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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The essence of entrepreneurial innovation … simply thrive or die!

Paul A. Zaman explores the essence of entrepreneurial activity and innovation … or more simply thrive or die!

Entrepreneurship is key to survival and growth of both small and large business. Therefore the owners of a small business can regard themselves as the Board of Directors. Good governance is primary role of the Board.  A key aspect of corporate governance is setting the corporate goals, setting the strategic direction and steering the business towards achieving those corporate goals. Within this framework there will be products and services to be sold by the company that brings in cash. The amount, sustainability and steady growth of the cash income must exceed the cash used by the business in innovation, producing and selling the product. When the cash income exceeds the company’s cash consumption, then the strategy is creating shareholder value. In a large or small company this is easy to see and monitor, by watching the cash flow or even more simply the ebb and flow of the bank account balance. If the cash at the end of a period, as shown say by your bank account balance for a small business, is growing, you are doing well. If it is decreasing period by period, then you are losing money, which means destroying your start up investment funds and destroying shareholder value. Monitoring a business really is that simple.

Perter F. Drucker suggests that any business must be entrepreneurial and that this means doing well in just two things, innovation and selling.

Corporate Governance is focussed at Boardroom issues so what is the connection between corporate governance and entrepreneurship?  The role of the Board is to look after shareholder interests of whom the key interest is to increase long term shareholder value however increasingly with the eye to the triple bottom line of caring about shareholders, society and the environment.

Investors assess a company’s ability to increase shareholder value based upon just three aspects. The first is: the formulation of a sound strategy, the execution of the strategy, and the measurement and monitoring to keep on track. The second is having the right mix of debt and equity investment. The third is the operational and financial track record of the management team.

If we expand upon entrepreneurship being the two aspects of innovation and selling. We understand that the company must have a strategy that leverages innovative technology to develop and deliver innovative new products and services. These products and services must meet a customer demand at the right price and performance level such that customers recognise the value and buy the company’s products and services. To achieve this the company must make profitable product & service sales. If this does not happen then slowly yet surely the company will have less and less cash in the bank and DIES. Therefore the Board in being entrepreneurial, or simply directing the business for survival must embrace innovation and sales.

The Board must understand the business model, understand the products being sold and the customer segments buying the products. On a regular basis, monthly or quarterly the Board must receive a report that provides enough detail so that they can see and understand the selling and cash flow story. If the cash flow is too lean, then questions must be asked about the quality and performance of the sales function and/or the quality and performance of the products. The products could be sold into new markets or additional new products are needed for the existing markets. It is the CEO and Sales Director to execute the sales plan, yet the Owners and the Board of Directors must provide a check and balance to ensure the sales and cash are being delivered.

If new products are needed then innovation is required. Innovation needs investment cash, takes time to achieve and has risks attached. Modern R&D and innovation is focussed upon serving known and perceived customer needs. Very little R&D activity is now focussed upon fundamental research that may or may not have any commercial applications and payback of the cash invested. Even the largest of companies like Hewlett-Packard have very well managed R&D and innovation management processes. So what are the lessons for a small business? To manage the R&D risks and investment cash.

Again Peter. F. Drucker in his 60 years of business management wisdom can give us guidance. Innovation must be connected strongly to fulfilling customer needs and generating cash from sales. Drucker also suggests that innovation is best done with simple low risk products and then product development done with an active customer base and listening to their feedback. Yes every business must innovate, yet innovation without a careful eye on the bank account balance and real customers lining up to use your new innovative solutions invariably means disaster.

Is Drucker a 90-year-old management guru correct? Well a consulting firm, Innovaro (http://www.innovationleaders.org/) specialises in assessing successful innovation. They have demonstrated that the top innovative companies, that are innovation leaders, are rewarded with share market out performance of around 30%. The innovative leaders include corporations like: Virgin Atlantic, Toyota, Samsung, IKEA, Apple, Google, Addidas, Canon and Nokia. These large firms exhibit several common traits.

• A recognition that innovation is key

• Ongoing intelligence gathering and making insights about their marketplace, customers and changing the products to meet emerging needs.

• Active collaboration with customers and suppliers to innovate together.

• A simple approach to conceiving, qualifying, developing, and then quickly launching, new products.

• An innovation and selling organization with roles, culture and performance measures of success.

These successful traits can also be easily replicated by the smallest of business.

Back to the Board room. These traits can easily be formulated into a check list to be used by a Director or owner. Overseeing technology innovation does not need an understanding of the core technology, just checking that the development process is strongly connected to customer needs and there is customer involvement and feedback. No active customer involvement means additional unnecessary risks. The Directors or owner can ask meaningful and probing questions. Asking such questions, listening to the answers and making a considered response will influence if the innovative company thrives or dies.

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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.