested they will ask for the management team to present themselves and explain the: business model and franchise; management team and track record; and investment opportunity. This presentation needs only the last three minutes as they are assessing the calibre of the management team and understanding the investment opportunity. VCs are usually polite and let the entrepreneurs have 30 minutes and waffle. If the VC is convinced on the calibre of the team, then they may discuss the investment opportunity. VCs contrary to popular belief is in reality an administrative screening process of thousands of candidates ideas to find a few good ideas that have investment merit. The Entrepreneur needs to help the VC get through the process. Get the single page submission correct first time and know what and how to present the key points in three minutes.

In the corporate world the investment approach is similar it is just not such a transparent and simple end-to-end process. Many well-run corporations have a step-by-step investment process. First a good idea is approved by the department head.  Then it is submitted into the investment process, which is often led by the finance group. Different levels and depth of submission are needed at the feasibility stage, production planning stage and the final commercialisation stage by the sales force. Often there is a investment process committee chaired by the finance group, with representatives from corporate strategy to review and approve strategic fit, sales to review and approve fit with customer base; production to review and fit with production capability and so on. However even in a large corporate, a chance meeting with the CEO in the lift, gives the chance to tell the story and jump several steps in the investment process.

Any entrepreneur seeking a discussion with a business investor must describe in less than three minutes, one minute for a journey in a lift, the following: What do you want? What will you offer in return? What is your business model? Why do you have a great franchise? What is your management team track record? When do I get my investment return? Again for simplicity lets demonstrate this by considering getting attention and investment funds from a venture capital or business angel investor.

Entrepreneurs always think they have a great business idea and are baffled why they cannot convince others, apart from family and friends whom are duty bound, to investment in their company. Even more difficult is to get a discussion with a venture capitalist and the mythical business angel. Entrepreneurs need to understand the investor’s viewpoint and get a powerful first conversation.

Venture Capitalists have preferences for types of deal, company size, industry and investment approach. VCs invests a pool of private equity funds. They also often syndicate investments with other VCs to share the risk by taking smaller bites.

A business angel is investing their own private money, sometimes on behalf of a small private partnership or syndicate,in areas they can understand and are interested in.

The first step is to find the investor. The second step is to ask yourself if your idea fits their investment profile and selection criteria. If not move directly to the next, otherwise your time wasting reputation will move ahead of you. VCs follow a standard process starting with the one page initial application format. Get it and follow it. Business Angels tend to be more individualistic.

The best way to get an investor interested is to get referred by a friend whom has a professional connection to them. In California, this traditionally approach centered on a couple of coffee shops in San Jose and Stanford Village California. Often over early morning breakfast after jogging. This is California VC guanxi. Asia entrepreneurs will not have the guanxi so the office front door is the next best option. For an entrepreneur seeking a discussion with an investor be prepared to describe in less three minutes the following areas.

What do you want?

Be clear about how much money and when you want it. Be specific on any other business capabilities like alliance partners and distributors you want. Say if you want hands on involvement by the investor and even help in filling management team gaps.

What will you offer in return?

Be specific in what you will be offering in return such as interest, equity stake, share of franchise fee, consulting fee and royalty.

What is your business?

Describe what your business is about from your perspective. Then describe the business from the customers’ perspective of features, benefits and value adding. Specify how your product serves the customer’s need in terms of: a solution, solution options, and getting into action.

Why do you have a great business model and franchise?

Describe why you have a great business franchise, which means you will be better positioned than current competitors and new entrants. Describe your competitors and their products and their likely reaction to your product.

What is your management team capability and track record?

What is the capability and track record of the entrepreneur and the members of the management team? What gaps are there and how and when will you fill the gaps?

That’s all there is to the pitch.  The investor will be judging the calibre of the team first and the opportunity second. Always be convincing, committed, expectant and passionate.

Remember, the investor does not invest in business plans, ideas or technology they invest in people. Investors, in the west favour entrepreneurs whom have a track record of starting business, even if the businesses failed. In Asia, failure is often seen as losing face. This is a poor perspective to hold as a VC as untried entrepreneurs increases the risk profile of the investment over tired and failed entrepreneurs.  The profile of a good entepreneur is being committed, passionate, flexible, innovative, balancing risks, visionary and having multiple back up plans. The investor will first assess if the entrepreneur and the management teams values in the above and then functional and customer know-how in terms of innovation, financial control, marketing and sales. Do not be surprised if a condition of investment is to strengthen the management team, which will mean sacking a founding buddy sooner or later.

The investor needs to know the investment return, the downside and upside investment risks, and the exit approach. He will be assessing if the business can be sold to a trade investor or listed on a public security exchange. Investors tend not to lend money that is the province of banks, rather provide equity, which they later sell for a capital gain. Often the starting point is a mixture of equity plus debt with the debt later converted into equity or just repaid at the investor’s discretion or subject to pre-determined conditions. So do not be naïve and ask to borrow money and return it with a good interest rate, or ask for equity and suggest you will buy the equity back from your share of the profits. If you do not understand why this is naïve do not even attempt to raise investment funds.

The investor will also be looking to see if the entrepreneur is wedded to the business model. Passion and commitment is wanted but not ownership. After all the investor wants to sell the business to a new owner either a trade investor or the public via a listing. Many new listings of companies have the founder and majority owner stay on for too long and the listed company fails after a few years. The new owners will choose the Board of Directors and streamline the old management team and the founding members. Many great investment deals never get started because the founding entrepreneur and family members are fixated on owning the business. This approach largely precludes venture capitalists and business angels from getting involved. A true entrepreneur is motivated by starting and growing a business, and recognises that they will exit themselves when the business has out grown them. Professor Henry Mintzberg a expert in business organizations and strategy suggests there are six organization states, the first being direct supervision, which is suitable for small business, family run or entrepreneurial. To grow into a large organization different organization states and capabilities, processes, and structures are required. Simply, entrepreneurs have skills, capabilities and passion for creating a business and not for managing a large business.

Good hunting

Paul A Zaman is the CEO of Qualvin Advisory, would you like to know how to create sustainable wealth and become a good corporate citizens  email: pzaman@qualvin.com or visitwww.qualvin.com.

Many ways to create lasting wealth!

Many ways to create lasting wealth!

Who else wants to make a positive social impact?

Who else wants to make a positive environmental impact?

Now you can feel good as the company you invest in, contributes and makes great profits!

Some of you may be feeling that these are mutually exclusive themes. I intuitively know that these are mutually inclusive.  Buckminster Fuller, the renowned social engineer talked and lived his life applying the universale laws of the universe, including the law of precession. The gyroscope and how it can balance on a needle’s point and seemingly defy gravity is the law of precession in action.  In the same way if we have you or your company with a code of honour focussed upon making a positive social and environmental impact. The energy of your motion and the energy of the universe work together. Which do you prefer, using your own energy to achieve a big goal or allowing the energy of the universe to work for you?

In late July 2008, people gathered in Kuala Lumpur, Malaysia to discuss Corporate Social Responsibility.  The distinction at this conference was the strong focus on investing for good returns finance rather than philanthropy, NGOs, activism and rhetoric.

The sustainable wealth of a company is going to be determined by how well social and environmental trends are captured as opportunities. Whether the company is small or big and private or publicly listed. That means allowing these trends  to drive goals, form strategies and direct actions.  Why would a person claim that?

The United Nations has sister initiatives to the familiar Millennium Development Goals (MDG), UN Global Compact www.unglobalcompact.org and the Global reporting Initiative (GRI).  A lesser-known initiative is the UN Principals for Responsible investors www.unpri.org, based in London.  Their research shows that there are over 180 Socially Responsible investment funds in Asia with US$34billion of assets under management.  James Gifford, Executive Director of UN-PRI shared the principles, which included: use environmental, ethical, social and governance issues in investment analysis, active equity ownership and encourage corporate disclosure.  UN-PRI has over 170 financial services sector sponsors and a mandate to promote the principles in the financial sector, corporate and governments.

The World Resource Institute www.wri.org based in Washington, researches social and environmental issues.  They have a Capital Markets Research arm.  They provide complimentary research to security houses like GoldmanSachs. The objective being to provide institutional investors with insights in how social, ethical and environmental trends affect the quality of future cash flows and hence valuations of listed companies. GoldmanSachs was reported as having 12 fulltime research analysts in London researching social and environmental issues and valuation impact analysis.

Social and environmental trends are drivers affecting sales, costs and risk to cash flow. Ms Hiranya Fernando, WRI demonstrated how these trends could be used sector-by-sector and even better at a specific company level to identify opportunities and threats.

Another two groups are the World Business Council for Sustainable Development www.wbcsd.org centred in Washington and the UNEP Finance Initiative www.unepfi.org for innovative financing for sustainability, based in Switzerland.  Talking with Cheryl Hicks a manager at WBCSD, she said they found that sustainability reports are not generally valuable for the investment community. Investors want to hear only sustainability performance material about the core business and in investor friendly language.  Investors also want to have a management discussion and analysis on core business issues on the same quarterly reporting basis as financials.  Which investors  had these views?  Goliath investors like Hermes, Calpers, Innovest, Allianz, Pictet and HSBC investments.

The overall perspective at the conference was optimistic and win-win. Social and environmental issues are opportunities not threats. They create innovation and new products and services. They create the tension for re-engineering the processes and substituting resources to ameliorate the issue and at the same time reduce costs.

The training given by myself, Paul Anthony Zaman, focused upon Qualvin Advisory’s research findings from CEOs of Singapore and Malaysian listed companies. The research findings show that the Board of Directors are aware of social and environmental issues.  Yet they had to deal with these as operational cost centre issues. They lack corporate goals and strategies that have social and environmental goals built in. They also therefore do not have a corporate wide investment decision-making framework and the necessary justification of achieving corporate goals.

Cheryl Hicks also suggests that, capital markets will fully reflect sustainability issues when a significant number of investors deem it financially relevant, and the information is fed to the investment community in a timely, consistent and meaningful manner.  Currently there is a lack of common templates and techniques for valuation analysis.

The content conclusion drawn is that an increasing number of long-term institutional investors are aware of and are using social, environment land governance analysis in their ongoing investment decisions.  Listed companies have yet to adapt to being able to make corporate wide investment decision-making.  Listed corporate are generally therefore unable to do quarterly reporting on social and environmental goals, strategies and investments.  These issues are operational and not yet corporate wide strategic issues.

The context conclusion drawn is that the universal law of precession is not fully being used in business. Corporates are focussed upon old-fashioned goals for financial and physical capital based upon the industrial era’s philosophy of a shortage of capital and resources. Corporate goals need to include managing capital of human resource, society and reputation.

Lets now bring this down to the individual level and the small enterprise.  Action you can take today.

• As an owner of a company let decision-making include social, environmental and governance issues.
• As an investor, choose your investments wisely and ensure they create social and environmental wealth.
• As an employee ensure that you approve of their social, environmental and governance policy and track record.
• As a consumer, be more sophisticated. Understand the social and environmental track record of the company you will support by buying their products.

Be wise, lever the energy of the universe to create wealth for you and leave a great legacy for your children.

Paul A Zaman is the CEO of Qualvin Advisory, we provide “smart support for busy executives” to Want to have help creating a Grey2Green2Gold action plan? then email: pzaman@qualvin.com. www.qualvin.com.

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