The Ways that the Friends and Families Can Provide Her with Capital - Assignment Example

LATROBE UNIVERSITY SCHOOL OF LAW LL.M. Global Business Law LAW5UCF – Corporate Finance for Lawyers Prof. Jennifer A. Quaid Student Name: (a) Advise Sara on the different ways that her friends and family can provide her the capital they promised. Through loans or investment. Explain the consequences of each way of providing capital, both from the perspective of PP Inc and its shareholders and those who provide the capital. What do you recommend in light of her circumstances? Different Ways that the Friends and Families Can Provide Her with Capital There are two ways that the families and friends can provide money for capital as they promised Sara. The friends and family members can choose to loan her or can choose to invest in her business. There are two forms of receiving this money. In business finance, they are known as debt financing and equity financing. Since this is an incorporated company, it would be advisable for Sara to have documents showing the transactions that took place between her and the friends or between the company and her friends. Friends and family members can be a problem sometimes in the future if they act as a source of capital through any form. If for example Sara takes a loan from a friend, the friend may change the terms of repayment when the business is already running and may request more pay. For this reason, it is advisable to accept the money from friends and relatives but such transactions have to be documented. Debt financing is borrowing money from a lender (in Sara’s case a friend) with an agreement that the full amount will be paid in future with some interest. The terms and conditions of paying the debt are also documented. Equity financing is a strategy that involves an investor giving money for capital and sharing ownership of the company. This does not need repayment but the investor will benefit later from the business when it grows and makes profit (Bouchoux 1-3; Leach and Melicher, 513). Advantages of Debt Financing With debt financing, the founders of the company retain ownership of the company unlike equity financing. The founders or owners of the business are also left with a lot of financial freedom once the debts are paid. It is also not expensive when it is a long term debt to small business owner however very expensive when it is short term. Taking debts from friends and relatives is more advantageous since the terms of repayment may be more flexible than other sources such as banks and private investors (Bouchoux, 3-4; Leach and Melicher, 513). Disadvantages This type of financing requires regular payment in instalments either monthly or as agreed upon by the two parties. Since newly started business still do not have sufficient cash flow, it is not easy for the companies to make such regular payments. If a company cannot make such regular payments then the business is already affected since its credit rating in the market is affected and it cannot easily obtain future financing (Bouchoux, 3-4; Leach and Melicher, 513). Advantages of Equity Financing With equity financing, there is no responsibility to repay any money. Since equity investors seek growth from a business, they are always willing to take their chances in start up businesses; this enables the business to get different ideas from different people for growth (Bouchoux, 3-4; Leach and Melicher, 513). Disadvantages of Equity Financing Investors share the ownership of the company therefore the founders of the business do not control the business alone. For start up companies, selling of some equity from initial offering is not easy to administer and requires assistance from accountants and attorneys (Bouchoux, 3-4; Leach and Melicher, 513). The decision depends on the amount of control the business owner would like to maintain and the long term business goals. It is advisable to use both equity and debt financing methods in an acceptable ratio when looking for capital. The reasonable ratio is always 1:1 or 1:2. Sara can choose to accept loans from friends and can also accept those investing in the form of buying shares considering the ratios noted (). Debt financing is always not advisable for start up companies since payment of the loan in instalments is not easy. Since Sara is obtaining this loan from friends and relatives and the terms of repayment are not as high as the regular lenders, she may take the loans still on a ratio of 1:2 with the equity financing. (b) Sara is discouraged but she does not want to give up yet. After consulting with Bob and Ami, they all agree that there is no choice but for PP Inc to approach an arm’s length sources of funds. They are apprehensive about what is involved. Advise Sara, Bob and Ami as to what types of information potential investors will expect from PP Inc before providing any capital. Venture capitalists aim at entrepreneurial an business, that is, they look for the ability of the business to grow, the aspirations of the business’s investment, the strong business models, the management teams and not the size of the business. Venture capitalists risk investing a lot of money into a business and therefore expect some valuable return to their investment. These investors would therefore not invest in a project or a business if the project or the business cannot offer some significant returns. The investors look at the business plan of the vision of the business to determine if the business is in a position to offer significant growth turn over within five years (Cardis et al, 102). This clearly indicates that an entrepreneur in need of venture capital should develop a business plan that can enable effective running of the business through several challenges and should have acknowledged ideas about how the business will be conducted (Cardis, 103). The business plan should have the information the venture capitalists need. It should be able to explain to the venture capitalists the financial structure of the business and the one the business will have if they invest in it and how soon the business will make money in case they invest in it so that they are assured of the business making payments on the loans acquired (Cardis, 103-104). As noted previously, investors look for the ability of the business to grow. There are so many factors that affect business growth. If a business for example requires $100,000 to expand its operations and seeks $50,000 from an investor, the investor has to be informed of the other sources of capital that the business intends to use. Competition is another major factor that affects business growth. The entrepreneur should be able to show the investors in the business plan how the business will maintain a competitive advantage in the market. Sara, Bob and Ami should develop a business plan considering the importance of the business to the investor. They should look for the benefits the business will offer the investors. Considering the above information, a business plan should be developed showing how the business will remain competitive in the market and still make profits, how the equipments they plan to buy will help the business grow, how the equipments and hiring of the two technicians are of value to the investors. A clear explanation of how the investors’ money will be used and its expected returns should also be indicated. Building confidence in the investors is all that is important and this requires good management of the business including its finances, ideas of how it will be conducted and expected growth over a specific period of time. Sara, Bob and Ami should show the investors the business potential to grow within five years and what this will offer the investors. (c) CO is willing to be a passive investor in the business and leave the scientific and strategic decisions to management and the board. However they want the ability to increase their investment if things go well. Sara, Bob and Ami are uneasy about this. They ask you to explain how this could be done what the consequences would be for PP Inc. Explain all possible approaches for structuring Confederation Oil’s passive investment. Passive investment is the investing in an asset through a second party for example investing money through mutual funds in the market. What favours passive investing is market efficiency and it is also believed that it is not easy to beat the average market value as active investors try to do. With passive investment, the investor avoids the risk of making costly mistakes by the money manager. The portfolio decisions made by the fund’s manager ensure that there is very little risk taken for example, avoiding capital gains tax and minimized transaction costs. This kind of investment needs very little time and attention, it is exempted from taxes, it requires very little experience and it has a relative sure profit. It however does not have the ability to defend or propose actions in response to market conditions (Focardi and Fabozzi, 566). Active investing is the kind of investing where the investor aims at outperforming the investment benchmark index. The active investor aims at making profit out of the securities bought. Active investing involves analysis of the market index values and invests in undervalued indexes with the hope of making improvements and increasing the performance hence making profits (active investing). The investor can also short sell overvalued securities with the hope of making profit out of it. In active investing, there are very many losses that can be experienced in a row due to short term trading but there are no huge losses involved. Active investing also requires a trading plan in order to make money out of the stock market. An active investor depends on the market inefficiencies and works towards outperforming the benchmark index while a passive investor (Focardi and Fabozzi, 566). Comparing passive investment and active investment requires understanding of the two types of investments in order to determine the effect of such an investment on the company. Active and passive investment differences is in the degree of value added to the company’s portfolio compared to the contribution the market makes to the portfolio. The question in Bob, Ami and Sara’s case is, can the passive investor deliver a performance that they expect or can an active investor deliver more than the passive investor? (Focardi and Fabozzi, 566-567). Based on Sara’s requirements, it would not be advisable to go for the active investor. Sara does not have the business knowledge and experience to run the business and believes she is a scientist. The business is however in its initial stages. She requires an investor that is willing to persevere for the business performance to improve and for it to grow. Sara believes in the business value but only lacks the management strategies, with a passive investor; there is a solution since there will no active participation in the running of the business by the investors. Sara can hire qualified skills to do the management job and ensure the investors achieve some returns. Structuring Approaches Being a passive investor by buying the securities or stocks of PPL Inc, CO Incorporation has to restructure its corporation. Restructuring of a corporation can be done through so many forms. These are; Sale of all or substantially all – assets vs. shares Mergers Takeovers Amalgamation Arrangement Divestitures Demerger Reorganization (Lecture Notes-Corporate Restructuring). In the case of CO, the company can choose the most appropriate depending on the assets achieved, for example if the company acquires all common shares or if the company conduct a complete takeover of CO. The company could reorganize its structure after buying some shares, could form a merger with PPL Inc, could amalgamate depending on what strategies it selects to combine with those of its own or could take over the whole company (DePamphilis p. 448). (d) Sara, Bob and Ami are intrigued by this expression of interest from GES Inc and want to know more. Explain to Sara, Bob and Ami the different methods by which PP Inc and GES Inc might be combined. Be sure to outline for them the advantages and disadvantages of each method. What method do you recommend them to pursue with GES Inc? The two companies can be combined to form one company through an acquisition or through a merger. When two companies combine to form a single company, the formed corporation is said to have been formed through a merger. The two companies that have merged to form a single corporation hold on to a shared interest in the single newly formed corporation. An acquisition however, involves the purchase of one company by the other with the purchasing company retaining a bulk of stock from the acquired company. This creates an uneven balance of stock between the two companies, hence uneven ownership of the formed corporation (DePamphilis, p. 446). Advantages of Mergers The cost of merging two companies is not as much as the cost of acquiring a company. Mergers are also legally simple except for the cases where the companies are found to conspire to exploit the market and reduce competition. In mergers, corporations agree to combine their entire operations and both companies share the interests in the new corporation. Mergers reduce competition in the market and also influence other economic scales of the market. When two companies merge for example, their competitive advantages are amalgamated keeping the company growth. After a merger, the new corporation has to be restructured. Since the two companies’ strategies are shared, those that can strengthen the organization will be implemented and the weaknesses eliminated forming a stronger company than the previous two in operated as separate corporations. Mergers can make use of surplus money to make new investments or more investments for the corporation for more profit. Mergers are also characterised by increased market share since two companies combine to share their markets making the firm reliable. This leads to increased trust from the two companies’ consumers hence attracting more customers (DePamphilis, pp. 446-447). Disadvantages of Mergers For a merger to take place, it must be approved by the separate companies’ stockholders’ votes which has to be more than or equal to two thirds. It is time consuming and not easy to obtain two thirds of votes from the stockholders of the two companies. Obtaining the cooperation of the new corporation’s management is also not easy to obtain (DePamphilis, 447). Advantages of Acquisitions Just like mergers, acquisitions can lead to increased market share that in turn leads to improved revenue for the formed company, they can create cost efficiency through economies of scale and they can lead to tax gains. Acquisitions lead to greater value generation: Greater value generation is achieved through the increased shareholder value compared to previous shareholder values of the separate companies, through generation of a more competitive and cost efficient firm when one weak firm is acquired by a strong market firm and through accumulation of larger market share by the purchasing company. Acquisitions create economies of scale that in turn leads to cost efficiency. With cost efficiency, the firm is able to make new investments and enter new markets. They can decrease the cost of capital, increase revenue and generate tax gains (DePamphilis, pp.447-448). Disadvantages of Acquisitions The new corporations may not get any return on investment if the acquisition was not a match and if after the acquisition the firm was defectively managed. When a firm is acquired, it losses all its assets to the acquiring company if the acquiring company buys all the assets. The cash received from the sale of the company is given to shareholders as dividends leaving the company with nothing (DePamphilis, pp.447-448). The Best Solution for PP Inc From the above information it is evident that going for an acquisition is not the best option for PP Inc. If the benefits of an acquisition will be acceptable to the owners of the company with some profits, then it is fine to go for an acquisition, but if the company does not want to sell the company, then they should not go for an acquisition. It would be advisable for the company to form a merger with GES Inc based on what mergers provide for the company as indicated above. The two companies will still have shares and will have increased their strength due to amalgamation of the strong strategies. (e) Assuming that PP Inc is not in default of any of its obligations under the loan agreement, explain to Uncle Bob, Sara and Ami how this clause affects the deal with GES, Inc. Can the deal still go forward? According to article 8 of the OBIB loan agreement, there are two conditions under which Amalgamation, Consolidation, Merger, Conveyance, Transfer or Lease are restricted. “The company shall not The Company shall not amalgamate, consolidate with or merge with or into any other Person or convey, transfer, lease or otherwise dispose of its properties and assets substantially as an entirety to any Person by liquidation, winding up or otherwise (in one transaction or a series of transactions), unless: (a) either the Company shall be the continuing corporation or the Person (if other than the Company) formed by such amalgamation, consolidation, or into which the Company is merged or the Person which acquires by conveyance, transfer, lease or other disposition the properties and assets of the Company substantially as an entirety shall: (i) be a corporation incorporated under the laws of the Canada or a Province thereof, and (ii) expressly assume, by a supplemental agreement, all of the obligations of the Company under this Loan Agreement; and (b) The Company is not in default of any of its obligations under this Loan Agreement” (Loan Agreement Conditions). This article means that both conditions apply and the satisfaction of one of them cannot make the company continue with the consolidation, amalgamation, conveyance, merger, transfer or lease. Sara, Uncle Bob and Ami cannot sell the outstanding common shares as it is against the law as indicated in the OBIB loan agreement. The deal between GES Inc and PP Inc does not include PP Inc continuing as a corporation and neither does it show that there is a person other than the company that can be a corporation incorporated according to the laws of Canada, assuming all the obligations of the company as per supplemental agreement. Sara is only employed as a Chief Research Officer. (f) Explain to Sara the differences between a publicly held company and a privately held company. Identify any particular things that Sara should be aware of as a potential member of the management team of GES, Inc. Privately held companies are those owned by private managers, private investors or the company’s founders. Publicly held companies however, are those that have sold part of the company to the public through its stock. This means that the shareholders of the publicly held company have a right to claim the company’s profits and assets (Costales and Szurovy, 14-15). Public companies are required to disclose their financial information to the public for example, hey are expected to file several terms earnings reports (quarterly, annually etc). The Securities and Exchange Commission if applicable must also be included in the reports. The same information is made available to the shareholders. In privately held companies however, there is no disclosure of financial information to the public. The private companies do not trade their stock on a stock exchange like the public companies (Costales and Szurovy, 14-15). In public companies, there is a gap between the management and the ownership of the company unlike the private companies where the owners invest with the expectation that they will participate actively in the management of the business (Costales and Szurovy, pp.14-15). Sara as an employee and a share holder to be should be aware of this. (g) Explain to Sara what an option is and why GES has offered options to her in connection with her employment. In corporate finance, an option is contract between two parties (a buyer and a seller) that is accompanied by some rights. The contract is that the buyer has the right to buy or sell the asset for which the contract is signed, before the agreed expiry date of the option or on the expiry date but has no obligation to sell or buy the product (Ehrhardt and Brigham, 279). In the case of Sara and GES, the option is an offer to buy the company’s common shares and the shares bought should be held for more than five years before they can be re-sold. The option gives the buyer the right to buy and sell the asset under the contract and so if the buyer accepts the offer and exercises his or her rights, the seller has an obligation to sell the asset or even buy it at an agreed price. In the case of Sara and GES, she has been offered to buy common shares at a set price each year like other employees. She has been offered the options for 30 common shares at a price of $7 to be exercised till December 31, 2012. The seller has selected $7 as the price yet the current trading price for GES common shares is $ 5 per share (in 2007 it was $3 and in 2006 it was $1). The obligation t sell or buy at an agreed price explains the price set for Sara (Ehrhardt and Brigham pp. 279-180). The reason why Sara has been offered the option in connection to an employment is because of the executive compensation of the company. There are so many types of options. In Sara’s case, it is an executive compensation strategy offered to the management team of GES therefore an employee stock option (Ehrhardt and Brigham pp. 279-280). (h) Based on the information above and the financial statement of GES, Inc. (see pages 7-9), give Sara both an assessment of the Company from an equity holder’s perspective and an indication of how valuable the options offered to her might be now and in the future. Support your analysis with appropriate financial calculations. An equity holder is a shareholder or a stockholder of a company. In the case above, the employees are among the shareholders. They are granted an option of buying common shares at a specified price and allowed to sell before a specific period of time ends. Sara is one of the employees and if she accepts the offer will be among the shareholders. In order to determine how effective the company’s assets are being invested, which is the interest of investors, the return on equity has to be calculated. The return on equity is given by: net Income/Shareholders Equity (Lecture Notes-Financial Analysis; Kennon 2010). Return on equity measures the effectiveness of asset management in order to produce earnings. It measures the company’s potential to grow and profitability. When selecting a company to invest in, it is important to analyse the return on equity after some period of time for example, 3-5 years. A company that can produce more profits from its asset management is the best to invest in. High return on equity shows high potential to grow and high profits. This applies when a firm has no or little debt. With high profits and less debts, the shareholders can withdraw the cash and invest in other businesses. The following assessment gives GES position important for investors (employees including Sara) in decision making on whether to invest or not and on the value of the shares they have been (Sara has been) offered. Assessment of GES Inc ROE= Net Income/Shareholders Equity This is derived from: ROE = ROA x financial leverage Where: ROA = net margins x asset turnover Net Margins = Net Income/Sales Asset TurnOver= Sales/Total Assets ROA= (NI/Sales) x (Sales/Total Assets) = NI/A Financial leverage (Equity Multiplier) = Assets/Shareholder Equity (A/E) ROE = NI/A x A/E ROE = Net Income (NI)/Equity (E) (Lecture Notes-Financial Analysis). Calculate ROA for the year ended 2009 ROA= Net margins x Asset turn Over Net Margins = Net Income/Sales GES Inc. Net Income= 14,000 GES Sales= 120,000 Net Margins = 14,000/120,000= 0.1167 Asset Turn Over = Sales/Total Assets GES Sales =120,000 Total Assets = 274,000 = 120,000/274,000 = 0.43795= 0.438 ROA = 0.0511146 ROA = Net Income/Total Assets = 14,000/274,000 = 0.051 Financial Leverage for the year ended 2009 274,000/ 40,000 = 6.85 2009 ROE = 0.051x 6.85 = 0.34935 OR = 14,000/40,000 = 0.35 (Net Income/Equity) = 35% ROE for the year ended 2008 = (Net Income/Equity) = 6,500/26,000 = 0.25 = 25% ROE for the year ended 2007 = 2,000/19,500 = 0.103 = 10.3 % The ROE of the Company = [(2,000 + 6,500 + 14,000)/3]/ [(19,500 + 26,000 + 40,000)/3] = 7500/28500 = 0.263 = 26.3% GES had an ROE of 10.3% in 2007, ROE of 25% in 2008 and an ROE of 35% in 2009. This data shows some improvement in the growth of the company each year. As noted earlier, ROE measures the potential of the company to grow and the kind of returns it achieves out of managing its assets. The value of the shares can improve with time based on the analysis shown above. Q11 Advise the Board. Can it proceed with the transaction? Explain why or why not. The only applicable law in this case is the Supreme Court of Canada decision in BCE. The Supreme Court of Canada overturned the Quebec Court of Appeals decision on BCE Inc Vs 1976 Debenture holders. In the BCE case, there was an arrangement which led to the acquisition of BCE outstanding shares through leveraged buyouts. The shares were purchased at 40%more than the market price. The purchasers acquired the firm through borrowed money which a different company (Bell Canada) was to guarantee 30 billion of BC’s debt. This transaction was approved by shareholders but some debenture holders of Bell Canada opposed it. Because of the increased interest, the trading value of short term debentures reduced almost by 20% and this could make the bonds lose their investment grade status. The debenture holders who opposed the arrangement went to court to seek remedies under Section 241 of the Canada Business Operations Act and Section 192 of the Canada Business Operations Act which challenges the arrangement on the basis that it is not fair and reasonable”( Lang Michener LLP 2009). Section 241 of the CBOA (Oppression remedy) gives a complainant the right to sue a corporation for oppressive, unfair actions or those actions that do not regard the interests of the creditor, shareholders, officer or director. The QCA ruling dismissed the debenture holder’s actions. The Supreme Court of Canada ruled that under Section 192, the corporation should prove that: “1. The statutory procedures have been met (2) The application has been put forward in good faith and (3) the arrangement is fair and reasonable” (Lang Michener LLP 2009). Number three has other specifications which are: (a) “The arrangement has a valid business purpose and (b) The objections of those whose legal rights are being arranged are being resolved in a fair and balanced way” (Lang Michener LLP 2009). The assessment on claim of oppression required that analysis be conducted in two parts which are; To find out if the evidence supports that the action is not reasonable as the claimant asserted considering the size of the corporation, commercial practice, the relationship between the parties, the failure to discuss protections and come to an agreement, the structure of the corporation, the fair resolution of conflict of interest, the nature of the corporation, the representations and agreements. To determine if the evidence proves that the creditors’ or other stakeholder’s reasonable expectation was violated in accordance with the definition of oppression, unfair disregard or unfair prejudice (Lang Michener LLP 2009). Reference can be made to the Supreme Court’s decision on this case when dealing with GES’s case. The Supreme Court of Canada held that under oppression remedy, the claimant has the burden to prove oppressive actions or unfairness while in section 192, it is the corporation with the burden of proof to establish that the action was reasonable and fair considering parties whose legal rights have been arranged (Lang Michener LLP 2009). In GES’s case, the transaction cannot continue because the creditors of the company can pursue the legal remedies of oppression remedy and can challenge the arrangement as unfair and unreasonable in relation to section 192 of the Canada Business Corporations Act. If the Corporation can prove that the action was reasonable like it is noted that the corporation had obtained a fairness opinion from a reputable firm that the action is fair and the claims of the action being oppressive dismissed according to analysis of evidence provided by the claimant, then the corporation can continue with the transaction. GES cannot continue with the transaction because; 1. The proof the corporation has is only that the transaction is fair to shareholders. There is no proof that the transaction will be fair to other stakeholders like the creditors. In this case it is the creditors that will sue the corporation. According to the information provided, GES has long term debt from creditors (1998 Bonds, which mature in 2018 and have a 10% rate of cumulative interest. When issued, the bonds did not have an investment grade rating, but as of April 2009 they did). 2. The debenture holders can prove that the action is oppressive. As at 2009 April, the bonds to long term investors (creditors) had an investment grade rating. GES transaction increases the interest. The shares of the company went for $15 but were bought at $20. With $5 increase the interest rate will also increase. According to GES’s Income statement, the basic earnings per common share is 2.80 and the diluted is 2.55. In this case, the basic earnings per common share will be used to prove unfairness and oppression (Lang Michener LLP 2009). If $15 corresponds to 2.80, what of $5? 15=2.80 5= 2.80/15 x 5 = 0.93 20 = 2.80/15 x 20 = 3.73 The interest rate has increased by 0.93. % Increase = 0.93/2.80 x 100% = 33.21% Any Increase in interest rate decreases the market value for bonds. An increase by 33.21% can decrease the market value of the bonds back to junk bonds having no investment grade rating. As at April 2009, the bonds had risen to reach the level of investment rating. An increase in interest rate can decrease their value to unrated level. Works Cited Bouchoux, Deborah E. Business Organizations for Paralegals. 5th ED. Aspen Publishers, New York, USA. 2009. Cardis, Joel., Kirschner, Sam and Richelson, Stan. Venture Capital: The Definitive Guide for Entrepreneurs, Investors, and Practitioners. John Wiley and Sons, New York, USA. 2001. Costales, S. B. And Szurovy, Géza. The Guide to Understanding Financial Statements. 2nd Ed. McGraw-Hill Professional, London, UK.1993. DePamphilis, Donald M. Mergers, Acquisitions, and Other Restructuring Activities. 4th Ed. Oxford, UK. Academic Press, 2007. Ehrhardt, Michael C. And Brigham, Eugene F. Corporate Finance: A Focused Approach. 3rd Ed. Cengage Learning, Sydney, Australia. 2009. Focardi, Sergio and Fabozzi, Frank J. The Mathematics of Financial Modeling and Investment Management. Vol. 138. John Wiley and Sons, New York, US. 2004. Kennon, Joshua. Return on Equity - The DuPont Model: Analyzing the Three Components of Return on Equity. Retrieved on 11th Feb, 2010 from: http://beginnersinvest.about.com/od/financialratio/a/aa040505.htm Lang Michener LLP. The Supreme Court of Canada’s BCE Inc. Decision: Essential Advice for Directors, Creditors and Commercial Litigators. Publication. Published on February 24, 2009. Retrieved on 12th Feb, 2010 from: http://www.langmichener.ca/index.cfm?fuseaction=content.contentDetail&ID=10468&tID=244. Leach, J. Chris and Melicher, Ronald W. Entrepreneurial Finance. 3rd Ed. Cengage Learning, Sydney, Australia2008. Read More