Corporate Finance for Smes

8/6/2019 Corporate Finance for Smes

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Corporate Finance for SMEsby Terry Carroll

Executive Summary Corporate finance has evolved over many years to become a sophisticated specialism, for which the

fees may be substantial. The principles are the same for SMEs (small and medium enterprises) as for any larger company. Often transaction-led, it is recommended that a wider full balance sheet approach be adopted because

of the strategic financial significance. SMEs often originate as owner/proprietor businesses, and this structure can often trigger transactions

such as change of ownership or disposal for tax purposes. By applying the same basic principles, there is no reason why similar sophistication should not be

available to SMEs at affordable rates. Working capital is a fundamental need in a recession. In order to survive, SMEs should strategically

review and simplify the business, exploring all available sources of capital.

Introduction

The term corporate finance is widely, and sometimes loosely, used in business. In accounting firms ittypically relates to a department or function that primarily deals with:

mergers, acquisitions, and disposals (M&A); raising finance (early stage through to mature businesses); flotations; management buyouts and buy-ins; business valuations; due diligence; succession planning and exit strategies.

These might represent the practical application of corporate finance. In theory, however, its primary roleis to maximize the value of the business while minimizing the financial risks. The essence of the presentarticle is that the practice of corporate finance has become oversimplifiedpotentially to the detriment of thebusiness.

Furthermore, while corporate finance is usually a specialized department in larger accounting firms andin some smaller ones, its application in SMEs can often be quite different. Here, accessing and managingsources of working capital becomes a fundamental need, especially in a recession.

We shall propose a wider approach to corporate finance, based on asset/liability management principlesand the full balance sheet approach, that is just as applicable to SMEs as it is to larger, more sophisticatedcompanies.

A Full Balance Sheet Approach

A full balance sheet approach is recommended as the underlying principle of applying corporate finance.This involves looking at each and every asset in the context of the liabilities that actually or notionally financethem. Two key measures are:

The amount by which the profit would increase or decrease as the overall result of a 1% change ininterest rates.

The difference between the average duration (i.e. asset life weighted by value) of the assets andthe average duration of the liabilities that fund them. The importance of this is that, if the duration ofthe liabilities is shorter than that of the assets and, for example, interest rates rise, there will be anadditional cost to the profit and loss account that cannot be recovered by the assets.
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A More Sophisticated Approach to Corporate Finance for SMEs

SMEs are often started and/or owned by owner/entrepreneurs. Corporate finance transactions may beprecipitated by owners, their bankers, accountants, or lawyers, or by approaches from elsewhere. Forexample, two sets of circumstances have recently led to a flurry of transactions:

1. The British Government changed the capital gains tax (CGT) arrangements for businesses from April6, 2008, ending taper relief. One result was that, leading up to this date, accounting and law firmswere deluged by a spate of entrepreneurs seeking advice on financial restructuring or sale of theirbusinesses to children, managers, and other interested parties so as to minimize CGT.

2. A growing number of owner/entrepreneurs are approaching retirement age and want to pass theirbusinesses on to their children or managers.

Both of these typical situations create the need for advice and support on corporate finance, funding, and taxand legal advice.

The transactions referred to in points 1 and 2 are circumstantial. Other typical examples are refinancing thebusiness, management buyouts and buy-ins, and M&A. These are routine corporate finance transactions,but if we return to the theory and apply it there are many more sophisticated possibilities which can be more

appropriately driven by business or financial strategy, rather than circumstance. One of the less obvioustimes to consider these is during a recession or economic slowdown.

Business in Three Boxes

Entrepreneurs who have started their own business often end up trying to juggle all of what are known as thethree boxes, though such a simplified approach is entirely appropriate in a recession. The three boxes are:

business development, which includes both sales and marketing and the development of the businessitself, whether organically or by acquisition;

operations, including delivery; finance and administration.

It has been possible to outsource the last of these for at least 20 years. Not every business can afford orjustify the appointment of a full-time finance director, but even that function can be contracted out these daysat an economic costcreating the virtual F.D.. By doing so, the entrepreneur is able to focus on thoseaspects where his or her skills and experience are usually best appliedin the first two boxes. These shouldgo hand in glove, as together they represent the end to end customer-focused processes.

Recession, Review, and the Application of Corporate Finance

A recession or similar downturn is absolutely the time to do a root and branch review, lift the drains,and spring-clean the business. Why? Two reasons: First, because you have more time to do it during arecession; and second, because having done so, you will emerge lean and mean when the economic cycle

turns favorable once more.

So often, corporate finance is transaction-led. Most accountants routinely offer the corporate financeservices listed at the top of this article, but (and not just in the application of theory) there are many moreopportunities, both holistically and in detail, to add measurable and lasting value to the businessand betterunderstand itif a corporate finance transaction starts with strategy and a thorough business review.

Business and Financial Reviews

Any accountancy firm worth its salt can do a financial review of sorts. This would probably focus on the profitand loss account, or tax, and how you can thereby save money. But the central focus of corporate finance ismuch more on the balance sheet. For example, an acquisition needs financing, either by debt or equity, or by

both. Both need to be seen in the context of and integrated into the existing financial structure of the balancesheet.
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A thorough financial review should ideally begin with a thorough businessreview. Every financial transactionis the consequence of a business decision. The business review starts with a review of strategyespeciallythe marketing strategy. It can go all the way through to the business processes and the systems that supportthem.

Its rather too simplistic to think that corporate finance transactions result solely from a need such as raisingmore working capital, financing capital expenditure, saving tax, selling or passing the business on, etc. Evenif these are the circumstances that trigger a corporate finance transaction, each transaction should still bepreceded by a thorough business and balance sheet review to see how it fits into the whole and ensure thatthe overall goal of maximizing the return on the balance sheet at a managed level of riskcan be achieved.

Corporate Finance in a Credit Crunch

Credit shortages and squeezes are not unusual; they typically follow a credit bubble, where credit hasgrown so fast that it necessitates an economic readjustment. More importantly, the recent credit crunchhas actually been a liquidity shortage. Funds have been scarce and the cost of borrowing has gone higherbecause the banks could not raise sufficient, or even any, longer-term funds to lend to business.

The smaller the enterprise, the harder it is to raise sufficient funds and the higher the likely cost. Its hardenough that the economic slowdown has squeezed financial performance. Being unable to find additionalfunds readily when they are most needed can all too often lead to business failure. Its not lack of capital butlack of cash that busts businesses. So creativity in corporate finance becomes even more important.

So What Can SMEs Do?

Few SMEs have the opportunity to float via either an Alternative Investment Market (AIM) or full listing on theLondon Stock Exchange. Furthermore, the new issues market is unlikely to return to anywhere near normalbefore 2010. Most corporate finance transactions for SMEs involve rather less finance than might be raisedthrough an IPO (initial public offering, or flotation).

One factor that unites all SMEs is the need to find and manage working capital. Many are wedded to theidea of unsecured debtusually an overdraft. Some will even resort to moving banks just to get a biggerunsecured overdraft facility.

This may not be the most efficient or, especially, the cheapest means, however. The credit crunch producedsome fundamental changes in the commercial and corporate banking markets (many UK bankers referto finance for companies with turnovers of up to $1.5 million as commercial and above that level ascorporate; there is no real difference in principle). First, it accelerated the transition from overdraft financeto invoice discounting. One of the key reasons for this was because in most cases banks wanted security forthe debt.

This security can take many forms. The most common is assetsproperty, machinery, other capital assets,cash, stock, receivables, etc. The practice of taking unsecured personal guarantees has decreased, but

banks may routinely ask for a statement of personal assets and liabilities. Ideally, they prefer to take acharge on personal assets, such as the owners or directors house.

Parallel with these changes has been the move away from base rate related finance. At the worst of thecredit crunch, Libor (the London Interbank Offered Rate, i.e. the rate at which banks lend each other money)diverged by up to 1.6% from base rate (usually equal to the Bank of England Base Rate as reviewed and setby the FOMC monthly), so banks preferred to use Libor as the basis for their lending rates. It also allowedthem to blur the edges from one bank to another, as opposed to the common metric of the base rate.

So unsecured overdrafts became relatively dearer (up to 5% or more above base rate) and invoicediscounting relatively cheaper (as low as 1.2% over base rate, although it rose as high as 2% above as Libordiverged).
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The Cheapest Form of Working Capital

The cheapest form is that generated by the business itself, i.e. from sales. It is amazing how many SMEsapproach their advisers or bankers seeking to borrow more money for working capital purposes when theycould devote more time to selling and less to administration. This is the principle of working inthe business

rather than onthe business. Sir Alan Sugar, the British entrepreneur and businessman, is not alone inreferring to the concept of the busy foolsomeone who works long hours and makes little or no profit.

Other Forms of Funding

Beyond sales and shorter-term borrowing, banks offer several other forms of financing, at various cost levels:

Asset-backed

property finance; asset finance, including leasing, HP, etc.; stock finance.

Quasi-secured

payroll finance; invoice discounting (not the same as factoring, but similar).

Unfortunately, as the credit crunch deepened, the availability of finance fell and the price increased. Inparticular, property finance became scarcer, with much lower loan-to-value (LTV) rates, as banks foundthey were yet again overcommitted to commercial property finance less than 20 years after the last propertycrash.

In summary, therefore, funding has always been available for well-run, profitable companies of any sizegenerating regular cash flows and with assets to act as collateral. With little interbank lending taking place,resulting in shrinking wholesale funding and a liquidity squeeze, it has been no surprise that banks in generalbecame more cautious about the scale and security of their lending.

Transaction-Based Corporate Finance

As in the wider markets, M&A activity has slowed dramatically, due both to a shortage of funds and to thegreater overall perceived risk of corporates in a slowdown. In the case of both M&As and managementbuyouts/buy-ins, the transaction is primarily based on the track record of sales and profit generation and thecapability of the business being acquired.

The more doubtful the recent and projected profit record, the more likely it is that the majority, if not all, of thefunding will need to be based on assets and/or quasi-assets.

Tax, Legal, and Professional AdviceSome may think that corporate finance is an industry invented by professionals to generate fat fees.However, there are many pitfalls in trying to do it yourself. The finance director or owner is generally unlikelyto get the best terms possible, even if they run a competitive auction.

Professional advisers, such as the accountancy firms, will usually have better and more banking andfinancing contacts. They should also be able to exert more leverage on the banks, as they have their wholeclientele as the lever, rather than the business and assets of a single company or business.

Many people also resent paying what they regard as high or exorbitant fees, especially to lawyers. Whilethere may be the odd less scrupulous professional adviser, in the main you will be paying for massiveaccumulated experience of the best and most efficient ways to source, transact, and document the finance,as well as avoiding myriad pitfalls.

While sale and purchase agreements and shareholder agreements may have a standard form at their core,each company and set of directors is different. Finally, there will be tax implications for every corporate
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finance transaction, whether for the organization or the individuals concerned. If you have the right advisers,there is no harm in taking a degree of responsibility on yourselves, but your advisers can save you moneyand help you avoid penal costs and consequences.

ConclusionCorporate finance can mean different things to different people; even the banks divide it into at least threecategories: commercial finance, corporate finance, and structured finance. In truth, however, it is about justone thinghow the business is financed. The key is the whole balance sheet approach, looking not only atthe optimum mix of short- and longer-term finance, but also at the overall picture: which liability funds whichasset, at an optimum balance of cost and risk.

At its best in practice, corporate finance can be a sophisticated science. This does not make it any lessapplicable to SMEs. While the scale and nature of transactions may often be smaller or simpler, there is noreason why similar principles and practices shouldnt be applied. Equally, for firms that have the necessarybreadth of skills, the fees do not need to be exorbitant either.

See Also

Best Practice

Capital Structure: A Strategy that Makes Sense Investing in Structured Finance Products in the Debt Money Markets Managing 21st Century Finances Private Investments in Public Equity

Checklists

Investors and the Capital Structure Options for Raising Finance Using Mezzanine Financing

Thinkers

Joseph SchumpeterFinance Library

Financial Management for the Small Business

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Corporate Finance for Smes

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