Archive: Business Finance

Resolve the Deal Breaker

lores_handshake_agreement_deal_reach_blue_MBDisagreements over a business’s valuation aren’t uncommon.

If, for example, you want to sell your business, you may feel it is undervalued because of market conditions, so ou want to factor into your asking price the company’s future performance. A buyer may come along, however, who isn’t so sure that those future projections will be realized and hesitates when it comes to closing the sale.

That disagreement doesn’t have to be a deal breaker. You can bridge the gap of the two valuations by arranging an earn-out agreement, where you receive a partial payment with future specified amounts paid when the business meets certain goals.

For example: You set a sale price of $1 million based on projected sales for next year. The buyer feels those sales projections aren’t guaranteed. So you agree to take $500,000 on the spot and the remainder is paid out of, or adjusted to reflect, the income your business actually earns based on those projections.

You both benefit: The buyer gains an additional source of financing while minimizing risks and costs and you get to share in future earnings and, because the deal isn’t simply an installment plan, you gain some tax benefits. 

But the agreement needs to be structured properly and address several issues, including:  

  • Duration: Earn-outs can typically run as long as five years. However, the longer the term the more difficult it can be to attribute performance to the business alone. On the other hand, you may face resistance to a short term if the buyer is concerned that a shorter duration could encourage you to make business decisions that favor short-term results but damage the long-term viability of the business. Moreover, to be able to get the benefits of using the cost recovery method when you pay your taxes, the Canada Revenue Agency (CRA) insists that the agreement last no longer than five years.
  • Authority: You may want to draft an employment contract that specifies who has ultimate control over management and strategy. As the seller, you may want to retain control over operations to help ensure performance goals are met, over the sale or purchase of additional assets, and over the hiring of key staff members. Pay particular attention to the duration of the contract: the buyer may not be willing to maintain an employee role once the earn-out is paid.
  • Performance goals: The agreement should outline such clear and achievable performance goals as sales, pre-tax earnings or gross profit as well as non-financial goals such as product or account development, capacity utilization, or service improvements.
  • Performance evaluations: Clearly define the measurement base and be sure it is monitored. If the base is pre-tax earnings, you should ensure that the agreement specifies how one-time costs, unexpected costs, new management costs, transfer pricing and other costs or windfalls will be treated. Periodic audits can ensure that systems and operations aren’t manipulated to artificially boost or suppress performance measures.

Last Word: Any of these issues create the risk of litigation, so you should choose some method to resolve disputes and avoid litigation.

Reap Tax Benefits from an Earn-Out Agreement

lores_canada_money_dollars_coins_calculator_pen_glasses_mbOrdinarily, any income from your business or property is fully taxable but when you sell your business you benefit from a capital gains tax, where only half of the proceeds from the sale is taxable income.

But let’s say you sell your business under an earn-out agreement where the buyer pays a partial amount up front and the remainder is derived from and based on meeting certain financial goals. The precise amount of your proceeds cannot be determined at the time of sale and, in fact, may not be known for several years.

That type of earn-out agreement depends on the use of — or production from — the company’s property, and ordinarily the money generated would be taxed as business income, not as a capital gain.

Canada Revenue Agency (CRA), however, recognizes that bind and allows you to use the cost recovery method of reporting the gains or losses if you meet the following five conditions:

  • You and the buyer deal at arm’s length.
  • The gain or loss is clearly of a capital nature.
  • It is reasonable to assume that the earn-out feature relates to underlying goodwill and that the two parties cannot reasonably be expected to agree on that value at the time of the sale.
  • The duration of the agreement does not exceed five years.
  • You, as the seller, file a copy of the sale agreement with your income tax return for the year of the sale, send a letter requesting the application of the cost recovery method to the sale, and agree to follow the cost recovery procedures.

Keep in mind, however, that if the deal amounts to an installment plan it is not considered an earn-out agreement for purposes of using the cost recovery method.Under the cost recovery method, you reduce the adjusted cost base (ACB) of your company’s shares when you are able to determine the amounts that will be paid. Amounts exceeding the ACB are considered a capital gain and the ACB becomes nil. All amounts that can then be calculated with certainty are treated as capital gains.

So let’s say your company’s stock’s ACB is $120,000 and you sell them all in an earn-out agreement. The sale price for the shares is $100,000 up front plus additional payments based on an earn-out formula over the next four years. The first $30,000 payment is due the year following the year of the sale. Here’s how the cost recovery works:

Year of the sale: You report no capital gain or loss, but the $100,000 reduces the ACB of the shares to $20,000 ($120,000 minus $100,000).

Year after the sale: The $30,000 payment due exceeds the $20,000 ACB, so you recognize a capital gain of $10,000. Half of that is included in your income as a taxable capital gain. You adjust the ACB of the shares to nil.

Following three years: The remaining payments under the earn-out formula are treated as capital gains, half of which are taxed.

The CRA recognizes a capital loss only when the maximum payable to you is less than the ACB of the shares. In that instance, the loss can be reported at the time of the sale. If, over time, it becomes clear that the actual total paid will be less than the initial maximum amount, a further capital loss can be claimed.

If there is no maximum amount set out in the agreement, a capital loss can be reported once it can be established that the total of the amounts to be paid will not exceed the ACB of the shares.

Regulators Keep Tight Reins on Corporate Behaviour

lores_business_man_building_street_walk_corporate_AMCanadian securities regulators are serious about corporate transparency and the need to maintain investor confidence in capital markets.

To achieve that objective, the regulators follow one set of rules in all provinces and territories and they apply to public companies, income funds, limited partnerships and some other entities. While the guidelines are voluntary – aimed at allowing business to tailor governance to their specific situations — companies that don’t comply with the disclosure rule will be breaking securities law and could face enforcement proceedings, as well as sanctions.

The governance guidelines set out a series of recommended best practices, including:

  • Maintaining a majority of independent directors on the board.
  • Appointing an independent chairman of the board or lead director.
  • Holding regularly scheduled meetings of independent directors without the presence of non-independent directors and management.
  • Adopting a written board mandate.
  • Outlining board responsibilities such as reviewing and showing satisfaction with the integrity of the company’s top officers and their efforts to develop a corporate culture of integrity.
  • Approving strategic plans at least once a year; actively taking part in succession planning; and overseeing internal controls.
  • Developing job descriptions for the board chairman, the chief executive officer and board committees.
  • Providing each new director with a comprehensive orientation, and all directors with continuing education opportunities.
  • Adopting a written code of conduct and ethics that deals with: conflicts of interest; protection of corporate assets; fairness toward shareholders, customers, competitors and employees; confidentiality; legal compliance, and ways to report illegal or unethical behaviour.
  • Appointing a nominating committee and a compensation committee composed entirely of independent directors.
  • Adopting a process for determining the competencies and skills of the board as a whole and applying this to the recruitment of new directors.
  • Assessing on a regular basis the board’s own effectiveness, as well as the contribution of each board committee and individual director.

Under the disclosure rule, companies must file a Corporate Government Disclosure Form with the provincial or territorial securities commission that requires information about each recommended governance practice, including:

  1. Information about the independence of directors and the names of other boards they sit on.
  2. Disclosure of whether the independent directors hold separate meetings and an explanation if they don’t.
  3. Disclosure of whether the board has adopted the recommended governance policy and if not, how their governance practices differ from the recommended standards and why that is appropriate to the company’s circumstances.
  4. Descriptions of the policies in effect and how they achieve the desired governance goals.

Companies are also required to file a copy of their ethics and conduct code (or any change to it) on the System for Electronic Document Analysis and Retrieval (SEDAR) by the date on which the issuer’s next financial statements must be filed.

Maintain Liquidity by Minimizing Credit Risk

Liquidity is critical to the viability of any business, regardless of the industry where it operates.


Shore up Listless Collection Practices

When your business is confronted with some past due accounts, there are several ways to help encourage payment of bills. The first step, of course, is to be sure the invoice contains the due date. Providing incentives for prompt payment will also help. You can offer discounts for payments received before the due date and you can charge interest on late payments. If you apply penalties on overdue accounts, be sure the amounts you charge fall within the provisions of the Criminal Code and the federal Interest Act. When a customer does miss a due date, prompt and courteous contact will generally produce results. This can be done by telephone, mail or fax. Document all your collection attempts by sending written notices and keeping copies. It is important to respond rapidly in case the customer does clear the account so that unnecessary delays in shipping are avoided. Your company’s credit department and the accounts receivable bookkeeper should maintain close communication.

The most extreme method to obtain payment is to stop providing goods or services until you receive full payment. But be cautious. This could damage your company’s relationship with an important customer who provides you with significant business. If it becomes clear that you are not going to be paid, you have three main choices:

1. Write-off the account if you determine that it is not worth spending more time and money trying to collect it.

2. Hire a collection agency. You will have to pay a fee or a percentage of the amount collected. Meet with the agency to discuss its procedures and confirm that the collector will not incur any costs of start litigation without your permission.

3. Take legal action. This is no guarantee of being paid, so before you start litigation try to determine the likelihood of collection. Assess whether the individual has sufficient assets to cover the debt and legal fees.

Simply put, liquidity is the ability of your enterprise to meet its financial obligations, usually with cash on hand or by converting assets to cash. It also entails making sure your business has the financial ability to continue providing goods and services without heavy discounting and collecting your receivables timely with minimal write downs and write offs.

One way to avoid sliding into a liquidity crunch is not to extend credit to customers with little creditworthiness. Your enterprise’s liquidity and survival depends on a steady inflow from timely collected receivables.

Accomplishing that requires taking cautious steps before extending credit and staying on top of collection procedures. (See right-hand box for ways to encourage credit customers to pay on or before the invoice’s due date.)

Credit policies and procedures, however, do not always ensure the cash flow to sustain a business. Without a steady stream of revenue from sales, your business runs the risk of illiquidity and therefore being unable to pay its own debts.

When a customer asks for credit, be sure that the application requires:

1. The names, addresses and phone numbers of at least three companies the applicant has had credit dealings with.

2. The applicant’s bank accounts with branch addresses and account numbers.

With this information, you can start taking action. The next steps are critical to helping ensure your customers stay on track with their payments:

  • Call the applicants’ banks to ask if they are a good credit risk.
  • Verify the applicant’s bill-paying history with the business references.
  • Run a credit check with one of the two main rating agencies in Canada, Equifax Canada and TransUnion Canada.

Staying in Control of Receivables

Of course once you’ve granted credit to a customer, your job is just beginning. Your company’s collections manager needs to constantly monitor receivables and closely monitor slow-paying accounts. Part of that process involves balancing the benefits of extending credit, which will boost sales on paper, against the costs of carrying receivables and perhaps being unable to collect them.

There are tools to help you stay in control. Three of the most critical are:

1. Receivables Ratio. You should hold receivables for the shortest time possible. This boosts the timeliness of payments and maximizes the accounts receivable turnover ratio, or the rate at which you are collecting bills during a given period. To determine the ratio, divide net credit sales by average accounts receivable.

2. Aging Schedule. This gives you a bird’s eye view of your receivables and the due dates. It’s a straightforward way of understanding your collection efforts and highlighting overdue bills. The accounts receivable aging schedule typically includes the name of the creditor, the total due, and the amounts due in the current month, the previous month, the preceding two months and more than 60 days.

3. Average Collection Period. One of the most important measurements is the average number of days it takes to collect a bill. This is the length of time it takes to convert sales into cash and underscores the relationship between accounts receivable and cash flow.

The longer the collection period, the more you invest in accounts receivable. And a long collection period means less cash available for your company’s own needs. Remember your firm isn’t the banker so stop acting as if you are. It will only add to your financial problems if you continue doing so.

To calculate the collection period, divide the number of days in the year by the accounts receivables turnover ratio. Or you can take the average accounts receivable and divide that by the average daily sales (net credit sales/days in a year).

The average collection period is commonly used to compare your success at accounts receivable management to that of your industry peers. It can also be used to analyze your collection efforts across various time periods, and determine how well your customers are doing paying their bills when compared with your credit terms.

These are just some of the tools that let will assist you in controlling and monitoring accounts receivables. Your accountant can help you implement the use of these tools and interpret other ratios, reports and measurements involving credits and collections.

Unplug the Money Valves

thmb_pie_chart_half_nhYour company’s ability to manage cash flow is critical to its survival. Enterprises that successfully practice good cash management generally survive and prosper. Those that don’t are likely to be undone by the weight of increasing debt — if it’s even available — and the inability to pay employees and suppliers.

Maintaining smooth cash flow requires juggling most aspects of your enterprise, from accounts receivables to extending lines of credit and managing inventory. Increasing cash flow reduces the amount of fixed capital required to support your ongoing operations.

It may help to think of the process in terms of the cash cycle, which is the amount of cash your company needs in terms of days of activity to keep operating. Let’s assume your business had the following financial statistics at the end of its most recent fiscal year:

Annual sales $3,600,000
Annual cost of sales $3,285,000
Billed accounts receivables $   600,000
Unbilled accounts receivables $   400,000
Accounts payable and accrued expenses $   450,000

The first step in calculating the cash cycle is to determine the amount of average daily sales and the cost of sales. Dividing sales and cost of sales by 365 days gives you average daily sales of nearly $10,000 and average daily cost of sales of $9,000.

Then you calculate the number of days’ investment in billed and unbilled accounts receivable:

Billed accounts receivables $   600,000
Plus unbilled accounts receivables $   400,000
Subtotal $1,000,000
Divided by average daily sales $     10,000
Number of days investment            100

Thus, it takes 100 days on average between production of a good or service and payment. Similarly, using the daily cost of sales average, you can determine the number of days financed by vendors and employees:

Accounts payable and accrued expenses $   450,000
Divided by average daily cost of sales $       9,000
Number of days financed              50

With that in mind, here are eight tips to strengthen your business’s cash cycle and increase cash flow:

1. Stretch out your payables. Take the maximum time to pay your suppliers. Essentially this amounts to an interest-free line of credit and gives you more time to use your working capital.

2. Take advantage of payment incentives. If your suppliers offer you a discount for paying early, take it. Refusing it can be a major mistake. Let’s say you owe $1,000, but you could reduce that to $980 by paying the bill in 10 days rather than the usual 45 days. Foregoing the discount costs your business $20 to hold on to your $980 for 35 days. That is like borrowing money at a 21.3% interest rate. If your suppliers don’t offer incentives, ask for them. Many will be willing in order to speed up their own receivables.

A healthy cash cycle requires some cash flow forecasting. This helps you plan your cash balance and know if you will need to borrow at certain times of the year and how much surplus cash you are likely to have at certain times. Your cash flow forecast is usually done for one year or a quarter in advance and divided into months or weeks. For companies  who are barely making ends meet to pay their day-to-day expenses, a daily cash flow forecast may be needed.

3. Organize your billing schedule. The faster your business collects receivables the more money it has to spend. Prepare invoices as soon as goods or services are delivered. Waiting until the end of the month may add as many as 30 extra days to your cash flow conversion period. Offer discounts for fast payments, and if your business provides a service, ask customers for a deposit before work begins.

4. Closely track and collect overdue accounts.Software can help your business automatically classify the age of accounts receivable and flag overdue accounts. Act immediately on past-due accounts and use a collection agency if necessary.

5. Use fund transfers. If you use electronic fund transfers in place of cheques you can reduce your collection cycle.

6. Split business between suppliers. Sometimes you want to buy equipment, say computer hardware, from a value added reseller who can help you choose the right system for your needs. Other times, however, consider buying routine materials such as cables, software, paper and printer cartridges from a mail order catalogue at commodity prices. Alternatively, get together with some colleagues to buy supplies in bulk.

7. Keep a lean inventory. Having too much stock can tie up large amounts of cash. Calculate your turnover ratio (cost of goods sold divided by the average value of inventory) to keep turnover within industry norms. Regularly check for old or outdated stock. You can defer future orders to get rid of that stock or sell it at cost, which would improve your company’s liquidity.

8. Consider leasing instead of buying. Leasing computer equipment, cars, tools and other gear costs more than buying, but you will avoid tying up cash. Lease payments are a business expense, so they will also help lower your taxable income.

Talk with your accountant or business advisor who can help you review your cash flow statements, find weaknesses and come up with solutions to maintain a healthy balance between cash flowing in and out of your enterprise.

A Quick Guide to Bankruptcy

lores_bankrupt_business_debt_due_mbHere are some frequently asked bankruptcy questions. However, these answers only provide general information.

Consult with your accountant and legal adviser about how to proceed in your specific situation.

Q. Times have been hard on our business and we’ve been considering bankruptcy. What are the pros and cons?

A. Bankruptcy filings are generally a last resort. They could ruin your company’s reputation and will damage its ability to get credit for years. If you run into a brick wall with your creditors and run out of alternatives, however, your business may have no choice but to file for bankruptcy, primarily under one of the following two federal statutes:

 Types of Bankruptcy and Characteristics
 The Bankruptcy and Insolvency Act (BIA) Available to companies whose debts total more than $75,000 and less than $5 million. Allows for both reorganization under court supervision and liquidation.
 The Companies’ Creditors Arrangement Act (CCAA)  Available to businesses with debts exceeding $5 million. They continue to operate under court supervision while negotiating a Plan of Arrangement to pay creditors.

Creditors can initiate an involuntary bankruptcy proceeding under both laws, subject to certain requirements.

Under the BIA, if your enterprise is insolvent a trustee takes possession of its unsecured assets and liquidates them, distributing the proceeds to creditors. Under reorganization, your business continues to operate while it comes up with a proposal to pay its debts, generally at a discount. A majority of creditors, as well as the court, must agree to the plan.

Once the reorganization is complete, the trustee discharges your business from bankruptcy. If creditors or the court reject the plan, your enterprise automatically is placed into liquidation.

Under the CCAA, the court appoints a monitor to look after the interests of creditors and to report on the reorganization progress. Your company’s management generally remains in charge, but the monitor will have a certain amount of authority.

Talk to Creditors

Talk to your company’s creditors to try to work out lower payments over a longer time frame.

This may buy your company more time to get back on track and you might be able to settle your debts for less than you owe, while maintaining a good credit record. Your accountant and legal advisors can provide guidance on how to go about these negotiations as well as help you find other options.

Q. One of our company’s customers owes us a great deal of money and has told us that the business is declaring bankruptcy. Should we back off?

A. Yes, provided that the customer has actually filed for court protection from creditors and is reorganizing. In BIA reorganizations, an automatic stay of proceedings is imposed on secured and unsecured creditors. The court can lift the stay under certain circumstances. Unsecured creditors can ask for relief from the stay but rarely are allowed to seize assets.

Similarly, under CCAA reorganizations, a broad stay on collections is imposed on both secured and unsecured creditors. As long as the stay is in place, creditors cannot take any action to collect debts. The initial stay is limited to 30 days, but the court may extend that any number of times if it determines that the Plan of Arrangement isn’t prejudicial to the creditors.

Until the customer actually files for bankruptcy proceedings, however, you can take whatever legal means are available to get your money, including repossession or negotiating a deal under which you might get more than you would in a bankruptcy proceeding.

Caution: If a customer pays you in preference to other creditors under a negotiation and then files for bankruptcy, the company may be charged with fraudulent preference.  If that happens, its possible you — or the customer — will have to pay back the money.

Q. If a customer files for bankruptcy proceedings, will we get any of our money?

A. That depends on the nature of the case and your creditor status.

Under the BIA, if the customer goes into liquidation, the trustee sells all inventory, accounts receivable and other property covered by a court order. The proceeds will be used first to pay priority creditors and trustee costs. The balance, if any, is paid to unsecured creditors. Secured creditors aren’t affected by this process, as they have the right to repossess secured assets and liquidate them to recover what they are owed.

If the customer is reorganizing, the amount you  receive  will depend on the terms you and other creditors agree to and your creditor status.

In CCAA reorganizations, there is a lot of flexibility on what the Plan of Arrangement can involve. It often includes offers to pay a percentage on the dollar of the money owed, and can call for swapping stock or a combination of cash and shares for debt. In order to be able to vote on the plan and receive any distribution you must file a Proof of Claim with the monitor.

Generally, creditors are paid in this order:

  1. Super-priority creditors such as the Crown for environmental damage costs and certain unpaid pension plan deductions.
  2. Secured creditors, including lenders and debt holders, who have a claim for debts incurred for a specific purchase (for example, a bank holding a mortgage).
  3. Preferred creditors, including those with certain wage claims, municipal tax authorities and landlords owed rent.
  4. Unsecured creditors such as suppliers and credit card companies who extended credit based on a promise to pay.
  5. Preferred shareholders.
  6. Common shareholders.

Under the CCAA, if a company defaults on a payment to a secured creditor, that creditor has the right to take possession of assets, sell off collateral and sue the company for any amount still owed. Also, if a class of creditors or the court does not approve the plan, the stay is lifted, which increases the likelihood that your business will be placed into bankruptcy.

Q. Will my company’s tax debts be eliminated in a bankruptcy filing?

A. Only if your business actually goes bankrupt. But even then, there are special rules that deal with tax debts in bankruptcy, so you really need to ask your tax accountant to review your company’s situation and confirm that your tax liability will be discharged if your enterprise goes bankrupt.

Q. I am on a corporate board. Are my personal assets at risk if the company files for bankruptcy proceedings?

A. That depends on the provisions of your directors and officers liability insurance policy (D&O policy). Review your company’s policy to determine if it covers defense costs and damage awards in the event of bankruptcy. For example, among other protections, the policy should:

  • Provide separate coverage for directors and the corporation or include excess coverage for directors and officers.
  • Allow continued coverage for innocent board members.
  • Require the insurer to pay covered defense costs and damages in advance or as they are incurred so that you don’t have to pay potentially millions of dollars and wait for reimbursement.

There are many other significant provisions related to bankruptcy that should be included in your D&O policy. Your professional advisers can help you determine what specific coverage you need.

Q. I hold stock in a company that appears likely to file for reorganization under CCAA. What happens to my investment?

A. Holders of common stock are typically last on the list and often get none of their investment back. Holders of preferred shares rank ahead of common shareholders, but often do not get back the full value of their shares. The CCAA allows a company to include shareholders in its reorganization plan and they then typically can vote on the proposal.

Tally the Pros and Cons of Going Public

For many business owners, going public is the pinnacle of success. But the process is rigorous, requires enormous effort and time, and can be extremely expensive.

Leading up to the day your business goes public, you need to engage an investment banker, build a successful IPO team, avoid some pitfalls and be ready to meet the stringent requirements of a publicly owned corporation. The process is rigorous, requires enormous effort and time, and can be extremely expensive.

Going public is not for everyone, but if your company is set on it, carefully consider the pros and cons.


Terms You Need to Know

Here are some of the other terms you will hear during an initial public offering:

Aftermarket performance. The difference between a stock’s initial offering price and its market price.

Expression of interest. A firm and obligated order to buy a specific number of shares.

Greenshoe. An agreement that the underwriter may authorize more shares for distribution if demand for an offering is high.

Oversubscribed. The spread between demand and supply for an issue. If an issue is four times oversubscribed, expressions of interest are four times greater than the amount of stock available.

Pricing date. The day underwriters determine the final price, yield, and size of an offering.

Selling group. A group of dealers the lead underwriter appoints to market a new or secondary issue. Members may or may not be a part of the underwriting group.

Syndicate. A group of investment dealers who underwrite and distribute a new issue of securities.

Time, Expense and Wary Investors

First you need a clear idea why you want to sell stock on the public market. Among the benefits:

  • Raising money for growth and expansion without taking on additional debt.
  • Providing liquidity for shareholders. Bear in mind the securities exchanges and underwriters generally want principal holders to stay with the company for a certain period of time, during which their shares typically are in escrow and released over time. Moreover, company officers and senior executives have access to material information and cannot trade shares until that information is made public.
  • Increasing stockholder value. Publicly traded shares generally trade at higher prices than holders can demand in private transactions.
  • Boosting your company’s profile and reputation. However, while an increased profile can help raise more capital, the spotlight can also attract hostile bidders that eventually could result in a loss of control of your business.
  • Acquiring shares for stock option incentives to attract and retain skilled employees or to use in place of cash to make acquisitions.
  • Increasing liquidity for a succession plan if family and associates don’t have the money to purchase your stock.

But having a reason to go public isn’t enough. Your company must be ready to face investors, who generally scrutinize three factors:

1. Earnings: Investors buy into potential growth and want to see a strong record of good returns on sales and assets. If you have been adjusting your earnings for the best tax benefits, you may have to restructure your business and restate earnings. Carefully review potential tax reorganizations and individual tax consequences with your accountants.

2. Business Plan: Having a business plan helps gauge the soundness of your intention to go public. It also helps write the prospectus that investors need to evaluate your offering. The business plan should include a market analysis, a description of your company’s products and services, management structure, and financial information and projections.

3. Management: Investors want to know you have an expert management team that can carry out your business plan. Investor reaction to both your prospectus and your management team can play a large role in determining the valuation of your company and the pricing of the stock issue. As well, you need a strong board of directors that understands your industry and reflects a varied business background. The board will be accountable to all shareholders for overseeing the operations of your public company and must consider their rights in all major business decisions.

Examine the Drawbacks

Finally, you want to discuss with your advisers the potential disadvantages to ensure they don’t outweigh the advantages. Among the drawbacks:

  • Financial Costs: Going public is expensive, and among the costs that can quickly add up are: Underwriting fees can range as high as 15 per cent;
  • Legal and accounting fees, as well as printing, listing and registration costs can add up to as much as four per cent; and
  • Continuing costs that include annual reports, board and shareholder meetings, shareholder registrations and transfer, and publishing disclosure information.
  • Time Costs: Typically, preparing to go public can take one to two years and eat up as much as 50 per cent of managers’ time. This can distract them from the efficient running of your business and can lead to lost opportunities.

Public companies must follow stringent, expensive, and time-consuming reporting and filing requirements. Some of the information you make public could be sensitive and you must disclose any information that can affect an investor’s decisions. You may have to spend a considerable amount to upgrade your accounting and information systems to handle the volume and variety of information required. Regulatory compliance can add from $25,000 to $200,000 in expenses.

Phase Two

But getting your business in shape for an initial public offering (IPO) is just half the battle. Once everyone involved determines you are ready, phase two begins.

While starting work on your prospectus, you must choose a lead underwriter, then file the prospectus and amend it if any of the appropriate securities commissions have concerns. And then you take the show on the road to market the offering.

The process is complex and time consuming, but the success of your IPO depends on it

The underwriter is typically an investment bank and acts as agent for the IPO. The roll is central to your offering so choose carefully. Get recommendations from your lawyers and accountants as well as others who have gone public. Check references thoroughly.

Among the qualities to look for in an underwriter are:

  • Reputation in your industry.
  • Availability of experienced analysts.
  • Existing relationships with your current and future customers, suppliers and competitors.
  • Chemistry with you and your management team.
  • Ability to provide after-market support.

Working with the underwriter you will determine the amount you want to raise and the number and types of securities you want to issue. The structure of the offering is typically one of two scenarios:

  1. A firm commitment, where the underwriter guarantees to raise a certain amount by buying the entire offer and then reselling to the public, and
  2. A best efforts agreement where the underwriter sells shares but doesn’t guarantee an amount.

Writing and Filing the Prospectus

Your prospectus serves two purposes: compliance with legal disclosure requirements and acting as the main marketing tool for your offering.

Your lawyer, managers, advisors and underwriters will work together to compile documentation about your company and its holdings, its capitalization, risk factors associated with the offering, a description of how the offering is structured, and a due diligence report.

You file the prospectus with securities regulators in each of the provinces where you plan to offer the shares. The more provinces you choose the higher your costs but the broader the exposure of your offering. Filing in Quebec will require English and French versions of the prospectus.

The regulators review the documents and issue comment letters with concerns they expect you to address, usually by modifying the prospectus. When regulators are satisfied, they will ask for a final prospectus and issue a receipt. You are then officially a reporting issuer and may start selling the shares.

The Quiet Period and Road Show

The time between filing the preliminary prospectus and getting the receipt for the final prospectus is the “quiet period” when you can market your offering only through oral statements and the preliminary prospectus. You must ensure that you do not issue any press releases, written presentations or other material that would be classified as advertising and that hypes the offering.

However, you can begin your road show, where you generally meet with two types of investment professionals:

  1. Buy-side analysts and fund managers working for mutual funds, insurance companies, and large investment groups looking for investments where they can put some of their pool of money, and
  2. Sell-side professionals who are usually brokers with retail investment houses looking for investments to recommend to their clients.

When the road show is over and you have distributed the final prospectus, the underwriter will set the final offering price and size.

The pricing will try to balance your need for cash with investors’ desire for investment gains. Your underwriter may recommend reducing the size of the offering if interest appears to be waning or increasing it in the face of strong demand. It is unusual to postpone an IPO due to lack of interest.

Once the sale is complete, you are a public company and subject to all the disclosure laws and regulations and responsible for your shareholders’ best interests.

Consider Some Middle Level Financing

If your company is mature and you are looking for financing to bring it to the next level, but you don’t want to go public and are unwilling to give up any control of your business, mezzanine financing could be for you.

Mezzanine financing –  also known as subordinated debt, junior debt, structured equity, and equity-linked notes – can be particularly useful when your capital needs exceed what your senior secured lender and your equity holders are willing to provide.

Mezzanine Applications

 Mezzanine financing can be a good option if your company has exhausted such secured financing as term loans based on capital assets, or short-term financing based on current assets.

In addition, because this type of financing helps preserve cash flow needed for daily operations, it can be particularly useful if you are raising capital to:

  • Boost market penetration;
  • Improve research and development;
  • Expand payroll;
  • Broaden distribution;
  • Finance marketing programs;
  • Increase inventory;
  • Acquire equipment;
  • Expand geographically, and
  • Develop export markets.

Other reasons to consider subordinated debt include:

  • Management buyouts and succession planning;
  • Leveraged buyouts;
  • Acquiring intangible assets such as intellectual property;
  • Strategic mergers and acquisitions.

What It Costs

This type of financing is a hybrid of debt and equity that lenders expect to generate a 20 per cent to 30 per cent return through capital appreciation and interest. With that expected return, mezzanine financing is not cheap.

First, the lender advances cash through a term loan at interest of between eight per cent and 12 per cent. The interest payments, paid regularly over the term of the loan, are tax-deductible.

Then the lender enhances the rate of return with an “equity kicker,” which is usually some form of participation in the expected success of your company.

These participation features can take the form of royalties on sales; a percentage of net cash flow; participation fees; warrants or options to buy shares, and rights to convert debt into common stock.

And finally, origination fees generally run between two per cent and three per cent of the transaction, although in some cases the lender may waive the fees.

Mezzanine lenders don’t really want an interest in your company, so instead of holding real assets as collateral, as is the case with equity loans and venture capital financing, mezzanine financers prefer rights to convert their stakes into ownership equity should your company default on the loan. As a result, the debt doesn’t dilute your equity stake and you retain control of the business.

Getting in and Getting Out

Given that cash flow and the success of your business account for much of the lenders’ return, they typically will want to see that your company has a sound track record and management team; a history of profits; strong margins; an established line of credit, and a strong business plan. Start-ups and businesses with financial difficulties need not apply.

The lenders will also want a clearly defined exit strategy, which could involve selling the company, recapitalizing, refinancing, or even an initial public offering.

One disadvantage of mezzanine financing comes from its position on your company’s balance sheet.

Subordinated debt is sandwiched between senior debt and equity. So, in the event of bankruptcy or the sale of your business to pay debts, proceeds first would go to pay off senior lenders, then subordinated lenders. Your common and preferred shareholders would come last and likely receive a much smaller share of those proceeds.

A Borrowing Advantage

On the other hand, a mezzanine layer in your financing could help your company raise more total capital.
For example, say you wanted to make a $100 million acquisition through bank debt and equity. The bank might lend you $50 million, leaving you with an equity requirement of $50 million.

If you added mezzanine financing, the bank might lend just $40 million, but the subordinated lender might provide $25 million, for a total capital of $65 million. Your equity requirement then has dropped to $35 million.

Moreover, banks often look more favourably on companies that have institutional backers and may offer more attractive credit terms.

Your financial advisor can discuss the merits of mezzanine financing and help determine if it would be an ideal solution for your company’s growth needs.