CandidCapital

Aim of the Chapter

To give a manager a clear understanding of the personal implications of raising external finance as well as an overview of the business implications (although these are developed more fully later in the book). To pose the key questions which he must ask himself in coming to a decision on whether to seek external finance.

Key Concepts described in the chapter

Proprietorial businesses
Equity businesses

Introduction

A manager who is reading this book, is probably considering some idea or project which is likely to lead to significant change in his current business, which could include buying it, or he may considering buying another business or of starting a new one. He may own and run his own company, in whole or part, and may be considering raising finance to fund major expansion, perhaps by acquisition or by increasing the size of the operation or by developing a significant new product or service. Alternatively, he may work for someone else and be considering buying the business he works in, or another business or, again, be looking at starting a completely new venture. Whichever path he is considering, following it is likely to be both professionally and personally demanding.

However, on top of the demands that the business project itself will impose, funding it by raising external finance will have further implications. These implications must be taken into account before deciding whether to go ahead with the project; whether to raise external finance; and, although the implications differ, whether to raise external finance by borrowing or by selling shares. These implications will extend to the ambitions, personal values and lifestyle of the manager as well as making demands of his family, employees and any existing shareholders or partners in the business. This chapter discusses these general implications of raising external finance. Later chapters describe the detailed managerial implications of specific forms of external finance.

Determining your personal aspirations and the consequences for your business

First, a manager, or management team, must determine what they want from their business:

• wealth and property;
• status;
• to prove a point;
• a comfortable existence;
• or, something to hand on to family or employees?

Whichever of these they are seeking, or any other of the myriad alternatives, each has different implications for any decision about the future of the business. Timescales, the degree of personal control and whether it is acceptable to see the business sold, are all determined by the managers' personal aspirations. These factors, in turn, have a direct influence on whether to raise external finance and what type of finance.

For example:

1. For the owner and manager of a family business, where handing the company on to the next generation is central to the plan for the future, it makes little sense to fund development by seeking external investors who will need to sell or float the business, within a predictable timetable to get the right return from their investment. A well established family business is likely to have a sizaeable asset base and therefore the ability to borrow to fund its growth. However, even a lender will want to understand the strategy of the business, verify the quality of management and ensure that there are adequate financial control systems; since he must be satisfied that the company can service and repay the borrowing.

2. Equally, a highly successful entrepreneur who wants to grow his company rapidly, perhaps by making acquisitions, may well consider raising external finance. He likely to run his business in a way which makes best use of assets (ie there will be few attractive assets free to secure significant borrowing) and may therefore be looking at equity finance. However, he has got to think about the limits which will be set on his personal freedom to act by an external investor who will require, at least , consultation and probaly a decisive say on most significant business decisions (see the section on Business Implications of External Finance below).

3. However, an experienced management team in their forties or fifties, who have managed a subsidiary of a large company and are looking to retire with some personal wealth, are likely to have objectives which are compatible with an external equity investor. They are used to having an owner who has a say in their strategy and who must be consulted on major decisions and both they and the investor want to see the business sold or floated for a large capital gain.

Both borrowing and equity finance will affect the way a business is managed and will affect the freedom of action and personal lives of its managers, especially if they are its owners, and employees. The first step in deciding to raise external finance is to determine what type of business the management team is currently running and what type of business they want it to be in the future.

Do I want a Proprietorial or an Equity Business?

This is the key question managers must ask themselves before making any decision about whether to raise external finance, either by borrowing or by selling shares. Any business can be categorised under one or the other of these two descriptions:

Proprietorial Business A proprietorial business is managed by its owners for their direct personal benefit. The business is often a sole tradership or a partnership (perhaps between husband and wife) where the direct personal involvement of the owners is critical to the day to day running of the business. Many retail or catering businesses (such as small shops, pubs and restaurants) fall into this category but so do a surprising number of much larger manufacturing and service businesses. In such businesses, decisions are likely to be determined by issues of lifestyle, tax efficiency and personal status before the growth of the business growth or profitability for shareholders.

Equity Business An equity business is managed by its directors as stewards of the interests of shareholders. The directors will usually be shareholders themselves and, in smaller companies, will often own a controlling proportion of the total share capital. Nonetheless, they will be expected to manage the business in the interests of shareholders as a whole. This will usually mean that, while they will be able to pay themselves very good salaries for the successful management of the business, they will make their principal financial gain by receiving dividends or by sale of shares in common with the other shareholders.

Unsurprisingly, it is difficult to raise larger amounts of external capital, especially share capital, for a proprietorial business. While a banker may be prepared to make a commercial mortgage or some other lending secured against a specific tangible asset available to such businesses, he will be less likely to offer a loan secured on debtors or other variable business assets to a proprietorial business, especially if it is not incorporated. Investors who are buying shares in the business can only invest in an incorporated (or limited) company, and will take great pains to ensure that it is not a proprietorial business where the management shareholders are extracting value to the detriment of the shareholders as a whole.

Personal implications of raising external finance

Structure The first implication of raising external finance, especially finance by sale of shares, is that an existing business which is a sole tradership or partnership will need to be incorporated into a limited company: which may affect the personal tax position of the managers who will need to take specialist tax advice. An externally funded start-up will have to be set up as an incorporated company.

Control Secondly, the management must be quite sure that their personal business aspirations are compatible with the burdens and obligations which go with both large scale borrowing or equity finance. They must be prepared to accept that the personal control of their business will be limited by the demands and rights of the investor or lender. Both investors and lenders will expect and demand the fullest information and reporting on the progress of the business. An equity investor will expect that he, or a nominee director, will attend board meetings and be party to the most critical decisions. In the last instance lenders and investors will both have extensive rights in circumstances where the company faces failure.

Personal and family implications Thirdly, any manager who is contemplating leaving employment to buy or start his own business has to recognise the fundamental difference between being a successful manager in a large, highly structured organisation and being the over-stretched general manager of an externally funded small company with tight cashflow, an incomplete management team and an ambitious plan to achieve. Moreover, the demands of having an external investor will be felt by more than simply the management shareholders themselves. Their families will feel the pressure to achieve the strongest possible performance; in particular they may well find that their spouse or parent spends what appears to be an excessive amount of time on the affairs of the company. Additionally, in a new venture, such a start-up or buy out, the investor will expect the management to demonstrate substantial financial commitment through the personal investment they make in the project. As a rule of thumb, most investors will be looking for a cash commitment of one year's salary for each shareholding manager. Often this will require the individual to borrow against his house, meaning that he and his family face the prospect of selling their home, or even worse re possession, should the venture fail.

Business implications of raising external finance

Operation of the board This issue of control goes further, since a company with external equity investors must be managed to meet their aspirations as well as those of the management shareholders. It will not be possible to manage a rather cosy business where the directors' lifestyle is a central part of the rationale behind business decisions. Instead, the company must be managed by a professional board whose directors, both executive directors and those nominated by the investors, are seeking to maximise the profitability of the business usually with a clear strategy for some form of realisation.

Employees and working practices Secondly, in existing businesses, employees must be clear that external financing , especially where there is a high level of borrowings, will mean that management must seek the greatest possible productivity and commitment from its workforce. Unfortunately, management's strategy to achieve this may entail reorganisation and redundancies. Furthermore, there will be some workers who will feel the direct requirements of the investor on their working practices. Those responsible for the preparation of management accounts, in particular, will find themselves having to work to the investor's financial reporting requirements. Most equity investors will, on the other hand, encourage the management to set up worthwhile employee bonus or share option schemes so that employees can share in the success of the business.

Management information and monitoring the plan Lenders and equity investors will insist on effective management information systems which will produce reports showing the company's trading performance within fourteen days of the end of each month. This goes hand in hand with constantly reviewing the business's performance against the plan, which was agreedwith the investor or lender, and taking immediate action to rectify any problems.

Cashflow and margins An externally funded business will be under great pressure to maintain cashflow and margins. Cashflow will be critical to the business's ability to pay interest on its borrowings, and margins will be critical to the profitability of the business which determines the return to shareholders. Not only will external lenders and equity investors want timely information on cashflow and profitability, but they will require management to run the business on the tightest possible basis with searching monthly reviews of trading performance, including cashflow and margins, leading to immediate action to put right any problems in the business's performance.

Alternatives to raising external finance

For the management team which is used to being accountable only to itself, the demands of raising and living with external finance can represent a considerable, and potentially unacceptable, change from their previous business and personal lifestyle. They could consider the alternatives:

Funding from retained earnings The largest source of capital for growth among all companies is retained profits. Growth out of retained profit has the benefit of being sustainable because it is related to the success of the company's products or services in the marketplace. There will be constraints, however, on a growing company's ability to fund large, discreet projects, since a significant proportion of retained profits is likely to be absorbed by the need for additional working capital to fund increased debtors, stocks and work in progress. Therefore, retained profits are often well suited to funding organic growth in the company's existing activities but are unlikely to be sufficient to fund a quantum change in the company's business, such as building a new plant or acquiring another company.

Continue as you are If a manager is running a business which is proprietorial and which can meet his personal and financial aspirations then it may well be best to leave it operating on its current basis. The only drawback to this strategy is that, while the business can certainly resist internal change and maintain its traditional modus operandi, it will almost certainly not be able to resist changes in its competitive environment. Old and well tried methods may serve well in delivering quality of service, but can they resist innovative ways of delivering the same, or better, product or service at lower cost? In such a competitive environment, the company must recognise the need for development and investment or face being driven out of business.

Summary

It is essential for an entrepreneur or manager considering raising external finance to realise that the lender or investor will make considerable demands on him and that they will expect their interests to be protected and promoted along with those of the original owners. He must be prepared to accept limits to his personal control and an increase in his external accountability. He must have considered these implications fully and have decided that they are compatible with his own and his family's aspirations for the future.

Chapter glossary

Incorporation
Limited Company
Share capital
Equity