Dealing with Investment Bankers (#98)

In this podcast episode, we cover the reasons for using an investment banker, as well as tips for how to spot a good one. Key points made are noted below.

Role of the Investment Banker

If you want to either raise money or sell your company, there’s a good chance that you’ll be dealing with an investment banker. An investment banker acts as an intermediary between you and either potential investors or acquirers. Their job is to link you up with the other party, and consummate the deal. They have a couple of areas of expertise that makes them really valuable.  One is that they know how to translate what your company does into a package that someone either wants to invest in or buy. You may think you can do this on your own, but they do it all the time, and they know what works best.

Part of their assistance here is in doing a really fine presentation. The investment banker should create the PowerPoint presentation for you, and have several dry runs of the presentation with the management team.  Please keep in mind that you do the presenting – at most, a banker may do an introduction at a presentation, but after that, he pretty much sits down in the back and answers e-mail on his Blackberry and just tries to stay awake.

And their other area of expertise, and this is a huge one, is their contacts. They know tons of investors and acquirers – in fact, this really is their business.  They’re routinely getting in touch with nearly all of the senior management of companies that do acquisitions, and they probably know almost every fund manager who might want to invest.

And by the way, part of this is through junkets. The larger investment banking houses routinely put on things like multi-day golf tournaments and bring in really good speakers, and then they invite all of these buy side people to attend for free. For an investment banker, this is all part of the job.

And the final area where they provide assistance is in closing the deal. Now, they are not your attorneys. But – they handle most of the major negotiation points with the other party, and they’re pretty good at improving the terms of the deal.

Investment Banker Fees

This all sounds great, but what do they cost?

An investment banker is very expensive. If you’re trying to raise money, you’d better expect the banker to take at least 6% of however much you raise. Though if you’re raising a lot of money, the percentage goes down. If you’re selling a business, the minimum fee for a reputable firm is usually around $1/2 million dollars, and they’ll make even more money if they can sell the company for more than some pre-determined price. And on top of that, you can expect a monthly retainer that’s generally around $10,000 a month.

This sounds like a lot. Actually, I think a good investment banker is worth every penny. In a really sweet deal, they may be able to line up the exact investor you want, or the perfect acquirer, and it may seem effortless. But keep in mind, without the banker, you never would have found that other party. And also, the retainer really isn’t that much money, so the banker is working almost entirely on contingency.  If you raise no money or don’t sell the company, then the banker only gets the retainer. So they have a really good incentive to perform.

How to Obtain Investment Banker Services

So at this point you might think – grudgingly – that an investment banker is worth it, and you’ll go out and get one. Well, that’s not quite the way it works.  A good investment banker selects you – not the other way around. One banker told me that he interviews an average of 30 companies for every one that he agrees to work for.

And there’s a good reason for this. An investment banker works long hours, and he only makes real money if he performs. So he doesn’t want to work for a company that he knows in advance is going to be a tough sell. Instead, he wants the easiest sale he can possibly make. And for that reason, you can expect to meet with an investment banker, and decide to hire him, and then find – much to your surprise – that he doesn’t want to work for you.

The Fund Raising Time Line

So let’s say that you reach an agreement with a good investment banker. What kind of time line are you looking at to raise money or sell your business. It’s still a long time.  The banker may take a month to create a really good presentation, and then another month to line up a meeting schedule, and quite possibly another two months after the meetings to close a deal.

And if you’re talking about selling your business, then add another two months. It’s not that an investment banker isn’t efficient.  It’s just that there are lots of third parties involved, and so you have to work around a lot of schedules. So even with a really professional banker, it’s still going to be a slow process.

The Best Investment Bankers

Now, what makes a good investment banker. Essentially, it comes down to how comfortable you feel with him. Or her. You tend not to hire an investment banking firm, you tend to hire the specific partner or vice president who’s going to work with you.

I happen to really like a vice president who works out of the Baltimore office of Stifel Nicholaus. I just like him, and I think he’s really competent. It doesn’t necessarily mean that I’d be as happy working for someone else at a different office of the same firm. So ultimately, it’s about the personal interaction.

But there are some other indicators.  A big one is who takes responsibility for the PowerPoint. Smaller investment banking firms or one-man shops will just send you a few copies of presentations done by other companies, and tell you to put together something like that. That’s not so good.

A good banker will assign a specialist to create your presentation, and they will construct it for you.  It not only shows an advanced level of professionalism by the banker, but it leads to a much higher-quality presentation.

Another indicator of a poor investment banker is not being selective with the target list. A poor investment banker doesn’t necessarily know everyone on the buy side, so he just sprays a teaser letter to every possible investor or acquirer.  The banker does this because then you owe him a fee if you eventually do a deal with anyone he contacts on your behalf, even if you don’t do the deal through that banker.

It also harms you, because now your name is plastered all over the buy side, and if you don’t do a deal right away, then it’s kind of difficult to go back and re-contact everyone in the industry a few months later for a second try. They wonder why you couldn’t close a deal the first time.

And another bad sign is when the investment banker tries to ram a bad deal down your throat, just so he can earn his fee. He is certainly obligated to tell you about any offer made, but if he actually recommends one that’s clearly not in your best interests, then shut him down and look for a different banker.

And a final indicator of a poor investment banker is a badly organized road show. If the banker doesn’t have directions to the next meeting, or doesn’t have phone numbers for whomever you’re meeting with, then he is not doing his homework.

As you might have guessed, I’ve seen all of these issues with investment bankers.  Unfortunately, these are problems that you only see after you’ve hired the banker, so if you find a good one, it’s best to stick with him for later deals.

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Recording Revenue at Gross or Net (#97)

In this podcast episode, we discuss the criteria for reporting revenue at either gross or net. Key points made are noted below.

The Two Revenue Recordation Methods

Recording at gross means that you record all of the revenue from a sale on your income statement. Now at this point, you’re probably saying, hello, that’s what I’m already doing. Well, there is another way.

Recording at net usually means that you’re only recording a commission on the sale as your entire revenue.  If there isn’t strictly a commission, you can still report revenue at net by netting the amount billed to the customer against the amount paid to the supplier.

Presentation Impact of the Methods

Recording at gross or net has no impact on your bottom line, but the difference in reported revenue is gigantic.

A commission may only be for a few percent of the total revenue, so your company looks a lot smaller if you record revenue at net.  And this means that some companies prefer to record their revenue at gross, just to give the impression that they’re much larger than they really are. Their main concern is that some investors value a company based on a multiple of its revenues, so reporting a pile of revenue could result in quite a payoff if they sell the business.

So that’s the basic issue. Now, most companies record all of their revenue at gross. At the other extreme, if you’re paid a commission, and it’s called a commission, then you record the commission as your revenue, and that is net reporting.

Which Way to Record Revenue

The trouble is, there’re lots of situations that fall into a gray area where revenue could be reportable at gross or it could be reportable at net. For example, what if you’re a broker for magazine subscriptions, or you have a third party drop ship all of your product sales to customers, or what if you sell airline tickets, or sell anything that’s on consignment? These are the cases where it’s not so simple.

The Emerging Issue Task Force set up a bunch of guidelines for this in their issue number 99-19. The title of the issue is “Reporting revenue gross as a principal versus net as an agent.” I’m going to talk about the EITF’s guidelines, but keep in mind as I go through them that recording the situation at gross or net is a matter of judgment. There’s a continuum of situations with gross reporting and net reporting at either end, and you have to figure out where you’re positioned between the two. The trouble, and I’ve confirmed this with several audit partners, is that as long as your revenue situation is in a gray area, and you document your decision, you can pretty much argue a case to report revenues either way.

So.  The guidelines. Here are the indicators that should point you in the direction of reporting revenue at gross:

First. You are the primary obligor in the sales transaction.  This means, are you responsible for providing the product or service, or is the supplier? If you’re doing the work or shipping the product, you can probably record at gross.  This one is a major determinant.

Second, you have general inventory risk. So, if you take title to the inventory before you sell it to the customer, and you take title to any returns from customers, you can probably record revenue at gross.

Third, you can select suppliers. This one is important, since it implies that there isn’t some key supplier operating in the background who’s actually running the transaction.

Fourth, you have credit risk.  This means that if the customer does not pay, then you eat the loss, and not a supplier. However, if you’re only at risk for losing a commission if the customer doesn’t pay, then you’re probably looking at recording the revenue at net.

And finally, if you get to set the price, then you probably have control over the entire transaction, and you can record the revenue at gross.

Now, what are the guidelines that point you in the direction of reporting revenue at net?

The first is that the amount you earn is fixed.  This indicates a commission structure, which is sometimes set up as a fixed payment per customer transaction. A twist on this is if you earn a percentage of what the customer pays, which is also an indicator that you report revenue at net. In either case, you’re really just an agent for someone else.

And the other two guidelines for reporting at net are just the reverse side of some earlier guidelines.  If a supplier has credit risk, or if a supplier is responsible for providing products or services to the customer, then you’re probably looking at reporting revenue at net.

For most companies, you can pretty easily pick which guidelines apply to you, and in most cases you probably record your revenue at gross. But here are some considerations.

Let’s say that you run an Internet store, and you collect money from customers, and then instruct a supplier to ship the goods to the customer.  In this case, you have credit risk, so there’s an indication that you can probably record revenue at gross.  And in fact, most Internet stores do.  But what if there’s also a statement on the website that the website operator only accepts orders on behalf of suppliers, and the operator is not responsible for any problems with shipments?  Chances are, you’re now looking at net revenue reporting.

Let’s try a different arrangement, where you develop specifications for custom products with the customer, and then you find a supplier who can make it.  In this case, you can record revenue at gross, because you have credit risk and you get to pick the supplier.

Here’s another example. You’re a travel discounter, and you negotiate with the airlines for reduced prices. You then advertise the reduced rates to the public. You bill the customer, and you’re responsible for delivering the ticket to the customer. But – once the customer receives the ticket, the airline is responsible for all subsequent service.  There’s no inventory risk and the primary obligor is the airline, which points you toward net reporting. On the other hand, you can set the price and you bear the credit risk, which tends to point toward gross reporting.

This is an interesting one, because you can go either way. The EITF says that the primary obligor issue overrides the other ones, and that one points you in the direction of reporting at net.

And that brings us back to my earlier point about documenting your position.  You could have two companies in the same industry with identical business models, and one can record revenue at gross and the other at net – and they may both able to justify their positions to their auditors. So, this is one of those screwy topics that can go in either direction.

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Recording Reimbursed Expenses as Revenue (#96)

In this podcast episode, we discuss how to record expenses that are to be reimbursed by the customer. Key points made are noted below.

Reasons Why Reimbursed Expenses are Recorded as Revenue

This issue was addressed by a group called the Emerging Issues Task Force, or EITF.  The EITF passes judgment on smaller technical topics, and generally they do quite a good job of it.  But on this one, I wonder if they were passing around the bottle during their discussions.  And – by the way, one of my co-authors claims that the Accounting Standard Board actually had a pony keg in one of their meetings, and that might explain some of the accounting standards.

But anyways, the EITF came up with a pronouncement called EITF Issue number 01-14. The title is “Income Statement Characterization of Reimbursements Received for Out-of-Pocket Expenses Incurred.” I think they designed the title to put you to sleep, so they could slide the contents right on by. If this thing was an infomercial, they would have called it something like “Easy Way to Overstate Revenue – Operators are standing by.”

So, what the EITF said was that out-of-pocket expenses are things like travel and entertainment and photocopying charges.  Sometimes, customers agree to reimburse the company for these expenses. The question the EITF addressed was whether you treat these customer payments as revenue or as a reduction of the underlying expense.

Their conclusion was that you report the payments as revenue.  Ouch.  The main reason they gave for doing this was that customer payments for shipping and handling costs are already treated as revenue, and this is basically the same sort of thing.

The EITF also stated that this makes sense, because the buyer is benefiting from the expenditures, rather than the seller. Also, the seller has credit risk, because it receives reimbursement from the buyer after it paid for the expenditures. And to be fair to the EITF, they made one of those “on the other hand” points, which was that the company is earning no profit on these expenses, and that tends to point toward treating them as an expense reduction rather than as revenue. Despite that, though, the EITF came down on the side of recording reimbursed out-of-pocket expenses as revenue, and so that it what you’re supposed to do.

Reasons Why We Should Not Do This

Now, as you can probably tell, I’ve been busy sharpening the knives on this one.  I’m not going to tell you to handle this differently, but I will point out some holes in the argument.

First, when I’m going through a due diligence analysis on a possible acquisition, one of the first things I do is see if they have any reimbursed out-of-pocket expenses, and strip that number out of revenue.  The reason is that it skews the results of the company to make it look like it’s doing more business than it really is. This is really critical if you’re buying a company based on a multiple of its revenues.  I don’t advocate buying a company based on that type of valuation, but some people do, and this issue causes them to overpay. So right there, you know something is wrong when people are deliberately stripping out that figure – it’s a clear revenue overstatement.

My second point is theoretical, which is that revenue should reflect the revenue-generating activities of the company, like providing consulting services or shipping a product.  Being reimbursed for out-of-pocket expenses is not a revenue generating activity.  It simply means that either entity could have paid for the expense up front, and it happens to have been more convenient for the seller to do it. So, consider a situation where the buyer gives its corporate credit card to the seller, and it tells the seller to use the card to pay for all of those out-of-pocket expenses. Now the expenditure path goes completely around the seller, and the buyer pays.  The seller records no expense, and no revenue. You get the same result in your accounting records if you use the seller’s reimbursement payment to simply offset those expenses in your records, which flushes out the expense. But you’re not allowed to do that.

Now all of this may seem like a lot of arguing over nothing, since the seller records no change in profit no matter how you handle out-of-pocket reimbursements – only the revenue and offsetting expense figures are impacted. Nonetheless, it can give the impression of a business being larger than it really is.

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Rule 10b5-1 Trading Plans (#95)

In this podcast episode, we cover the need for and use of 10b5-1 trading plans for stock purchases and sales by corporate insiders. Key points made are noted below.

In a public company, people may have material information about the company that hasn’t yet been put into any filings with the SEC.  If they try to buy or sell shares with that kind of information, then it’s illegal insider trading, and they can get in a pile of trouble.

Rule 10b5-1

And that’s where this Rule 10b5-1 comes in.  The SEC created it so that insiders can create a legitimate stock trading plan that won’t get them in trouble for insider trading. This trading plan contains a pre-set buying or selling program, and it’s valid for a certain period of time.

Now, to make a 10b5-1 trading plan valid, it has to contain certain types of information.  It has to state which securities to buy or sell, and the allowable price points or ranges to do the trading, and the volumes to trade. In addition, the insider is not allowed to alter the trading instructions in the plan once it’s been set up.

Another key item is that you can’t just set up a trading plan at any old time.  It has to be when you’re not aware of any material information about the company that hasn’t already been disclosed to the investment community.  To be safe, that means you should initiate the trading plan right after issuing either a Form 10-K or 10-Q, since all material information should be in those documents.

And one other item is that the insider must be able to prove that subsequent trades were, as the lawyers say, “pursuant to the contract” – or in English, that the trades followed the rules that you set up in the trading plan. Obviously, this is tough to prove if you altered the plan or you engaged in some additional trades.  So to be safe, once you set up that plan, leave trades up to the broker. Don’t muck around with it.

That all sounds simple enough, and it is – but there’s a twist.

Cancelling a Trading Plan

The SEC has ruled that you can cancel the trading plan, on the grounds that you can’t be held liable for trades that haven’t yet occurred. Okay, so what does that mean?

Let’s say you created a six-month trading plan to sell some stock, and it’s been running for a month.  Then you think that the stock price is probably going to decline – or maybe it already has declined. Guess what? You can cancel the plan. So, this means there’s not really much downside risk with a trading plan.

Of course, you could be accused of getting around the intent of the Rule if you cancelled the plan based on insider information. But, the SEC has not yet gone after people for canceling their trading plans, so who knows?

A company might even create a policy to not allow its employees to terminate their trading plans early.  By doing so, they’re eliminating that loophole that the SEC opened, and its makes the company look a bit more ethical.

Using Short-Term Trading Plans

You can achieve the same thing, and make it look quite a bit more legitimate, by setting up a series of short-term trading plans. You let each one expire after a short time, and then adjust the terms of the next plan to match market prices. If you follow this approach, then consider creating plans that run for three months a piece.  That way, you can legitimately install a new trading plan right after each quarterly SEC filing.

Parting Thoughts

That covers the essentials of a 10b5-1 trading plan. Clearly, they’re quite useful if you’re in a position where you want to trade stock, but you’re always aware of insider information. So, how do you create a trading plan.  That’s the easy part.  Every brokerage already has a basic template, so you just fill in the blanks and sign it.

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Rule 144 (#94)

In this podcast episode, we discuss the intricacies of Rule 144, which governs the sale of restricted shares. Key points made are noted below.

I’ve been talking a lot lately about registering stock. Rather than stringing out the topic, I’m going to polish it off in this episode and the next one.  The next episode will be about Rule 10b5-1.

Overview of Rule 144

So, what is Rule 144? This is an important one.  And even if you don’t have any particular need to know about it as an accountant, you may very well want to know about it as an investor – because a lot of people use it.

So let’s say that you own stock in a public company, but that stock is not registered, so you can’t sell it.  And you want to sell it. If you flip over the stock certificate and take a look at the back, it probably has a legend on it – right in the middle – that says the shares have not be registered, so they can’t be sold, pledged or hypothecated.

Now I didn’t have a clue what hypothecated meant – maybe something to do with aggressive hyphenation – so I looked it up. The definition is “hypothecation describes the posting of collateral to secure the customer's obligation to the broker.” So, you can’t do that, either.

Rule 144 Requirements

You want to remove that pesky legend, so you can sell the shares.  You do it with Rule 144. The SEC has a couple of requirements, and if you meet these items, then you can have the legend removed.  Here’s the first one:

And it’s the most important one – there’s a holding period. You must have owned the securities for at least six months, and that’s if the company has been issuing its normal reports to the SEC, like the annual Form 10K and quarterly Form 10Q.  If the company has not been keeping up with these filings, then the holding period is a year. So, this is the big one.  If you’ve held onto your shares this long, and you’re not an affiliate of the company, then you’re basically in good shape, and you can have that legend removed.

Ah, but what if you’re an affiliate?  An affiliate is someone who’s in a control position.

The real definition is kind of lengthy, but basically it’s people who can directly affect company operations, like board members, the CEO, CFO, division presidents, and people who own more than 10 percent of the company.

If you’re an affiliate, then things become a lot more restrictive. I won’t quite go so far as to say that you’re screwed, but it is a lot more difficult to sell your shares. So let’s return to those SEC requirements.  We’re now at rule number two.

For affiliates, there’s a trading volume formula, which means that the SEC is going to make you string out your stock sales.  The rule states that the amount of shares you can sell in a three-month period can’t exceed the greater of 1% of the total outstanding shares, or (if the stock trades on an exchange) the average weekly trading volume during the past four weeks.

So for this rule, if the stock is trading on an exchange, chances are good that the trading volume will be high enough that it drives the number of shares you can sell.  But if the shares only trade on the Pink Sheets, then the second part of the rule doesn’t apply, and you can only sell an amount equal to 1% of the total shares in any three-month period.

And then we have the third rule, which also only applies to affiliates.  They’re only allowed to sell their shares through a broker as a routine trading transaction.  This one means that the SEC doesn’t want affiliates trying to solicit orders to buy their stock.

And then we have the final and fourth rule, which is that an affiliate has to file any proposed sale with the SEC on a Form 144.  This is only if the sale is for more than 5,000 shares or the dollar amount is for more than $50,000, and this filing is for any three-month period.  If you keep selling past the three month period, then you keep amending the Form.

So, you can see that being an affiliate is a bit of a pain. But there is a way out of these affiliate rules. If you’ve held those shares for at least a year, and you’ve not been an affiliate for at least the last three months, then you can sell without all of those extra conditions. And if the company is still filing all of the usual reports with the SEC, then the holding period drops from a year to just six months.

So that covers all of the rules.  Let’s say that you meet all of the requirements – how do you get that pesky legend off the back of the certificate?

How to Remove the Certificate Legend

Here’s the procedure. First, send the certificate to a broker.  The broker contacts the company’s attorney, and asks for an opinion letter.  The attorney will want a standard representations letter from the broker, and a copy of the certificate, and the Form 144, if there has to be one.

Then the attorney writes the opinion letter and sends it back to the broker. The attorney will also send a copy of the letter to someone at the company, so the company knows you’re probably going to be selling shares.

Once the broker receives the opinion letter, he sends it and the stock certificate and some other information to the company’s stock transfer agent.  And after all of those steps, the stock transfer agent creates a new stock certificate without the restrictive legend, and sends it to the broker.

At that point, you can go out and buy a stiff drink – and you can finally sell the shares.

Parting Thoughts

Though – to be fair – most of this discussion has been about the extra rules for company affiliates.  If you’re not an affiliate, then Rule 144 is pretty awesome.  You just hold the shares for the minimum amount of time, and then you get the legend removed and sell the shares.  Nice.

And that’s how people can sell restricted stock.  As you may have noticed, Rule 144 is really for investors, not the company.  The only real impact on the company is that the attorney who handles the opinion letters is probably going to charge the company for having issued the letters, and that may be a couple of hundred dollars for each letter.

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Registration Statements (#93)

In this podcast episode, we discuss the various types of registration statements required by the SEC. Key points made are noted below.

The Need for a Registration Statement

A company can only sell shares, and its investors can only sell their shares, if the stock is registered.  This means that you have to write up a looong registration document, and submit it to the SEC.  And then – most of the time – they take a month to review it, and then they send it back with comments – possibly dozens of comments – and then you respond, and then they take another month to review it, and so on.  Once they finally declare it effective, which can easily take a half a year, then the stock is registered. And then you or the existing investors can sell stock.  And by the way, only the investors whose shares are listed in the registration statement can sell.  Everyone else is out of luck.

This is annoying in two ways.  First, you spend an amazing amount of time writing the registration statement, which also calls for a lot of expensive input from your auditors and attorneys.  And second, you absolutely want to throttle the SEC by the time they’ve picked through the statement multiple times – and in excruciating detail.  More about that later.

Registration Statement Exemptions

Now, you can avoid a registration statement with exemptions.  I already covered Regulation A stock sales in episode 90, and Regulation D stock sales in episode 89. And I still haven’t talked about one more variation, which is Rule 144.  But if you can’t do any of those, and you’re stuck with doing a stock registration, then what’s that all about?

First of all, you may be forced to register your stock.  If a big investor puts in money, it may be on the condition that you register their stock within a certain period of time. And if you can’t register it by the deadline, then they may impose penalties.  Or, you may get verbal pressure from existing shareholders, who want to sell their shares.  So there may be reasons why you just have to do this.

Types of Stock Registrations

Well, there are several types of stock registration.  The biggest, baddest, and basically the worst one is called the Form S-1.  This one requires an amazing amount of information, with the worst of it under a category called “Information with Respect to the Registrant.” The company is the registrant. You have to describe the entire business in nauseating detail, and that includes any legal proceedings, financial statements, and management’s discussion of the financial results.  The result really will be the size of a small book.

A key issue in preparing an S-1 is whether you can incorporate a bunch of information by reference, which means that you can describe something elsewhere, like in your annual 10-K report, and then just refer to the 10-K in your S-1.  This would be way more efficient, but of course, the SEC doesn’t allow this for newer companies.  You cannot incorporate by reference if the company has been a blank check company or a shell company, or if you’re offering penny stock.  And you have to be current with your public filings.  If you went public by buying a public shell, then you have to wait three years before you can incorporate information by reference.

So, are there alternatives to an S-1?  Luckily, yes.  There’s the S-3 and the S-8.  The S-3 allows for the incorporation by reference of a lot of information; you can refer to the latest Forms 10-K, 10-Q, and 8-K, which address nearly everything in that section called “Information with Respect to the Registrant.”  This saves a pile of time, but of course, the S-3 can only be used by some public companies.

To use it, you have to have your principal business operations within the United States, and you already have to have a class of registered securities (that’s a big one), and you can’t have defaulted on any debt or lease payments recently, and the market value of the common equity held by non-affiliates has to be at least $75 million.  If that bit about the market value is less than $75 million, you can still use an S-3 if you’re listed on a national stock exchange, and haven’t been a shell company for the past year.

So, the S-3 is really designed for larger public companies.  If you’re running a micro-cap company, then you’ll be stuck with the S-1.

Now, there is a registration variation called the Form S-8, which is pretty nice.  But it’s also extremely restrictive.  The S-8 allows you to register securities that you’re offering to your employees under an employee benefit plan.  This can include things like an employee stock purchase plan, or stock options, or restricted stock units.  Stock recipients covered by an S-8 are employees, officers, directors, general partners, and consultants.  And even family members, if they received the securities through an employee gift.

The inclusion of consultants in this list is a little odd, since everybody else is clearly some variation on an employee. So, the SEC makes it a little more difficult for consultants to be included.  Any securities issued to consultants can only be registered under an S-8 if they provide bona fide services to the company, and those services cannot be related to the sale of the company’s securities.

The S-8 – obviously – is restricted to what is normally a tiny subset of all the securities that a company has outstanding.  Nonetheless, it’s really useful for the group that it applies to, and I absolutely recommend that you use it. And for two good reasons.  First, it’s effective as soon as you file it, so there’s none of that incredibly annoying back and forth with the SEC’s comment letters.  And second, it is really easy to complete.  All you have to do is state that the company’s regular filings are incorporated by reference, and describe how the company indemnifies its officers and directors.  And attach the employee benefit plan.  There are a few other minor requirements, but that’s really about it.

The S-8 is only available if the company has been current with its filing requirements for the last 12 months, and it hasn’t been a shell company for at least the preceding 60 days.

One other point with an S-8 is that you can’t keep issuing securities under it if you stop being current with your SEC filings.  That means anything previously issued under it can still be traded, but you can’t keep issuing more securities.

There’s also something called a shelf registration.  This is the registration of a new issue of securities, and it can be filed up to three years in advance of actually distributing the securities.  This allows you to obtain funds really fast when you need them.  This is really useful for debt offerings, because a company can do the shelf registration and then wait for interest rates to decline before issuing any debt.

You usually do a shelf registration with an S-3 filing, which still requires it to be declared effective by the SEC, which can take some time.  However, it can be effective immediately upon the date of filing.  This automatic shelf registration is only available to what are known as “well-known seasoned issuers”. Which sounds a bit like they’ve been marinated for a while.

Anyways, these companies must have common stock belonging to non-affiliates that has a market value of at least $700 million, or they must have issued at least $1 billion of non-convertible securities within the past three years.  So, this is essentially only available to mid-cap and large-cap companies. Everyone else is just too small.

When a Registration Statement is Effective

One last item.  Let’s get back to that bit about the SEC declaring a registration statement effective.  What’s that all about? It means that the SEC staff finds that your registration statement conforms to their regulations, and it includes key information about the company. So all the SEC is doing is making sure that the document is complete – they can’t pass judgment on whether it’s completely idiotic for anyone to invest in your company – only that the information is listed in the registration statement that tells investors that an investment is a really bad idea.

The SEC staff has one month in which to review a registration statement.  And they use the entire period.  And on the last possible day, they send you a comment letter.  I’m going to read part of their standard boilerplate, because it tells you what they’re up to.  It says, and I’m starting partway into a sentence:

“We think you should revise your document in response to these comments.  If you disagree, we will consider your explanation as to why our comment is inapplicable or a revision is unnecessary. After reviewing this information, we may raise additional questions.  Please understand that the purpose of our review process is to assist you in your compliance with the applicable disclosure requirements, and to enhance the overall disclosure of your filing.”

The comments they attach may include a couple of significant items, and then there’ll be a whole pile of items so nit-picky that you really start wondering about the SEC staff time that goes into these reviews.  I cannot possibly say that the SEC is being effective in how they review a document.  They really should just zip through a registration document, and comment on the big stuff, but that is absolutely not the case.  If anything, this looks like the worst possible case of make-work that I’ve ever seen.  But, that is the system.

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The Product Cancellation Decision (#92)

In this podcast episode, we cover the issues to consider when you are thinking about cancelling a product. Key points made are noted below.

The Need to Cancel Products

If a company has more than just a few products, it’s likely that a couple of them bring in most of the profits, and the rest are hovering around the breakeven level.  This brings up an issue for the controller, who may want to recommend that some of those marginal products be eliminated. By doing so, it’s easier to focus on the few products that earn the company most of its profits, and frees up more staff time to work on new products that may be more profitable.

This sounds simple, but it’s actually quite a bit more complicated, because you need to think through not just the cancellation calculation, but also the ramifications of dropping a product.

The Cancellation Calculation

So let’s start with the cancellation calculation.  The goal is to cancel anything that is outright losing money, but which ones are those?  To calculate a profit or loss for this purpose, you only include those expenses that are totally variable.  This includes things like the cost of materials, and the salesperson’s commission, and any processing work charged by a third party, and the packaging cost.

There’re two expenses that you do not include in the calculation.  One is direct labor, and the reason is that most companies have the same group of direct labor staff come in every day, and they work a full day on whatever is in front of them.  If a single product is cancelled, then they’re just going to work on something else, so canceling the product does not terminate the people who manufacture it.  On the other hand, if employees can be specifically identified who do work on a product, then fine – go ahead and include them in the cost.

The second expense that you do not include in the calculation is overhead.  Overhead is usually things like the plant management group, and depreciation on equipment, and quality assurance staff, and supplies, and so on – and none of these expenses will change if one product is cancelled.

If you were to do a product cancellation calculation with overhead, and the overhead expense is what tips the product over into the loss column, then all you’ve done is eliminate a profitable product – and then the overhead, which is all still there, is now spread across the smaller number of remaining products, and that in turn makes them look less profitable.  So in short, avoid overhead.

However, if you’re analyzing the cancellation of an entire product line, rather than single products, then a fair amount of overhead can be applied to the calculation.  For example, you can include the cost of marketing the product line, and procurement, and the cost of the product manager.  These all make sense, because if you cancel the entire product line, then these expenses will go away.

Now, if the analysis shows that there is a loss, you’re not really done with all of the analysis, because there’s also exit costs.  First, there may be a fair amount of inventory in stock, so you may want to calculate how long it will take at the current sales level to work the inventory down, so you can recommend a termination date.

And the same thing goes for fixed assets.  If there’s manufacturing equipment that the product is made on, and it’s scheduled for an upgrade or replacement, then you need to get the word out to prolong the maintenance on what you already have, until the scheduled termination date.  This is a lot less expensive than buying new equipment that the company will just have to turn around and sell in the near future.

And also, what if there’s a warranty period on the product, like a year?  For that period, you need to estimate the amount of inventory that you’ll probably need, and set it to one side.

These exit costs don’t really have an impact on the decision to cancel a product.  But what they do have an impact on is the timing of the cancellation, so you do need to work through these issues – not just once, but probably once a month as the cancellation date gets closer.

For example, you might find that sales of a product decline over time, so you may decide to extend the cancellation date further out to use up the last of the inventory.  That’s the sort of decision that requires continual updating.

So let’s say that you’ve done all of the analysis, and you know what to cancel and when to do it.  You still need to consider the ramifications of the cancellation.

The Ramifications of a Product Cancellation

One issue is that a clearly unprofitable product may the lower step of an upgrade path to another product that’s much more profitable.  If so, add together the profitability of both products.  If you still come up with a loss, then the upgrade argument doesn’t work, and you should still cancel the unprofitable product.

The same argument applies if an unprofitable product is crucial for the overall business of a customer who otherwise generates a lot of profit for the company.  If this is the case, make sure that the customer is really as profitable as you think.  If it is, and the customer insists on having that product, then you’re probably stuck.

And then there’s the product line issue.  A company may want to offer a complete product line, and if one product is unprofitable, then canceling it creates a hole in the product line, and perhaps a competitor could take advantage of that.  If so, the best approach is a long-term one, where you recommend that a product be developed that has a lower cost structure.  Then you cancel the old product when the new one is ready.

If you’ve gone through all of these calculations and analysis, there probably won’t be very many products left to cancel.  But, running a business is a bit like being a doctor, and their motto is first, do no harm.  The same principle applies in this situation.  You don’t want to slash and burn the product line.  Instead, it should be a careful review of the situation, and you only cancel as a last resort, when there’s really no alternative.

And that’s why I’ve done about a hundred product cancellation reviews over the years, and only recommended that two of them be eliminated.

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FASB Statement 165, Subsequent Events (#91)

In this podcast episode, we discuss the new requirement for the reporting of subsequent events in the financial statements. Key points made are noted below.

FASB Statement 165

Statement 165 runs through the reporting requirements for subsequent events.  It covers three main areas.  First, it describes the period after the balance sheet date when company managers have to evaluate whether a subsequent event needs to be included in the financial statements, or disclosed along with the financials.

Second, the Statement notes the circumstances under which that recognition has to occur.  And finally, it states very generally the types of disclosures that have to be made for subsequent events.

Of these items, the key factors are the time period and circumstances for a subsequent event.

The Recognition of Subsequent Events

The first point in the Standard is that you have to recognize in the financial statements the effects of all subsequent events that provide additional evidence about conditions that existed at the date of the balance sheet.

So for example, if you have a lawsuit that’s settled after the balance sheet date but before the financial statements are issued, and the settlement amount varies from the liability recorded in the balance sheet, then you really should be considering putting the settlement amount in that liability.

However, you don’t recognize subsequent events that provide evidence about conditions that DID NOT exist at the date of the balance sheet.  For example, if you settle a lawsuit where the claim arose after the balance sheet date, that is a nonrecognized subsequent event.

Another example of a nonrecognized event is a change in the fair value of an asset or liability that arises after the balance sheet date.

Now you might be scratching your head about this nonrecognition item.  It just means that you don’t recognize the monetary impact of the event in the financial statements.  You still have to disclose it.

If you’re just disclosing it, then you need to disclose the nature of the event and an estimate of its financial effect, or a statement that you can’t make such an estimate.

If a nonrecognized subsequent event is really significant, then you should consider including pro forma financial information along with the regular financial statements.

And also, the Standard requires that you identify the date through which subsequent events have been evaluated, as well as whether that date is the date the financial statements were issued or were available to be issued.

You may have noticed that I just mentioned the “available to be issued” date.  What’s that all about?  Well, the Standard defines it as whenever the financials are complete in form and format, and they comply with GAAP, and all approvals necessary for issuance have been obtained.

This definition really applies to private companies.  Publicly-held companies have a fixed release date for their financials, but private ones may not issue their financials to anyone, so you don’t want them to keep updating their financials for subsequent events for potentially a long time.

If you look at the end of the Standard, where they list all of the preceding accounting standards that have to be modified because of this new Standard, the same item occurs several dozen times, which is that the “issuance date” is being replaced with the date when the financial statements are issued or available to be issued.  So, based on the modification of past pronouncements, that appears to be the key change in this Standard.

And finally, the Standard applies to both interim and year-end financial statements.

My interpretation of this Standard is that it’s by no means monumental.  It’s more of a conceptual document, so they’re clarifying how you deal with subsequent events, and how long you need to deal with them.

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Regulation A Stock Sales (#90)

In this podcast episode, we discuss how fund raising can be achieved by using the Regulation A exemption. Key points made are noted below.

To return to the main premise of the last episode, you want to avoid doing a stock registration when you sell stock, because a registration is painful, and annoying, and very expensive.  One way out, from the last episode, was to sell stock only to accredited investors, which are basically high net-worth investors.  And in most cases, that works pretty well.  But, what if you can only raise money from investors who are not accredited?  Well, if you’re not trying to raise too much money, you can use the exemption provided by Regulation A.

The Regulation A Exemption

This exemption is designed for companies that aren’t going to raise much money, presumably on the grounds that they wouldn’t bother otherwise if they had to submit a full registration document.  The limit on Regulation A fund raising is $5 million per year.

But there is one catch, which is that $1½ million is the maximum amount of that $5 million that can be a secondary offering.  What that means is that existing shareholders may be sitting on unregistered stock that they want to sell, and Regulation A only allows them to sell $1½ million of their shares per year as part of the $5 million exemption.

And on top of that, the secondary offering cannot include stock resales by affiliates of the company if the company hasn’t generated net income from continuing operations in at least one of the past two fiscal years.  Examples of affiliates are officers and directors, and significant shareholders.

And on top of those restrictions, Regulation A is no available for investment companies or development-stage companies.

The exemption is also not available if a company has been having disclosure problems with the SEC over the past five years, or if the company currently has a registration statement being reviewed by the SEC, or if any affiliates or the company’s underwriter have been convicted within the  past 10 years of a crime related to a securities transaction.

So basically what all of these restrictions mean is that Regulation A is intended for smaller companies that have been around for a while, and which really need to raise money, and not to cash out existing shareholders.

Advantages of Regulation A

So, what are the advantages of a Regulation A offering?  First of all, there’s no limit to the number of investors, and they don’t have to pass the qualification test that was used for Regulation D.  Also, and here’s a pretty major item, there are no restrictions on the resale of any securities sold under the Regulation.  And finally, the key difference between a Regulation A offering and a registered offering is the absence of any periodic reporting requirements; which can be a pretty major cost reduction.

Regulation A Steps to Follow

Here are the steps you follow to complete a Regulation A offering:

First, you issue an offering circular, to see who’s interested in investing.  As you may recall from the last episode, this was not allowed under Regulation D.  But, you first have to submit the offering circular to the SEC for review.  And if they choose to review it, then you can count on some delays.  The SEC is not known for rushing its reviews.

Also, the offering circular is not small.  If you think you’ll get away with a two-page document, think again.  Unless you’re using amazingly small font.  The offering circular is detailed, and it takes a lot of professional input to construct.

Second, when the company is ready to start selling securities under the Regulation, it files a Form 1-A with the SEC, and then conducts a general solicitation.  The company cannot complete any security sales until the SEC approves the Form 1-A, so there’s going to be a delay there.

If the information issued to investors in the offering circular becomes false or misleading due to changed circumstances, then the company has to revise and reissue the offering circular.

And the third step is, that once the security sales are under way, the company has to file a Form 2-A with the SEC every six months, which describes the cumulative sales from the offering, and the use of proceeds.

And finally, it has to file a final Form 2-A within 30 calendar days of terminating the offering.

I do not recommend trying to bootstrap your way through a Regulation A offering.  There needs to be a qualified securities attorney involved in nearly every step of this process, and also to assist in communications with the SEC.  And if you add legal fees to the cost of preparing the offering circular, you’ll find that it’s still a pretty expensive way to raise money.  It’s less expensive than a full-blown stock registration, but it’s not cheap.

In short, Regulation A works well for smaller offerings, though it does still require some interaction with the SEC and filing of reports.  Still, it does allow stock to be registered, which investors really like.

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Regulation D Stock Sales (#89)

In this podcast episode, we discuss why a business might want to sell shares using the Regulation D exemption, and what that entails. Key points made are noted below.

When to Use Regulation D

At some point, you may be working with a public company, and you’ll be asked to help it raise money by selling stock.  If you do, you absolutely want to avoid filing a stock registration document with the Securities and Exchange Commission.  I’ll get into stock registrations in another episode, but trust me on this one, don’t do it if you can possibly avoid it.  There are major auditor and legal fees involved, and a registration takes up a lot of your time, and the SEC will pick it to death and keep making you modify it.  So, you don’t want to go there.

Instead, you want to use one of several SEC regulations that provide exemptions from the main stock registration laws.  A good way out is Regulation D, which provides an exemption from the normal stock registration requirement.  Regulation D requires that you only sell securities to accredited investors.

The Accredited Investor

There are a couple of definitions for an accredited investor, but the one used the most is that it’s a person having individual income of at least $200,000 per year, or a joint income with a spouse that exceeds $300,000 per year.  And that’s in each of the last two years, by the way, and there has to be a reasonable expectation that they’ll reach the same income level in the current year.  It can also be anyone with an individual net worth of at least $1 million, or it can be a director or executive officer of the company.  It can also be an entity, like a bank, or a trust, or an investment company. These guidelines keep going up over time, but those are the minimums that the SEC has established so far for accredited investors. The main point with the accredited investor is that it’s someone who’s wealthy enough and therefore presumably smart enough to make informed investment decisions.

How to Find Accredited Investors

So, your first task is to round up a group of these accredited investors.  Under Regulation D, you can’t pull in these investors by using a general solicitation.  That means no advertisements, and no free seminars for the investing public. What you do instead is either use personal contacts or use an investment banker who can contact a short list of accredited investors on your behalf.  This means you’ll need an investment banker most of the time, since they know who the most likely investors will be.

Another question is, how do you know if someone is really an accredited investor?  What if they don’t really have the financial resources required by Regulation D?  Actually, it’s not your problem.  Have your attorney create a questionnaire for the investors, which they have to sign.  The questionnaire asks them about all of the criteria that I just mentioned for an accredited investor, and if they say they are, and you have a copy of the signed questionnaire, then you’re covered.

The Stock Restriction

Now, the problem with Regulation D stock sales is that they are not registered, so when you issue the stock certificates, there’s a big restriction paragraph on the back of the certificate.  And that restriction means they cannot sell the shares.  The restriction says something like “These securities may not be sold, offered for sale, or pledged in the absence of a registration statement.”

Investor Motivations

Tt’s fairly obvious why a company wants to use Regulation D; it has far less reporting to do, and it still gets the money from investors.  But why would an investor agree to do it, since the shares can’t be sold?  Well, there’s a certain type of investor who’s willing to take restricted stock, and that’s the long-term investor.  They’re assuming they’ll be holding onto those shares for a number of years, and they expect to cash out when the company is sold.

Or, they may be expecting to have their shares registered whenever the company eventually registers other stock.  This is called having piggyback rights, and it means that the company is obligated to list their shares in any registration statement that the company eventually files with the SEC.  Piggyback rights are very common in a Regulation D stock sale.

The investors realize that they’re doing the company a favor by accepting unregistered stock, so they can also extract some other favors.  One common item is warrants, which is a right to buy the company’s stock at a certain exercise price.  If they get one warrant for every share they buy, that’s called having 100% warrant coverage.  If they get one warrant for every two shares they buy, then that’s called having 50% warrant coverage, and so on. A canny investor is very likely going to want warrants so he’ll be able to grab additional profits from any upside on the stock price that may occur over the term of the warrants, which is usually five years.

Now if you’re really desperate for cash, the investors can get even more onerous.  They may demand preferred stock instead of the usual common stock, which may give them really favorably conversion rights into common stock, or dividends, or even super-voting privileges over the common shareholders.

Parting Thoughts

So, it’s a great idea to use an exemption like Regulation D to avoid a stock registration statement, but use it when the company is in fairly good financial condition and isn’t overly desperate for cash.  Otherwise, you may be stuck with some really rapacious investor who will take the restricted stock, but will also gain quite a financial advantage over the company.

A final issue is, what if a stock sale occurs over several months, which may happen if some investors are straggling in ways after everyone else.  Do all of the stock sales in that period fall under Regulation D?  There are a couple of guidelines for figuring that out.  First, are the sales all part of a single documented financing plan? Also, does it involve the sale of the same type of stock? And, are sales being made for the same type of consideration? And finally, are the sales being made for the same general purpose.  If the stock sales in the time period all conform to those rules, then you’re covered by the Regulation D exemption.

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Types of Acquisitions (#88)

In this podcast episode, we discuss the different types of acquisition structures that can be used, and their relative advantages and disadvantages. Key points made are noted below.

The Requirements to Defer Taxes

When there’s an acquisition, a key part of the deal for the seller is avoiding taxes – or, actually, deferring taxes.  According to the Internal Revenue Service, if you want to defer taxes, the deal has to fulfill three requirements.

First, the acquisition has to have a bona fide business purpose other than just deferring taxes.

Second, there has to be a continuity of interest, which means that the ownership interest of the seller has to carry over into the acquiring company, which basically means that the buyer has to pay with at least 50% of its own stock.

And finally, there has to be a continuity of business enterprise, which means that the buyer either has to continue the seller’s business, or use a significant proportion of the acquired assets in a business.

Buyer and Seller Motivations

The IRS has come up with four types of legal reorganization that incorporate these requirements, which means that the buyer and seller have a few alternatives for deferring taxes.  These are called Type A, B, C, and D reorganizations.  We’ll skip the Type D reorg, since it’s only for a limited number of situations.  If you deal with many acquisitions, you’ll see references to these reorg types quite a bit, usually in the acquisition term sheet.

Now before we jump into the types of reorgs, let’s cover the positions of the buyer and seller regarding the type of acquisition.  The buyer usually doesn’t recognize any gain or loss at the time of the acquisition, but it would prefer to increase the assets it acquires to their fair market values, assuming that the fair market values are higher than their book values.  By doing so, the buyer can record a larger amount of asset depreciation, which reduces its future tax liability.  However, the buyer can only do this if it does an asset acquisition, and one other scenario that I’ll get to shortly.  Otherwise, it has to retain the acquired company’s tax basis.

Also, the buyer may want to retain the selling company’s legal entity, since there may be some contracts that would expire if the entity is liquidated.  If the buyer just wants to acquire some technology or other assets of the selling company, then it may not care so much about retaining the entity.

The seller may be OK with paying taxes now, if it’s being paid in cash, or if it’s going to recognize a loss on the transaction – in which case it isn’t going to pay any taxes.  Otherwise, the seller will want to use one of the IRS reorgs to delay its tax payments.

Types of Reorganizations

So, let’s get back to those reorgs.  In a Type A reorganization, you transfer all of the seller’s assets and liabilities to the buyer in exchange for a payment that includes at least 50% of the buyer’s stock, and then you liquidate the selling entity.  Under this scenario, the seller defers tax payments on that part of the payment that was made with the buyer’s stock.

The problem with a Type A reorg is that you liquidate the selling company, which means that any contracts associated with that company may be terminated.  So on this one, the buyer may not be too happy about possibly losing some contracts, while the seller may be quite pleased with some limited tax deferral.

A Type B reorganization is the same as a Type A reorg, except that the seller has to take the buyer’s stock for all of the payment, and the selling entity can be retained.  A Type B reorg tends to make buyers a lot happier, since they can keep the selling entity, but sellers may not be too happy about being paid only in stock.

A Type C reorg contains a little bit of both the Type A and B reorgs.  The seller has to accept mostly the buyer’s stock – at least 80%.  The buyer has to liquidate the selling entity, but it can mark up the assets to their fair market value.

In addition to these types of reorganization, it’s also possible to do either a triangular merger or a reverse triangular merger.

In a triangular merger, a subsidiary owned by the buyer merges with the seller, and the selling entity then liquidates.  This is called a merger instead of an acquisition, so approval of the selling entity’s shareholders is not needed – only its board of directors.

To achieve a tax deferral with a triangular merger, the buy has to obtain at least 80% control over its own subsidiary, and acquire at least 90% of the fair market value of the buyer’s net assets.

In brief, a triangular merger involves a shorter approval process, but you still lose the selling entity.  Usually, a better approach is the reverse triangular merger.  In this case, a subsidiary owned by the buyer merges into the seller, and the subsidiary then liquidates.  This also only requires board approval, and the buyer gets to retain the selling entity, which may be critical if it has a lot of valuable contracts attached to it.  However, the seller has to make do with no more than a 20% cash payment – the rest of the payment has to be in the buyer’s stock.

So, there’s five types of acquisitions, besides just paying all cash for the selling company, in which case there is no tax deferral of any kind.  In general, the buyer is writing the purchase agreement, and will insert the type of acquisition that will most benefit it – not the seller.  So… the seller needs a really good tax attorney to comb through the purchase agreement and negotiate for whichever type of reorganization makes the most sense for the seller.

And one final point of clarification.  If the buyer pays cash to the seller for any portion of a purchase price, then the buyer has to pay income taxes now on that cash payment.  It’s only that portion of a payment made with the buyer’s stock that is eligible for tax deferral.

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The CFO Position (#87)

In this podcast episode, we discuss the nature of the chief financial officer (CFO) position. Key points made are noted below.

What a CFO is Not

I’ll start this off with a story.  About 20 years ago, I interviewed with the CFO of a company that had just spun off from Hewlett Packard; the CFO wanted a controller.  To say the least, we did not get along.  I thought he was a jerk, and he thought that I didn’t know what the differences were between a CFO and a controller.  As it turned out, we were both right.

The problem with controllers being promoted into a CFO role is that they really think it’s an accounting job – and it isn’t.  20 years ago, I had not yet figured out the difference, and it took a long time to get it right.

The CFO role is easier to define by what it isn’t.  It does not involve anything remotely associated with accounting or any other transactions.  It does not involve preparing financial statements, or creating control systems, or installing accounting software, or preparing public company forms, like the Form 10Q or 10K.  All of those items are the responsibility of the controller, and the controller’s staff.

Now, anyone who’s come up through the traditional path of getting an accounting degree in college, and then picking up a CPA or CMA certification, thinks that what I’ve just described is the high point of an accounting career, because that’s what you’ve trained for.

Realistically, though, all of that training only gets you to the controller position.  It does not do squat for someone in the CFO role.  If you still do all of those things, and your title is a controller, then you’re in for a nasty surprise, which is that your title may be CFO, but you’re not.  Either you failed to hand off your job to a new controller when you were promoted, or the company president gave you a title instead of a pay raise.

What Does a CFO Do?

We’ve just established what a CFO is not; so what IS a CFO?

At the very highest level, it’s about being paid to think.  This is the hard one for an accounting person.  You’re no longer spending time dealing with interpreting accounting rules, and making sure that entries are made correctly.  Instead, it means taking a very hard look at the financials and related metrics to try to pinpoint trends.  And, if you think you’ve found something, then you need to cut right through the entire organization until you get an answer.  And then you’re paid to act on it.  For example, if the cost of goods sold has jumped a couple of percentage points over the past year, the controller is primarily concerned with reporting this information, but the CFO has to investigate the situation and correct it.

Another CFO role is monitoring controls, which does not mean daily reviews of controls, which an internal auditor handles.  Instead, the CFO is talking to the audit staff about problems they’ve spotted, and is figuring out how to keep those problems from occurring again.  Now, someone in a controller role is probably thinking that they do that, too.  Perhaps.  But the rule with controls is that you’re going to have a control breach exactly where you never expected it.  I’ve seen this over and over again.  And this is where the CFO needs to focus – continually reviewing the entire organization and trying to identify those key holes in the control system that need to be filled.

Of course, controls are only one piece of a bigger picture, which is risk management.  The CFO needs to be all over this one.  And it does not mean having a working knowledge of the various company insurance plans, though that would be nice.  Risk management involves all kinds of internal systems, and insurance is only the extra coverage you need in case everything else fails.  So the CFO needs to know about things like the risk of computer systems failing, and the possibility of a key facility being in a flood plain, and having a foreign currency hedging strategy, and so forth.

Here’s another one.  Finance.  The CFO usually runs the treasury department, assuming there is one.  This means that the CFO needs to have a very good handle on not only the cash situation right now, but where it’s going to be.  The reason is that the person responsible for fund raising is the CFO, and so he or she needs to be well out in front of any cash flow problems, so there’s always enough cash on hand.

The CFO also needs to be deeply involved in budgeting.  This does not mean the super-detailed accumulation of information that the accounting staff gets involved with each year.  Instead, the CFO needs to be spending lots of time on the general direction of the company, and where cash is really being allocated.  It’s one thing for management to talk about some nifty new direction, but it doesn’t do much good if the budgeting process is starving all the new initiatives of cash.  It can also mean that the CFO spends a lot of time questioning the reasons for larger capital investments.  So, again, the parts of the budgeting process that the CFO gets involved in are exactly those parts where he may not have much experience.

If a company is a public one, then the CFO needs to learn about investor relations.  There’ll be a quarterly conference call with investors, there may be road shows to raise money, and there’ll certainly be other types of meetings with investors and analysts.  In this role, the CFO needs to have some solid public speaking skills, to give investors the impression that the company is in good hands.  But, have you ever noticed how many people in accounting are introverts?  Once again, this is not a place where someone coming up from the accounting side has good fundamental training.

There’s a common thread that runs through most of these job items, which is that the CFO needs to be a forecaster.  It means constantly monitoring the entire organization to figure out what could happen, and what the odds are of those things happening.

And to be an effective forecaster, the CFO needs some pretty major people skills, since the foundation for most of this crucial knowledge is not sitting on spreadsheets – it’s in the sales staff, and the customer service department, and the engineering staff, and the CFO has to go out and get that information.  And in case you hadn’t noticed, that bit about people skills is also something you didn’t learn in school.

And finally, this is a persuasion job.  It means figuring out the direction that the company should be heading in, and then convincing everyone about why your vision is the right one.  If anything, figuring out what to do is the easy part – it might take up a third or so of your time.  The persuasion part is really hard, and it takes up the other two-thirds.

Parting Thoughts

In short, if you’re promoted from controller to CFO, congratulations.

But it also means that your presumably deep knowledge of accounting won’t provide any real basis for success.  Instead, you have to hand off all of your old job, and buckle down for a couple of years of serious additional training.

Related Courses

CFO Guidebook

Enterprise Risk Management

Investor Relations Guidebook

Credit Best Practices (#86)

In this podcast episode, we cover a number of best practices that can be applied to the credit function. Key points made are noted below.

This is all about whether to grant credit to a customer, and if so, for how much and under what terms.  Credit granting is treated very differently among companies.  At a smaller level, companies tend to not treat it as a key accounting function, until they have a large bad debt.  And even then, if there’s only one serious bad debt, it’s quite possible that management will avoid setting it up as a stand-alone function.

However, if there’s a string of bad debts, then they get pulled into credit management, whether they like it or not.

The Credit Policy

So… let’s assume that management is grudgingly requiring a credit function.  What do you do?  Well, the first step is to be consistent in how you treat customers, and that means a credit policy.  The credit policy outlines who is responsible for the function, and the general process flow for evaluating and assigning credit, and even general guidelines for the terms of sale.

Once you have that, the next thing to consider is when not to spend time doing a credit evaluation.  In other words, credit analysis takes a lot of time.  And if you have a lot of customers, the cost-benefit of reviewing everyone will not be good.  Instead, you want to focus on the largest and riskiest transactions.

This means that you establish a lower cutoff, below which you accept all orders.  For example, if someone places an order for any amount under $1,000, that’s fine.  However, this figure can vary all over the place.  In some industries, product margins are so tight that you just can’t afford to lose much in write-offs, so the minimum credit review level is really low.  Conversely, if the gross margins are really high, then a fairly high level of bad debt may not be that big a deal.

You can also loosen the credit policy in special situations.  For example, if you have a few remainder products that you’re trying to clear out of stock, it may make sense to really loosen up credit for anyone who orders those items.  If you’re going to throw away the goods otherwise, then there’s really not much downside risk.

And another issue is how frequently you update the credit policy.  Once a year should be a minimum, and you really want to jump on it if the economy goes into a nose dive, so that you can tighten the credit standards.

Information Collection

Beyond the credit policy, the next issue is collecting information about the customer.  This tends to start off as a really short credit application, which gets longer as the credit department becomes more sophisticated – and gets a bigger budget for doing more analysis.

At the most minimal level, the application is just asking for identification information, so the credit staff can run a credit check on the customer through a credit service, like Dun & Bradstreet.  If the credit score comes back high enough, then the credit staff grants a moderate level of credit, and subsequently changes that level based on how well the customer pays – or not.

Now, that’s a pretty minimal level of credit analysis, since you’re essentially outsourcing the analysis to a third party.  The next level of review is asking for credit references in the application.  This takes more work by the credit staff, and the information you get is not always that good.  After all, the customer is cherry-picking its best credit references, so it’s probably treating those three or four references listed on the form especially well.  To squeeze out any good information, you need to contact the references and see if they know of any other customers of the target, and then you contact them, to see what’s really going on.

This all takes a fair amount of time, and it may not be cost-effective to dig around for days on end, especially when the sales staff is badgering you for a credit decision right now.

So, what else can you do?  Lots of things.  Getting back to the credit application, you can keep expanding it.  One option is to add a personal guarantee clause.  This works well for smaller customers, though larger customers get irritated and cross it out.  You can also include a clause about the company getting a security interest in any goods that it ships to the customer.  It’s also possible to make the customer reimburse you for collection fees, and for bounced check fees.  Part of the reason for these extra features is to cover the company, but it also gives the customer the impression that the company is serious about collecting its receivables.

And, the big item is a request for financial statements.  Reviewing financials doesn’t really take much time, and it provides a really good picture of a customer’s financial position.  The trouble is, it’s kind of tough to require audited financial statements, especially from smaller private companies that have never had audits done.  So, keep in mind that those financials may not be entirely correct.

There are also some procedural things you can do with a credit application.  One is to require a new application if a customer hasn’t placed an order for some period of time, since the old application may not reflect the customer’s current financial situation.  Also, any time a customer does not fill out a field on the application, or crosses out a clause, that’s a big warning flag, and that application should automatically receive a lot more attention.

You can also require a new application whenever a customer consistently butts up against the upper end of its credit limit, or if it ever sends in a check that bounces.  Though, if their check bounces, the first thing you should do is yank their credit entirely until the situation is resolved.

Credit for Large Customers

Now, let’s cover credit for large customers.  This is where you spend most of the credit department’s time, because a bad debt on a large order is a really serious issue.  For a large customer, you do want audited financial statements, and you want them every year.  If they’re publicly held, then you’re in luck, because their financials are on file with the SEC, and you can access them on-line.  In addition, the credit manager should get to know the customer.  This means lots of phone calls, and a periodic site visit is a really good idea.  This also means running credit reports on a regular basis, so you can track any changes in their credit score.

These techniques help, but they don’t necessarily give enough clues about how a large customer is doing.  For that, you might consider joining an industry credit group, where they exchange information about customers.  If people there start mentioning problems with a customer, then it would be very prudent to start dialing back the credit level.

When Customers are in Trouble

So, what if the credit picture just doesn’t look good.  There are still some ways to do a limited amount of business with a customer.  One method is to impose a really short payment period, and if they don’t pay on time, you cut them off.

Another possibility is to refer a customer to a distributor, because the distributor might have a looser credit standard, and be willing to take on the risk.  Or, you could ask for a partial cash-in-advance payment.  Or, you could require a letter of credit, or you could obtain credit insurance on the customer.

There are a lot of variations here, so instead of just dumping a customer or requiring an all-cash payment, sit back and think about all of the possible variations where you can still make some kind of a sale without violating your credit policy.

Related Courses

Credit and Collection Guidebook

Effective Collections

The Acquisition Term Sheet (#85)

This podcast episode describes the contents of an acquisition term sheet and some of the clauses contained within it. Key points made are:

The Term Sheet

The term sheet lays out the initial terms of a possible deal between the buyer and seller of a company.  It’s the first time that the two parties get together to put terms down on paper.  In case you haven’t figured it out yet, that means this is the starting point of acquisition discussions.

Just because both parties sign a term sheet, that doesn’t even remotely mean that there’s a deal.  It just means that the parties are interested in delving into the deal a little deeper – and eventually, if everything works out, there’ll be a purchase agreement.  And the purchase agreement is a legal document that can hold up in court.  In most cases, a term sheet is not a legal document, and it will not hold up in court.

Why Use a Term Sheet?

So if the term sheet is non-binding, then why even have it?  You can skip it and go straight to the final purchase agreement, if you’d like.  However, there are some good reasons for having it.

First, it prevents misunderstandings.  It helps to have the general terms of the deal laid out in a document that’s probably just a couple of pages long.  Because of the simple layout of the term sheet, it’s not likely that the parties will have a falling out later on about general conceptual issues.

Second, the term sheet creates somewhat of a moral commitment to complete the deal.  Once the parties agree to the general terms that are in the term sheet, there’s a tendency to assume that the deal will be completed.  And if there’s an in-house bureaucracy that does acquisition deals, they tend to push them through once the term sheet is signed.

This does not mean that a deal is therefore inevitable.  Far from it.  A quality acquisition team is going to be highly critical of any possible deal, and they’ll keep probing until the last minute to make damned sure that this is really a good deal for the buyer.

A third reason for a term sheet is that it can be used just to narrow the field of possible buyers.

If a company is being sold in an auction environment, then potential buyers have to submit a term sheet in order to keep from being barred from the going further in the process.

And a final reason for using a term sheet is when you do make it binding.  This normally only involves a few clauses, like a built-in confidentiality agreement.  But, it can go a lot further.  It can include a no-shop clause, where the seller agrees to deal exclusively with the buyer for a certain number of months.  The buyer wants this because it reduces the buyer’s risk that the seller will shop the purchase price listed in the term sheet to other possible buyers.

When Used as a Binding Commitment

The term sheet can also be a fully binding commitment for the buyer to complete the acquisition – but the buyer would normally be an idiot to agree to this, since the buyer usually hasn’t completed much due diligence yet, and so doesn’t know if there might be some really serious problems with the seller’s company.

Term Sheet Contents

So, what’s in a term sheet?  They vary a bit, but most have a group of common clauses.

You’ll probably see a paragraph stating the general structure of the transaction, such as the buyer only acquires the assets of the seller, or maybe wants to do a tax-free reorganization.

Then, of course, we have payment terms.  It should state the amount to be paid, and the form of payment, such as cash, debt, or stock.  It may also note the terms of an earnout, which is an extra payment based on how the company does after the buyer acquires it.  The term sheet very likely also contains a statement that the purchase price is subject to adjustment, based on what the buyer finds during the due diligence process.

Also, if a public company buys the selling entity with its own stock, it may do so with unregistered stock, which means that the sellers can’t initially sell their shares.  This could be quite a surprise to the sellers, so it’s best to make a statement about registration rights, which obligates the buyer to register the shares that it plans to use for payment.

The seller’s management may also have some compensation concerns, which can be addressed in the term sheet.

For example, the owner may refuse to sell unless his key staff are protected, so the term sheet could state that all designated key staff will be retained for a minimum period of time.

Along the same lines, the sheet can point out that the buyer will honor all outstanding stock options and warrants, though a lot of them may exercise automatically if there’s a change in control.

While all of this may sound quite positive, there’s also a piece that deals with the downside.  This paragraph points out that the whole deal is dependent upon a variety of things, like audited financial statements, approval of the deal by regulatory agencies, approval by the shareholders or the boards of directors, getting outside opinions about the deal being tax-free, and so forth.  In particular, the buyer can put in a clause stating that the whole deal is contingent upon it lining up the funding to pay the seller.  They should just call this the “Comprehensive Walk Away from the Negotiating Table” clause!

And finally, there’s an acceptance period, which gives both parties a short period of time in which to agree to the term sheet, after which it’s automatically void.

There are a lot of additional clauses you can add to a term sheet, but most of them just add unnecessary verbiage.  However, there are two additional ones worth considering.  First, you may want to include an Announcements paragraph.  This states that each party agrees not to make any disclosures about the prospective deal without the agreement of the other party.  This can be good for both, since privacy is important.  You don’t want competitors interfering, which can happen if the deal appears in the newspaper before it’s really closed.

The other optional clause, which I mentioned earlier, is the no-shop clause.  It’s amazingly common for a seller to take the buyer’s offer and shop it around to everyone in sight to try and bring in a higher offer.  This really undercuts the buyer, so a lot of them won’t proceed further with a deal unless there’s a no-shop provision in the term sheet.

So, in short, the term sheet is not a mandatory part of an acquisition, but it’s a useful tool, and I recommend using it.

Related Courses

Business Combinations and Consolidations

Mergers and Acquisitions

Taking a Company Private (#84)

In this podcast episode, we discuss the mechanics of taking a company private. Key points made are noted below.

When to Go Private

Sometimes, a public company finds that the cost of being public outweighs its benefits.  There’re a couple of situations where this is the case: First, trading volume is so low that investors can’t easily buy or sell shares, so they don’t care if the company goes private.

The second scenario is when the company can’t raise money by selling its stock to investors.  This usually happens when the stock price is so low that the company would have to issue an awful lot of stock in order to raise any kind of serious money.

In these cases, management starts to look at the cost of being public, which I’ve seen reported as low as $50,000, but is generally closer to $1/2 million.  Now keep in mind that this expense range applies to really small public companies, which are the ones most likely to go private.  Larger firms can more easily raise money and have decent trading volumes, so they won’t go private.

Methods for Going Private

So, management looks at the costs and benefits, and decides to go private.  There are two ways to do this.  The first is going straight to a Form 15 filing.  This is an incredibly simple one-page form.  You file it, and you’re done.  Technically, you’re supposed to keep up your filing obligations with the SEC for another 90 days, but most companies stop reporting right away.  This sounds easy, and it is, except for one thing.  You must have less than 300 investors of record when you file the Form 15.  If you have more than 300 investors, then you cannot go private.  There is a variation that increases the 300-shareholder limit to 500 shareholders, but it’s going to be 300 for most everyone.

Here’s the problem with that first option – it assumes that you’ve done no stock buybacks in order to go under the 300 shareholder limit.  In other words, the company doesn’t have many investors to begin with, so it files a Form 15 and it goes private.

So, what if you have more than 300 investors, and you want to go private?

This brings us to option two, and it gets a bit more complicated.  It requires filing a Schedule 13e-3.  In this Schedule, you explain to the SEC how you plan to reduce the number of shareholders.  There’re two main methods for doing this.  The first is a reverse stock split.  In this case, the company is trying to eliminate its small shareholders.  So, for example, let’s say that you have a large number of small-lot shareholders, which are those shareholders having 100 shares or less.  If you did a 101 to 1 reverse stock split, then everyone having 100 shares or less would end up with a fractional share, which the company then pays for in cash.  This flushes out all of the small-lot shareholders, which in most cases leaves you with far fewer shareholders. Also, the total amount of cash paid out for these shares is typically very small, so it’s a good option.

The other way to reduce shareholders is to conduct a general solicitation to buy back shares, which is typically targeted at all shareholders – which makes it a fair site more expensive.

Both scenarios require a shareholder vote, so you have to create a preliminary proxy statement that gets filed along with the Schedule 13e-3.  The SEC has 10 days to comment on the proxy, after which you can proceed with the vote.  You should figure on taking about two months to conduct the vote, because you’re required to give brokers 20 days notice to figure out how many of your shares they’re holding on behalf of their clients, plus another month for the voting period.

Assuming the shareholders vote in favor of either option, you can then reduce the number of shareholders, and then file a Form 15 to officially go private.

So, in short, you have to file a Form 15 no matter what – it’s just that you also need to file a Schedule 13e-3 beforehand if you’re also taking steps to reduce the number of shareholders first.

Other Issues with Going Private

But there are some other issues to be aware of.  First, I mentioned earlier that there have to be less than 300 shareholders of record.  This is really important, because if your shareholders have placed their shares with a broker, then the broker counts as just one shareholder, even if it’s holding the shares of dozens of shareholders.  This means that you don’t necessarily have to buy back shares.

An alternative is just to encourage your shareholders to take their stock certificates out of their safes and give them to a broker.

But, unfortunately, that also brings us to the second issue, which is the broker kick-out.  When a broker finds out that the company has gone private, it has the option to send any stock certificates that it’s been holding back to the shareholders.  This means that each shareholder that was with a broker now counts as a shareholder of record.  And if too many broker kick-outs occur, you may very well find yourself back over 300 shareholders.  And if that happens, then you need to start reporting to the SEC again.

The Risk of Shareholder Lawsuits

Now, before you think this is a relatively mechanical process, there is a risk of shareholder lawsuits.  If a company goes private, it becomes much more difficult for them to dispose of their shares.  If you want to reduce the risk of the company losing these lawsuits, it really helps to create a special committee of the board that evaluates the going private decision.  This committee should be comprised entirely of independent directors, so that means the CEO is not invited.  Also, the committee should document its investigation extensively, with things like a compilation of the cost of being public, and maybe even hiring a third party to review their numbers.  And in addition, the committee should document how going private is good for the unaffiliated shareholders.  This means that a shareholder who is not a director or officer or large shareholder will be better off if the company goes private than if it continues with its SEC reporting.

Parting Thoughts

And finally, going private makes it very difficult to issue shares to employees as compensation.  If you do that, the shares won’t be registered, so the employees can’t sell any shares to pay for the income taxes on the shares.  And yes, even if you’ve already issued an S-8 registration statement, where shares issued to employees are automatically registered, this is no longer valid as soon as the company goes private.

There’s also an issue of terminology.  What I’ve been talking about is sometimes called going private, and sometimes called going dark. Going private is reducing the number shareholders so that you’re in a position to stop your SEC filings, which is essentially what the 13e-3 is all about.  Going dark is the Form 15 filing, where you essentially flip a switch and turn out the lights on your public filing obligation.

In short, going dark makes a lot of sense for smaller public companies, since the resulting cost reduction can be quite remarkable.  But there are some downsides, so the board needs to very carefully consider the ramifications of doing so, and document its discussion in detail.

Related Courses

Investor Relations Guidebook

Public Company Accounting and Finance

Accounting from Home (#83)

In this podcast episode, we discuss how to have your accounting staff work from home. Key points made are noted below.

Reasons to Work from Home

In my company, we have a number of locations, and the corporate staff mostly houses out of the office of one of the subsidiaries.  About six months ago, we physically merged that subsidiary with another one, and then subleased the space. This left the corporate staff with nowhere to go. So, we decided to try working from home.  This is not a common event for a public company, which usually has a bunch of extra accounting staff.  I’ve let a half a year go by before reporting on the outcome, just to accumulate a list of everything that’s both good and bad about it.

How to Make it Work

First, the logistics:  We set up an expense allowance of $2,000 for everyone who was going to work from home.  This may sound like a fair amount of money, but I really didn’t want anyone working from their kitchen table.  I also encouraged people to set up shop in a dedicated room, though that’s not always possible.

Also, everyone has a scanner.  The multifunction ones work surprisingly well.  I didn’t think that would be the case, so I bought a separate scanner and printer.  But, in something of a surprise, the HP ScanJet N6010 that I bought, which is a vertical sheet feeder, really doesn’t work that well – it pulls through multiple pages at the same time.  For reliable scanning, you need a horizontal sheet feed, which hardly ever jams pages together. For that, I use a Canon multifunction printer, copier, and scanner.  It’s very inexpensive and it never jams.  Just an excellent device.

The scanners have turned out to be critical.  We store everything on a central server, so all incoming mail is scanned and stored centrally in the accounting server.  This also means that we don’t store much paperwork at our homes at all.

And speaking of server storage, we’re all linked through a virtual private network to the company’s accounting software, which is stored in an offsite server farm that’s run by a third party.  The VPN is extremely useful for the assistant controller who deals with accounting transactions, so she pretty much logs in and stays there all day. 

Those of us who don’t need continual access to the accounting software don’t log in as much, since it can be difficult to print locally from the VPN.

We also have a check scanner, so that we can deposit checks on line.  This is now located at one person’s house, and works just fine through their home network.

There’s also the issue of paper storage.  Even though most everything is electronic, there are still some documents.  What we did for this was to rent indoor storage space at a local public storage facility.  We located it fairly close to the homes of those people most likely to use it.  Stopping by about once every two weeks seems to be typical.  And this is a very inexpensive solution.

Now, what about mail deliveries.  We didn’t want company materials being delivered to anyone’s house, so instead we rented a mail box at a local United Parcel Service store.  The nice thing about this setup is that they also sign for any overnight deliveries that come in.  And they even call me when there’s a delivery.  This gives us a street address for deliveries, which we’ve also put on our business cards, letterhead, and envelopes.  And again, we’ve centrally located the mailbox, so that several people have ready access to it.

The main question I get from people is whether we miss the daily interaction.  In short, kind of.  It’s very easy to hide in your own personal cave, though it’s great for an introvert.  What we do is a weekly lunch at a deli for those of us who live close enough.  Also, we have a monthly lunch for everyone in the area that’s next to one of our local subsidiaries.  On top of that, I’ve issued a Blackberry to everyone who’s OK with becoming addicted to one – which is nearly everyone.  I also recommend that people install a second phone line in their homes, so they get better reception than on their Blackberries.  The reason is that some of us work in our basements – I do – and cell phone reception just isn’t as good down there.

So, with the lunches and phones, I think we do OK.  And because of the Blackberries, we’re much more likely to stay in touch way outside of normal working hours.

We’ve also have some discussion about introducing webcams.  Those were very short discussions, because of the next item, which is the dress code.  Obviously, there isn’t one.

Nearly everyone wears jeans and T-shirts, and one person prefers a bathrobe.  OK, we don’t need to see that, so webcams are not going to happen.

The dress code also brings up the issue of employee savings from working at home.  First, the cost of dry cleaning absolutely vanishes.  Also, there’s no commuting cost.  Also, there are no snow days.  If the weather is bad, you don’t even notice.  Also, as one person pointed out to me recently, she was sick, but was not only still working, but also presented no risk of infecting anyone else.

Working at home also played a large role in a recent hire.  I needed a part time person to work on our SEC filings, so I specifically looked for someone with an SEC background, who was also a stay at home parent.  The job was virtually perfect for her, and now I have very good expertise available whenever I need it.

Now, we still have people in other parts of the company who still work in offices.  How does this impact them?  Obviously, if there’s a meeting, we go to their office.  We do not have meetings at anyone’s house.  When there’s an annual audit or a quarterly review, the auditors go to the nearest subsidiary, and we go there for meetings when they need us.

And there’s also the issue of people goofing off at home – or at least that’s what someone might say who’s dubious about the idea.  The reverse is the case.  People tend to work longer hours from home.  I very frequently get e-mails from people who’re working way past their normal quitting times.  Also, it gives people more freedom to shift their work hours around.  One person likes to go to the gym at 4 pm, and then comes home and works some more.  But, keep in mind that these are all senior people who know what they have to do, and who require very little supervision.

As for very junior people, I really don’t know if it would work.  They need more hands on training, so maybe you start them in an office until they’re fully trained, and then give them the option to work from home.

We’re not encouraging work from home throughout the company, but there is a trickle of activity in that direction.  Our corporate counsel and VP of human resources just switched to working from home, and I’ve also received an inquiry from our CEO on the same topic.

Related Courses

Lean Accounting Guidebook

Accounts Payable Matching (#82)

In this podcast episode, we discuss the many variations on accounts payable matching, and the situations in which they should be used. Key points made are noted below.

What is Accounts Payable Matching?

Matching is the process of comparing an approved supplier invoice to the original purchase order, to make sure that the price being charged is the same as the one that the company originally agreed to.  And, on top of that, matching also involves comparing the billed quantity to the amount the receiving staff says actually arrived at the receiving dock.

This is by far the most time consuming part of accounts payable, because there are a multitude of errors in the matching process that have to be reconciled before you can pay the supplier.  If you handle matching too carefully, then it takes a lot of staff time and delays payments to suppliers; but if you don’t do matching, then there’s a risk of paying for something that’s either overpriced or wasn’t fully received.  So, what’s the best way to handle matching?

When Not to Do Matching

Well, there are quite a few ways.  We’ll start with the simplest  approach, which is no matching at all.  This is not appropriate for a company that receives a lot of inventory, but it may work very well for a services business that only receives office supplies.  In this later case, even if the company is being grossly overcharged and received quantities are seriously off, it’s still pretty hard to lose much money.

Use Two-Way Matching

The next step up from there is to match received quantities to the supplier invoice, or the company’s purchase order to the supplier invoice, but not both.  This may work if you’ve had problems in one area, but not the other.  So essentially, you’re saying that there’s a certain level of mistrust of your suppliers’ ability to either ship the right goods or to bill the right price.

Allow Larger Variances

The next step up from there is to allow some pretty large variances in the matching process.  For example, prices or quantities can be off by five percent before you’ll bother to make an adjustment to the supplier’s invoice.  This works if the total amount of purchased goods is low, so your total potential variance is also low.  However, if a supplier figures out that the company uses this variance, then there’s a chance that the billed amounts will always be too high, so watch out for that.

So far, these have all been manual processes.  Now we get into more computerized solutions.

Use Automated Matching

First up is completely automated matching, which is nowhere near as perfect a solution as it sounds.  Under this method, the company installs some pretty high-end accounting software that does the matching for you.  This means that the purchasing department has to enter all purchase orders into the computer system, and has to do so line by line, so that the receipts can be matched against individual line items. 

Next, the receiving department has to have computer access, so that they can call up the purchase order and check off items as they’re received.  So, this shifts the quantity matching process from accounting over to the receiving dock.  And finally, the accounting staff has to enter each individual line of every supplier invoice into the computer.  The software then automatically matches everything up, and returns a list of items that don’t match, which the accounting staff has to reconcile.

While this may sound neat, the bit about entering every single line in every supplier invoice can be pretty aggravating.  Nonetheless, this is about as far as many of the larger companies have taken the matching concept.

And before I go to the next step, keep in mind that you can also implement just part of that last solution.  This usually means having the receiving staff check off items in the computer as they come in, which is a good way to at least ensure that the quantities are correct.  As for price matching, it’s possible to just audit those numbers from time to time, and then investigate those suppliers in detail who have pricing errors.

Use Evaluated Receipts

And that brings us to the niftiest of all the matching alternatives, which is called evaluated receipts.  Under this system, the company has suppliers deliver goods directly to its own production process, with no receiving people around to examine the goods.  Everything is immediately incorporated into the company’s products, so the assumption is that if something was produced, then the goods must have been delivered.

Then the accounting software uses the bill of materials to calculate how much of the supplier’s product must have been used, multiplies it by the unit price listed in the purchase order, and sends a payment to the supplier.  There is no supplier invoice at all.  In fact, there’s really not much of anything for the accounting staff to do.

This is really cool.  But, it only works if the setup is exactly right.  First, you have to pre-certify every supplier in the program, so that you can trust them to deliver the right products at the right time, and in the right quantity.  Second, only one supplier can supply each part.  Otherwise, its really hard to figure out who to pay.  Third, the bills of material have to be totally accurate.  If they’re not, then suppliers won’t be paid for the correct quantity of delivered parts. 

A fourth issue is that suppliers should be located nearby.  If they’re distant, then the company is more likely to order in bulk, and this type of system works best with small quantities that are delivered continuously.  And finally, there needs to be a system for paying suppliers for parts that are scrapped during the production process.

So, clearly, evaluated receipts only works in a sophisticated production environment.  And also, because this requires close coordination with suppliers, the company probably needs to be a fairly large one.  A smaller company that can’t offer much volume to its suppliers isn’t going to be able to attract enough supplier interest to make this work.

And finally, you need to buy the accounting software for it.  Evaluated receipts is not a common accounting module, so be prepared to install something in the price range of either Oracle or SAP software.

But if you are big enough, and can afford the software, and you have enough purchasing volume to warrant it, then evaluate receipts is a good solution.

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Accounts Payable Best Practices (#81)

In this podcast episode, we discuss several ways to improve the payables function. Key points made are noted below.

I think a lot of accounting people would agree with me, that payables is the most incredibly paperwork intensive and generally annoying part of accounting.  The accounting staff is forwarded supplier invoices from all over the company, and then it has to figure out which ones are authorized, and if the related goods or services were received – and then pay it on time.  If they don’t, then suppliers get ticked off and call in to demand payment.  It’s not a very pleasant job.

Shrink the Invoice Volume

So… let’s see what we do to streamline it.  The first order of business is to shrink the overall volume of supplier invoices.  A really good way to do this by issuing company credit cards to employees.  This gets rid of a lot of the smaller transactions that would otherwise eat up all kinds of accounting time.  This doesn’t take long, so you can start seeing the results in just a few months.

A much slower way to reduce the number of invoices is to reduce the number of suppliers.  This requires a lot of work with the purchasing staff to arrive at a short list of approved suppliers.  Over several years, you can achieve a smaller number of invoices that have more line items on them; but it’s still an improvement.

And there’s another way of looking at invoice reduction.  Is it the total number of invoices you’re trying to reduce, or is it the data entry of the invoices into your accounting system?  Because if it’s the second one, you can set up a web site and have your suppliers enter their invoices through that portal.  By doing so, you just shifted the data entry burden onto them.  If you’re a large company, with some power over your suppliers, then this works.  If you’re a small company, don’t even bother.  Your suppliers will ignore it.

Streamline the Invoice Approval Process

Another problem is the invoice approval process.  The standard drill is to send every invoice out to the department managers for approval.  If the manager never gets around to approving the invoice, then it doesn’t get paid, and everyone blames accounting.

The solution is called negative approval, where you enter the invoice into the accounting system, and send a copy of the invoice to the manager who should approve it, with a note stating that you will pay it unless you hear otherwise.  If the manager is fine with the invoice, which the case pretty much all of the time, then he throws out the invoice copy, and everyone’s happy.

Except for the internal controls auditor.  The auditor wants to see that there’s clear evidence of approval for every invoice, so you can end up in a tug of war between greater efficiency, and proper documentation of controls.

Eliminate Manual Payment Processing

Another good area for improvement is manual processing of payments.  This means there is no petty cash.  Ever.  It’s not only a waste of time, but there is always cash box pilfering.  If anyone complains, tell them about the company’s corporate credit card program.

Another item is cash advances.  Don’t do it.  It takes time to create the payment, and then you have to track the employee’s payback through the payroll system.  Since the employee who wants this special treatment is essentially treating the company like their private bank, go send them to the real bank down on the street corner, and get a loan.  If a department manager complains that his staff absolutely must have a loan to get through some business travel, then – again – tell them about the company’s corporate credit card program.  These types of manual activities take up a surprising amount of time, which is why it’s important to break the company of the habit of using them.

Minimize Expense Report Analysis

And then we have expense reports.  Some payables departments review these things to death.  Yes, I agree, there are cases of expense report fraud.  But.  It takes a lot of time to track them all down, and the cost-benefit on this is not good.  Instead, do a periodic audit of expense reports, and when you find something suspicious, then flag that person for permanent reviews, and go back and check their old reports.  This is way more efficient.

Enhance the Payment Process

And what about payments.  I really don’t like paying by check.  In fact, I really really don’t like paying by check.  This is partially because I’m an authorized check signer right now, and signing checks is a monumental waste of my time.  Sure, it’s supposed to be a control point, where you carefully review every check – but let’s be realistic here.

Any payment problems should have been spotted much earlier in the procurement process, so even if you find something, the company is probably obligated to pay it anyways.  And also, check signers are really bad reviewers.

If you want to learn about payables controls, then go back to episode 13.  For now, let’s just say that payment should be by the most efficient means possible, and that means electronic payment.  You can set up ACH payments through a lot of accounting systems, and certainly through your bank’s web site.  If you do this, there’s no more check stock to track, no check signing or mailing, no stop payments, no positive pay notifications – it all goes away.

Improve Document Retrievals

Another problem is document retrieval.  If someone wants to research a payment at some point in the future, they have to go to storage, get the invoice, and put it back.  Not only is this time consuming, but it’s quite possible that they’ll mis-file the document when they put it back.  A really good work around is to scan all invoices when they come in, and then attach the digital copy to the invoice record in the accounting system.  That way, there’s no more travel time to storage, and you’ll never lose a document again.

Ensure that W-9 Forms are Received

And then we have the W-9 form.  For listeners outside of the United States, you can tune out on this one.  Within the U.S., we have this annoying W-9 form that all suppliers are supposed to fill out; I won’t bother with the details of why it has to be done, but the basic problem is getting them to return the form.  A lot of companies ignore it until the end of the year, and then they go into crisis mode to track everyone down and beg for a form.  There’s a much easier way to do this, and it’s 100 percent effective.  You simply do not pay the customer the first time around until they submit a W-9.  This requires a little extra work up front, but it saves way more time than the initial cost.

Track Metrics

What about metrics, to see how the payables function is operating?  One option is to create a report that shows all invoices that were paid after the required payment date.  This is brings up a lot of process flow problems that you can fix.  Another good metric is the proportion of invoices paid that are under $100, or some other fairly low target figure.  If your corporate purchasing card program is working right, this should be a small proportion of total payments, and that represents good processing efficiency.  And finally, track the proportion of electronic payments to total payments.

If you follow just these three metrics, then you have the tools to track down mistakes, and to gradually shut down both small payments, and check payments.

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Acquisition Due Diligence (#80)

In this podcast episode, we discuss some of the key items to look for when conducting due diligence on a target company. Key points made are noted below.

Why We Need Due Diligence

Due diligence is the investigation of a target company by the buying company.  This is a seriously detailed review of the target’s operations and financial results.  A novice buyer won’t spend much time on it; but experienced buyers will have seen so many problems over the years that could have been avoided with proper due diligence that they insist on it.

So for an experienced buyer, the objective is to use due diligence to uncover every possible reason why the acquisition will not work.  You want to know all about these issues in advance, so you can think about whether you can overcome them or not.  If not, then walk away.

I’m not going to discuss every possible due diligence question – for that, go to accountingtools.com, click on the Resources button, and you’ll see a due diligence checklist that’s about six pages long.  Feel free to copy it.

What I AM going to do is spotlight some of the key areas where I’ve seen problems in the past – which, by the way, is somewhere around 100 reviews.

Review the Financial Statements

We’ll start with the financial statements, but keep in mind that this is only a piece of the review.  If you just look at the numbers, you’ll miss a great deal.  So, first – the question is, what is not there?  Quite a few companies have an annoying habit of only charging certain expenses at the end of the year, like depreciation and bonuses – so if they give you financials for almost the entire year, then see if these items are included.  If you need to guess at what these extra expenses might be for partial year results, and then go back to their last full-year results and see what expenses they recorded then.

Next, look at the trend of fixed assets over the past five years.  If it’s trending up fast, then you can expect to see that they’re capitalizing expenses.  It might even be legitimate, like for software development expenses, but you need to factor it into the company’s real year-to-year cash flow.  About 2/3 of the software companies I’ve reviewed were capitalizing so much development cost that they looked really profitable, but they were actually close to bankruptcy.

Next, look at the margins.  I look at net margins, not gross margins, because people can fudge the gross margin by shifting expenses out of it.  There needs to be a consistent net margin over several years.  Otherwise, if margins are small and getting smaller, you have to wonder how the acquisition will pay off for the buyer.

Review the Management Team

Next up, and frequently more important, is a review of the management team.  You have to travel to the target company’s location to do this, so you can see these people in their own setting, and see how their own employees react to them.  There are lots of clues to pick up about people, and it requires a lot of face time.

So, what am I looking for?  In all cases, we leave the management team in place, so we have to be able to work with them, probably for years.  So, the most critical issue is to avoid the command-and-control types.  This is someone who is at the center of everything, and who has to make every decision.  These people never ever fit into a larger organization.  When I see a company president like that, I cut short the due diligence, and head for home.

So, how can you spot these people?  One surefire indicator is when they have to be in the room with you during the entire visit; they don’t trust a subordinate to answer questions.  Another method is to ask subordinates what kinds of decisions they have to defer to the boss.

In one case, I spotted it by reviewing their policies and procedures manual.  For every procedure, absolutely everything required the approval of the president.

Now, due diligence discussions can be pretty broad ranging, so I like to drop hints about what it would be like for them to be part of a larger company, just to get a rise out of them.  For example, if I mention that the entire company operates on a single medical plan, or a single pension plan, the point is to see if they’ll complain that their plans are better, and that their employees will suffer under our plans.  I don’t really care about the differences between the plans – I’m trying to learn about their ability to fit in.

Review the Products

After the financials and the people, I look at the products.

If they’re a service organization, then I’ll deconstruct profits right down to the billable percentage and billing rate of each employee or department, so I can figure out exactly where the profits are.

If it’s a product company, then I absolutely want to know if they’re a one-hit wonder that still squeezing cash from the original product, or if they’re actually good at cranking out new products.  You can see part of this by reviewing a time line of when they’ve released new products, but what I really like to see is revenue by product for the last three years.  What I frequently see is that the old mainstay product still hogs the revenue, while the company is piddling away its cash on unprofitable new products.

Review Bottlenecks

And then there’s the bottleneck analysis.  A lot of the time, this means that most of the sales are coming from just a few maxed-out salespeople.  Other times, it’s a machinery constraint, but – usually, it’s people that are keeping the target from growing.

The Sequence of Activities

What is my due diligence sequence?  The financial piece is first, because it’s my initial gate.  If a target is blatantly unprofitable, then the due diligence is over, and I won’t waste any more time.  If things look good on paper, then I schedule a trip, with the intent of spending as much time meeting as many people as possible.  If things still look good – and keep in mind that we’re now down to just a fraction of the initial group – then I go back for a second trip, with more people, and we really dig in. In other words, this is a multi-layered progression.  We don’t want to put too much effort into it, so we build in a number of decision points to see if we should walk away.

Completing the Analysis

So, what is the result of a due diligence review?  Well, in my case, I go in assuming that I’ll find something critical that will make the acquisition fail.  And that’s totally acceptable.  I’d much rather find that out during a fairly inexpensive due diligence review, than afterwards, when we’ve already spent a few million dollars on the deal.

The final due diligence step is to document everything in a report.  This is intended to be a summary of the target company, and its financial and operational results, but I spend the most time specifying the main problems, and whether I think we can fix them.

And last of all, I put in a recommendation.  I leave no room for interpretation by the reader, because if it’s a bad situation, I want them to know.

Oh, and finally – the oddest thing I’ve ever seen in a due diligence is a software company that invested in – graveyards.  The president’s spouse wanted to invest in graveyards, so how could the president possibly say no to that?

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Analyst Relations (#79)

In this podcast episode, we discuss how analysts operate and how to deal with them. Key points made are noted below.

What the Analyst Does

The analyst investigates a public company, and creates an analysis of where he thinks the company’s stock price will go.  He normally adds a buy, sell, or hold recommendation to the analysis, and then issues it to his client list.  The clients are paying for this advice, so they want to see some good insights into each company being reviewed.  If there isn’t, then they stop paying for the analyst.  Alternatively, the analyst may work for a brokerage firm, in which case the brokerage will probably dump the analyst if there’s a string of bad calls. So, the analyst is on the hot seat.  This is not a easy job, because it requires a great deal of industry specialization, and excellent contacts within that chosen industry, and good analysis skills on top of that.

Why a Company Needs Coverage

So why does a company need analyst coverage?  Several reasons.  First, if a well-known analyst chooses to cover you, then that’s a mark of prestige for the company.  Also, an analyst can bring a large following of investors, which provides more liquidity for the company’s stock.  And finally, an experienced analyst has lots of contacts, and can direct company management to people who can help them raise funds or place large blocks of stock.  So, it makes a great deal of sense from a company’s perspective to have a strong analyst following.

The Lack of Analysts

The problem is that there aren’t so many analysts around any more.  Whenever there’s a market downturn, large brokerage houses reduce the number of analysts that they keep on staff.  Also, an independent analyst can’t survive very well in a down market, because clients won’t pay his fees when all stock prices are heading downhill.  For these reasons, the analyst population declined over the past decade, and I don’t see it increasing any time soon.

So, how does this impact a public company?  Well, the main impact has been on small and micro cap companies, which have lost all kinds of analyst coverage.

The reason is that a lot of analysts work for large brokerage firms, and each analyst recommendation has to generate the largest possible commission volume for the brokerage house in order to justify the cost of the analyst.  So, if an analyst spends a lot of time creating a great research report on a company with almost no trading volume, then it’s a wasted effort.

How to Obtain Analyst Coverage

This doesn’t mean that it’s impossible for a small cap firm to obtain analyst coverage.  But they need to avoid the larger brokerage firms and target small boutique brokerages and independent analysts, who have a lower cost structure, or perhaps who specialize in the company’s industry.

Your best bet for finding an analyst is to see who is covering competing companies that have a similar market cap.  That type of analyst has already invested a lot of time in learning your industry, so they don’t need to put in a lot of work to provide coverage for your company, too.

How to Maintain Good Analyst Relations

So, what about the care and feeding of an analyst?  If an analyst agrees to provide coverage, then what do you do?  First of all, if you’re not providing guidance, then start doing so, because the analyst needs some foundation information from which to build his recommendations.  If you’re comfortable with it, then also provide investor conference calls, so the analyst can ask more clarification questions.

Second, and this is critical, always provide conservative guidance.  If you issue some really high-end earnings estimates and then can’t make the numbers, the analyst has probably already issued a buy recommendation based on your guidance, and now looks like a fool.  Analysts really don’t like that.

Third, they like to meet directly with management, which is acceptable.  However, you cannot reveal any material information to an analyst that you haven’t already issued to the investing public.  To make sure that you don’t, it makes sense to have the investor relations officer sit in on these meetings and make note of any “indiscretions,” so that the company can file an 8K report to the SEC right away.

So, if you can’t reveal anything new to an analyst, why is a management meeting still important?  Well, the analyst can legitimately pick up a great deal of information from a company visit.

This can include figuring out if the parking lot is full, if there’s too much inventory in stock, and even just getting a feel for how competent the management team appears to be.  On top of that, it’s quite all right to discuss your view of the industry as a whole, and other competitors, and general operating conditions, which allows the analyst to build a piecemeal view of the company and its environment.  This is called the mosaic approach to building a recommendation.

One thing that a good analyst will absolutely pick up on is any weakness in a manager’s knowledge about the company or industry, so make sure that you have a pre-determined answer to the standard questions, like who are the main competitors, and their strengths and weaknesses, and what is the market size, and market growth rate.  One item that analysts love to address is the various risks that the company is subject to, so know what they are, and be prepared to talk about how the company deals with them.

Also, any time you update the corporate fact sheet, or fact book, or issue a press release or an 8K, always send them a copy.  This gives them the best and most up-to-date information, and they really appreciate it.

After the analyst has completed an investigation of the company, he may send an advance draft of his analysis and recommendation to the company.  I think it’s a good idea to note any incorrect information in the report, so that errors don’t start circulating through the investment community.  However, there’s a risk that the company could be seen to have participated in writing the entire report, so it helps to keep the original and corrected versions, so the company can prove in court that it did not write the report.  And under no circumstances should you comment on the analyst’s conclusions or recommendation, because that implies that you are taking ownership of the report.

If an analyst report turns out to be highly favorable, do not under any circumstances publish it on the company web site. The reason is that it gives the appearance of endorsing the report.  Also, what happens if the same analyst then issues a negative report?  Would you post that, too?  Of course not.  Instead, just list on the web site the name and contact information for the analyst.

Also, don’t expect too much from an analyst.

A “strong buy” recommendation only lasts as long as the company’s stock price is below the analyst’s target price.  At some point, the analyst may very well post a “sell” recommendation, though most of the time they waffle with terms like “moderate buy” or “long-term buy” in order not to piss off management.  They realize that those management meetings can be cut off at any time, so the standard drill is to simply back off their strongest buy recommendations.  If they do this, it’s OK.  Eventually, the stock price will drop to the point where they can issue a “Strong Buy” recommendation again.

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