Accounting Troubles at Lehman Brothers (#101)

In this podcast episode, we cover the underlying accounting issues that contributed to the collapse of Lehman Brothers. Key points made are:

• Lehman improperly accounted for repurchase agreements, recording sales of the securities held as collateral, without any offsetting repurchase liability. Normally, these agreements are legitimately used as window dressing at month-end to make the balance sheet look better, but are not recorded as sales.

• This approach gave users of Lehman’s financials the false impression of having higher-quality assets than was really the case, by making the firm look less leveraged. At the time, they had a 17:1 debt to equity ratio, and proper treatment of these transactions would have increased the ratio even more.

• They pushed the envelope by stretching the accounting rules, which would not have been possible under principles-based accounting, such as IFRS.

• They essentially made up their own accounting rules, and the auditors (Ernst & Young) went along with it, based on a legal opinion from a British law firm. EY also knew of the practice for a number of years prior to the financial crisis.

Related Courses

Fraud Examination

Fraud Schemes

GAAP Guidebook

A Look Back at the Podcast (#100)

In this podcast episode, we discuss what has happened to the show during the preceding 99 episodes, spanning about four years. Key points made are noted below.

I hardly ever talk about the podcast itself, since that’s not why you listen to it. Still, I figure doing this once every hundred episodes won’t bother people too much.

Recording the Podcast

I started Accounting Best Practices about four years ago, with some very basic recording equipment.  The first couple of episodes were horrible. You may have heard about how easy it is to record a podcast, but it’s more difficult to do one that actually sounds good. So, I spent about $500 for some basic equipment, and posted the episodes on iTunes, and then took them right back down again.

And then it took about a year to swap out all of the equipment and get everything working just right. So now I record through a professional-grade microphone, which then goes through a bunch of rack-mounted filters that stack about a foot high, and then it’s stored in a Marantz digital recorder. The full rig ended up costing about three thousand dollars.

I need all of those filters because my voice is not the best. In fact, it gets so gravelly that I can’t record before ten in the morning or after four in the afternoon. And on top of that, I speak with very strong sibilance, which is the “S” sound, so one of the filters is called a de-esser, which reduces the “S”. In fact, if I crank up the de-esser too much, it sounds like I have a lisp.

Once I had the recording system figured out, I went back and re-recorded all of the earliest episodes and reposted them. I also got a professional voice talent to record the introduction. There have been a couple of versions, but I think the latest one is the best. It’s done by Emma, who’s located near London.

The Show Format

I also kept altering the format of the show. There were some pretty long shows for a while there, with multiple segments. I finally altered the format to match another podcast, called – believe it or not - Grammar Girl. Grammar Girl is about using the correct grammar, and she has quite a large following.

What I liked was that she blew through the intro really fast, and told you what the episode was about within just a few seconds. That way, you’d know immediately if you wanted to listen to the rest of the podcast. And that’s where the seven-minute episodes come from, with just one topic on each episode.

Interviews

The next thing I wanted to do was get in some interviews. So I called around and recorded a few talks with other accounting authors, and even got some decent interviews with companies that put out accounting products.

The trouble is, companies just don’t believe it when you offer them free marketing, so most of the places I contacted either didn’t return the call at all or else acted really suspicious. So, after way too many calls to line up interviews, I finally backed off. It’s just too difficult. So, there may be occasional interviews in the future, but there won’t be very many.

You also may have noticed that I had a partner for a while there, named Ralph Nach. It was great to have him, because Ralph is an accounting trainer, and he really knows the subject matter, and he also talks better then me. I’d love to have him back, but this podcast is not a minor commitment. I spend three hours to create every seven minute episode. Ralph wasn’t doing any of the production work, but he sure as hell was doing a lot of the speaking preparation, and after a while, it just took up too much time.

The Number of Listeners

Speaking of commitment, I started doing this as marketing for my books, of course, but there’s no way that extra book sales pay me back for all the time required. I think the real issue driving me is just the number of listeners, because there really are a lot, and that creates an obligation to keep going.

So far, there have been 626,000 total downloads, and that works out to 6,300 downloads per episode. That doesn’t mean that there are 6,300 regular listeners, though. There was a huge spike in downloads back in February of 2007, when the show was featured on iTunes. In case you’re wondering what kind of impact that has on a show, the download volume per month went from 11,000 in January of 2007 to 58,000 in February, and right back to 11,000 in March.

Episode Popularity

In terms of popularity, the most downloaded show of all time was number 58, which was about forward-looking statements. But that was during the iTunes spike that I just mentioned. Outside of that one-time hiccup, the original series on accounting controls has been the most popular, with about 10,000 downloads each.

Copyright Issues

I haven’t copyrighted anything about Accounting Best Practices, so if you want to copy it, pass it around at work or at school, then of course, go right ahead. I would like to hear about how you’re using it, just for my own edification. So far, I’ve heard from an oil company in Bahrain that keeps a copy for its accounting staff, and the same goes for a master’s degree program in Singapore.

Parting Thoughts

The strange thing is how little I hear from anyone. If you like the podcast – then, please – go to iTunes, look up the podcast, and right a review. Also, if you have any suggestions for future shows, then please send me a message. My e-mail is bragg.steven@gmail.com.

And finally, about advertising. I don’t intend to allow any on the show, because it’s already there. I usually plug one of my books at the end of each episode, and that’s enough. Accounting Best Practices is all about giving you some good, usable information, and I’m not going to water that down with a bunch of additional advertising.

The Non-Deal Road Show (#99)

In this podcast episode, we cover the mechanics of a non-deal road show. Key points made are noted below.

Types of Road Shows

A road show is one of two things. You’re either going on the road to generally talk about the company to the investment community, or you’re going on the road to raise money. The approach is different for each one, and I’m going to tackle the first version now. In the first case, it’s called a non-deal road show, because you’re not trying to raise money. You normally schedule a non-deal road show right after you’ve released your quarterly results on a Form 10K or 10Q. With this timing, you’ve just made all of your financial information public, so it’s fairly difficult to say anything during a presentation that’ll get you in trouble.

Road Show Destinations

So that’s the timing. Another issue is, where do you go? Well, a non-deal road show should move around the country, so you don’t keep visiting the same people over and over again. If you keep going to the same place and talking to the same people, then nobody new finds out about your stock, and that means that nobody new buys it. And if nobody is buying your stock, then why have a road show at all?

The People You Meet

Now, a non-deal road show is about meeting people in volume. To be successful, you should meet with a lot of people within just a few days. Chances are, you don’t even remotely have the contacts to personally line up a road show. Instead, you use an investment bank or an investor relations firm. They line up the investors and brokers, and then you just show up and do the presentation.

Most of these presentations are to stockbrokers, because there’s a multiplier effect. You talk to them, and then they turn around and talk to their clients about you, so by talking to a couple of hundred brokers, you end up reaching potentially a couple of thousand investors. Now brokers are a different breed. They can show up late and wander out early, and their dress code can be absolutely unique. You may see more sneakers than suits, and I’ve run across a lot of Hawaiian shirts in these meetings, too. And if you offer alcohol, they will take advantage. My favorite was the guy who ordered a beer, and drank it off, and then got it filled to the top with wine – twice. And that was a lunch meeting.

Anyways, the main point is that a broker is coming to your meeting, so treat him with respect. Offer him a decent meal, if you’re doing a lunch meeting, and keep the presentation short. Absolutely do not go droning on in a broker meeting. These people have very little time to listen to you, so get the presentation over with fast – say 15 or 20 minutes – and then open it up to questions.

Road Show Questions

And you will get some very interesting questions. Keep in mind that brokers rarely research your company in detail, so their questions can be really off the wall. My favorite was when the CEO and I were presenting a company that did geographic information systems, like land grid, and somebody asked how we competed in the market against Russian spy satellites. Oh boy. Still, after a few meetings, you’ll have heard just about every possible question, so the meetings do become more routine.

Building a Mailing List

A non-deal road show is not just about presenting information. You also want to build up a mailing list of the folks you’ve met. A good way to do this is to offer a door prize, and people have to put a business card into a pot in order to qualify for it. Then you bring back all the cards and dump them into a database.

One door prize that we used on one trip was a really nice book about recipients of the Congressional Medal of Honor. The reason for that was that one of our board members had been awarded the Medal of Honor, and we got him to come along on the road show and do a short speech. Since he’s a fairly well-known television commentator, that really helped to bring people to the meetings. The problem was that at one of the meetings, a stockbroker walked off with the book – just stole it – so we had to order another book for the person who actually won the prize.

The Road Show Presentation

Now, because you’re dealing with a lot of people, you really need to have a presentation on a projection screen. It’s not workable to just hand out a PowerPoint binder and walk them through it – though there should be a handout.

This type of presentation has some implications. First, you will need a lot of handouts, so you have to lock down their contents before the trip starts, print out a bunch, and either lug them around or mail them ahead to the various hotels. If you’re doing multiple cities – sometimes several cities in one day – then it can be tough to link up with the handouts if you mailed them ahead.  For that reason, I prefer to carry quite a few with me, and then replenish the supply from whatever we already mailed ahead.

As for the projector, I prefer to drop that one on whoever is organizing the trip, so that they supply it. And then I bring another one as a backup. I’ve never had a projector fail, but of course, having said that, it’ll probably blow up on the next trip.

Another issue about a non-deal road show is that you’re talking in front of a lot of people. And let’s face it, most accountants are a pack of introverts. We don’t like to do this. The worst I’ve ever seen was at a CFO conference in London. I was presenting, but I had some time off, and so I sat in on someone else’s presentation. And this poor guy was dying – sweat just dripping off him, and he had to keep stopping to wipe the fog off his glasses.

There are some ways to avoid that. Before the trip begins, stand up in front of an empty room and run through the speech four times. At least, that’s the number I use. I find that I screw up a lot on the first pass, but that I’m not really getting much better after doing it four times, so that’s a good stopping point.

The other thing you can do is just before the presentation. Stand in the doorway to the meeting room, and greet everyone who comes in. You don’t necessarily have to shake hands, but make eye contact and say something. If you can engage in some small talk, that’s even better. Then, when you look out on the audience for your speech, you at least have a little familiarity with the audience. This really helps.

Now, to turn that around, that means you do not stand off a corner in a little group before the presentation starts. You really, really should mingle with the audience.

Non-deal road shows get a lot easier over time. After you’ve done a couple, you only need to tweak the presentation each time, so there’s less need for any sort of elaborate dry runs. And also, you’ll have already been hit with every possible question, and you’ll know how to answer them.

It still makes sense to have someone review the presentation and make suggestions every now and then, so it doesn’t get too stale, but that’s basically it. So in short, a non-deal road show is about spreading the word in a canned presentation to a lot of people. It’s more stressful at the start, but it gets easier over time.

Related Courses

Investor Relations Guidebook

Public Company Accounting and Finance

Dealing with Investment Bankers (#98)

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

Role of the Investment Banker

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

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

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

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

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

Investment Banker Fees

This all sounds great, but what do they cost?

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

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

How to Obtain Investment Banker Services

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

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

The Fund Raising Time Line

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

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

The Best Investment Bankers

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

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

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

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

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

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

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

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

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

Related Courses

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Corporate Finance

Treasurer’s Guidebook

Recording Revenue at Gross or Net (#97)

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

The Two Revenue Recordation Methods

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

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

Presentation Impact of the Methods

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

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

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

Which Way to Record Revenue

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Related Courses

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Recording Reimbursed Expenses as Revenue (#96)

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

Reasons Why Reimbursed Expenses are Recorded as Revenue

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

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

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

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

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

Reasons Why We Should Not Do This

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

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

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

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

Related Courses

Revenue Recognition

Rule 10b5-1 Trading Plans (#95)

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

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

Rule 10b5-1

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

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

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

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

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

Cancelling a Trading Plan

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

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

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

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

Using Short-Term Trading Plans

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

Parting Thoughts

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

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Rule 144 (#94)

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

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

Overview of Rule 144

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

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

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

Rule 144 Requirements

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

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

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

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

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

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

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

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

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

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

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

How to Remove the Certificate Legend

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

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

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

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

Parting Thoughts

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

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

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Registration Statements (#93)

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

The Need for a Registration Statement

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

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

Registration Statement Exemptions

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

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

Types of Stock Registrations

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

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

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

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

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

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

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

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

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

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

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

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

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

When a Registration Statement is Effective

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

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

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

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

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The Product Cancellation Decision (#92)

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

The Need to Cancel Products

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

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

The Cancellation Calculation

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

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

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

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

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

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

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

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

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

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

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

The Ramifications of a Product Cancellation

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

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

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

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

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

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FASB Statement 165, Subsequent Events (#91)

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

FASB Statement 165

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

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

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

The Recognition of Subsequent Events

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

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

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

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

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

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

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

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

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

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

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

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

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

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Regulation A Stock Sales (#90)

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

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

The Regulation A Exemption

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

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

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

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

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

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

Advantages of Regulation A

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

Regulation A Steps to Follow

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

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

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

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

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

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

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

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

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

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Regulation D Stock Sales (#89)

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

When to Use Regulation D

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

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

The Accredited Investor

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

How to Find Accredited Investors

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

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

The Stock Restriction

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

Investor Motivations

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

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

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

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

Parting Thoughts

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

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

Related Courses

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Types of Acquisitions (#88)

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

The Requirements to Defer Taxes

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

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

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

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

Buyer and Seller Motivations

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

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

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

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

Types of Reorganizations

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

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

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

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

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

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

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

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

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

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

Related Courses

Business Combinations and Consolidations

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The CFO Position (#87)

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

What a CFO is Not

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

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

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

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

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

What Does a CFO Do?

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

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

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

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

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

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

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

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

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

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

Parting Thoughts

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

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

Related Courses

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Credit Best Practices (#86)

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

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

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

The Credit Policy

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

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

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

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

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

Information Collection

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

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

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

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

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

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

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

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

Credit for Large Customers

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

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

When Customers are in Trouble

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

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

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

Related Courses

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The Acquisition Term Sheet (#85)

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

The Term Sheet

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

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

Why Use a Term Sheet?

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

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

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

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

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

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

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

When Used as a Binding Commitment

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

Term Sheet Contents

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

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

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

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

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

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

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

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

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

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

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

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

Related Courses

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Taking a Company Private (#84)

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

When to Go Private

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

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

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

Methods for Going Private

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

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

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

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

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

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

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

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

Other Issues with Going Private

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

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

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

The Risk of Shareholder Lawsuits

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

Parting Thoughts

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

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

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

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Accounting from Home (#83)

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

Reasons to Work from Home

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

How to Make it Work

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Accounts Payable Matching (#82)

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

What is Accounts Payable Matching?

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

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

When Not to Do Matching

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

Use Two-Way Matching

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

Allow Larger Variances

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

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

Use Automated Matching

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

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

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

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

Use Evaluated Receipts

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

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

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

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

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

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

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

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