Category Archives: Notes from a non-exec

Is management telling the whole story?

Info graphic The company was in financial difficulties, as changing market conditions had seriously exposed the misplaced strategy. There was however no suggestion that anything improper had gone on. The external auditors were high quality, and there was a competent internal audit team with appropriate risk models.

Yet something didn’t feel right. Whilst the strategy had failings, the execution must also have been wrong, yet none of the KPI’s showed anything wrong. Eventually, management admitted that they had changed an accounting policy to capitalise losses, and then report the lower numbers. The figures that the board had been looking at, and relying on, were in fact useless and misleading.

Fortunately, outright distortion of data for a board is very unusual. However, a board can only work successfully if it knows all the salient information. A board cannot know everything that matters. It just doesn’t have the time. With luck, executive management will know most of what really matters. It will then brief the board on what it thinks the board needs to know. This will be supplemented by knowledge that non-executives glean from other roles and sources.

The prime source of information for non-execs is therefore what the executives choose to pass onto the board. NEDs can of course ask further questions, and this will elicit further information. Non-execs need to spend some time trying to crosscheck information. One way to do this is to look hard at the standard performance indicators (KPI’s) given in board papers.

A new non-exec might be surprised at how often a KPI appears to contradict what management is saying. It is worth challenging this, as the explanation is usually illuminating. It may well be that the KPI is being distorted by a one-off factor. Sometimes, this provokes a useful discussion as the distorting or one-off factor may be being forgotten. It may be that the question is followed by an awkward silence as the CFO starts flicking through his packs to find a reason. This may itself trigger a concern in your mind.

Management is likely to present information in a way that fits with its view of the world. This is perfectly natural. However one of the roles of independent non-executives is to be independently minded, and even to apply a little ‘devil’s advocacy’. The executive team is quite likely to be pulling one way under the CEO, so the NED’s can play a vital counter-balancing role.

If someone in management does decide to distort (or ‘re-present’) the data, it will be very difficult for a non-exec to detect. In my example, neither internal nor external audit spotted a change in an accounting policy, let alone reviewed if it was the right thing to do. Non-execs should not expect auditors to spot such problems. They may do so. They may well see such an event so early that it is corrected before the board even hears about it. But the auditors feel no responsibility for internal management performance data (even if, as here, the data was subsequently published). Internal auditors will only take responsibility if they are directed to review the performance measure itself.

You should expect any material change in accounting policies to be presented to, and approved by, the Audit Committee. This is an important check and balance for non-execs. It is also however worth asking whether any changes in accounting policies, treatments or estimates might have had an effect on important KPI’s.

If you spot an issue through advance reading of the board papers, it is good etiquette to ask the initial question before the meeting. If the answer is easy, then it can be dealt with quickly. If the response suggests to you that there is a real issue, it gives you a chance to raise this in the subsequent board meeting, at which management have had notice of the point you will raise and so will not feel ambushed.

If something doesn’t feel right, especially if the management narrative doesn’t seem to fit with some of the numbers or the KPI’s, it is worth asking questions. You may need to start out by asking apparently dumb questions. You will be surprised at how often an apparently stupid basic question elicits a very revealing reply. You may well find that one question leads to another and so on. It is worth persisting until you have an answer that satisfies you. Of course, it may be better to ask these question outside of a board meeting. Your colleagues will thank you for saying that you will take the issue up after the meeting and report back if anything material arises, rather than elongate a board discussion at the time. It may also be more comfortable for management to research the answers rather than to be put on the spot in the meeting.

 Summary

 

  1. Boards thrive on good information. Most of it comes from management and from regular board reporting, such as financial statements and KPI’s.
  2. Most management teams try to provide the best, balanced information that they can.
  3. Occasionally, information can have a little spin added or even be distorted, and this can be challenging for non-execs to spot.
  4. Try to cross-refer information with financials and KPI’s. If there are discrepancies, or things just don’t feel right, ask about them.
  5. Watch how any change in accounting policies might affect KPI’s.
  6. Keep asking questions to drill down to get the answer you want, but not necessarily at a board meeting itself.
  7. Look for help from auditors, but do not rely on them. If unsure, ask the internal auditors to do a specific project on the area concerned.
  8. Use the time between meetings to gain information and establish if there is an issue, but feel free to raise the issue at the meeting for discussion and to alert everyone to the point.

 

 

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Just say ‘No’ – assessing an offer for your company

 

Hand of cards.jpg

In previous articles, I covered how a board should react to an unsolicited approach or offer for the company, how it would value it, valuing shares versus cash offers, whether it’s friendly, unfriendly or hostile, and irrevocable commitments. Here, I am going to look at the different sorts of offers that you might receive as a board and how you might respond.

The ‘knock-out’ offer

This is an offer that you think is so good, that you and your advisers want to accept it without much ado. You will want to be sure that the offer is ‘real’, ie that the offeror will carry through on it and has the means to do so. Assuming that you are happy with this, you can proceed onto the next stage, due diligence. Beware, of course that the bidder may use the information gained in due diligence to justify reducing their offer in the same way that house buyers sometime use structural surveys to negotiate a lower price.

The ‘interesting, but not enough’ offer

This is a very common type of offer. It isn’t high enough, but it’s enough that you can’t dismiss it out of hand. Typically every first offer is rejected as inadequate and very rarely do bidders put their final offer in first. Your advisers might describe this offer as ‘well judged’. It is high enough to show they are serious, and, since everyone assumes they would be prepared to go higher, it may be difficult for the target board not to engage with them.

The target board can respond in a number of ways;

  1. A straight ‘No, thanks’ and a refusal to engage. This is confusing for the bidder, as they want to know whether the board is refusing to engage at any price or whether it is just waiting for a higher price. Almost certainly there will be adviser-to-adviser contact as the bidder tries to understand this. Faced with a brick wall ‘No’, the bidder has a number of options; to move to a ‘knock out’ offer; to go away, at least temporarily; or to appeal directly to the target’s shareholders.
  2. A ‘Not at this price’ response. This is a come on, suggesting that the offer is close but not quite high enough. The bidder may then seek guidance from the target’s advisers as to what price would be acceptable. The target board’s advisers may or may not provide such guidance. It doesn’t really matter as this is now a negotiation. This is quite common and most ‘agreed’ mergers will have gone through a few private rounds of offers, refusals and improved offers.
  3. A ‘Not at the moment’ response. There may be a non-price reason why the target board doesn’t want to talk at that moment, and the message may go that the time isn’t right. This could typically be when a new CEO has just joined and the board wants to understand what the new person thinks they can achieve. Alternatively, the target board may be aware of a price sensitive development that it thinks will boost the share price, such as a new product launch or new contract.
  4. An ‘Interesting, but there’s more you need to know’ response. This can be linked to the last point, as for some reason the target board believes that outsiders don’t fully appreciate its value. It offers to ‘lift its skirts’ to tempt the bidder to make a higher offer. The target offers due diligence access to financials and/or commercially sensitive data on the clear condition that it won’t accept the original offer, but is prepared to help the bidder come to a higher value. This would be a common situation, particularly for a private or specialist company.

The ‘insult’ offer

There are several reasons why a board might receive an offer so low that it regards it as insulting. The bidder might be playing a PR game, prior to going hostile. The bid price mysteriously leaks into the market, which may hit the target’s share price. It can become accompanied by negative comments about the target company, its products or management. This used to be more common in the 1980’s when companies could take out adverts knocking target boards. Alternatively the bidder may just be trying it on, just to see how strong the target board is. If the target engages, the offer may yet be lifted to an acceptable level in time. Although the offer may feel insulting, the target company is best advised to react coolly and professionally, making great efforts to ascertain the real motivation of the bidder. However dubious the bidder’s methods, institutional shareholders rarely applaud a public fight about them.

 The ‘Spurious’ offer

This is an offer where the target doesn’t believe that the objective is to succeed. The most obvious would be where a competitor bids, perhaps with the objective of getting confidential information from the process. In this case, the target board may either refuse to engage, or decide that it is prepared to entertain an offer, but won’t provide due diligence information. The bidder will then have to bid with either publically available information only or heavily redacted private information.

The ‘I want to join the party’ offer

This is where an offer has been made by someone else, and others then also knock on your door. They may do so in order to gain information, especially if they are competitors or private equity interested in the sector. They may also do so if there is a regulatory inquiry. When Morrisons and Safeway announced a merger in 2003, Sainsbury, Tesco and Wal-Mart all announced their intentions to make an offer. This had the effect of ensuring that the original offer, together with the new ones, would get referred to the Competition Commission, and possibly blocked or at least delayed (ultimately by 14 months). It also meant that the competitors had a seat at the table with the Competition Commission, although the Safeway board refused to give those competitors any due diligence.

Non-price considerations

I have covered only the share price here for simplicity. The board may take other factors into account, although, especially in a public or private equity company, price is likely to be the dominant factor. Once the price has been broadly agreed, then non-price factors, such as keeping factories or production, may come more into play, as the final details are negotiated.

Summary

  1. Most first offers will be rejected, as the first offer is very unlikely to be the final one.
  2. ‘No’ can mean ‘No’, but it can also mean ‘yes, at a higher price’.
  3. Not all offers are equal. Some are real and some have different motives.
  4. Make sure that an offer is deliverable, especially if it looks too good to be true.
  5. Offering due diligence can be a key negotiating tactic.
  6. If you don’t think the offer is really genuine, don’t feel that you have to engage.

An unsolicited approach: Let battle commence

Boudicca soloMy earlier article talked about how a board should respond to an unsolicited approach for the company. This looked at a straight-forward offer that the board has to review and accept or reject. However it’s not always so easy, as much depends on the attitude and tactics of the offeror.

The chairman of one of my competitors, calling out of the blue, explained that they were about to offer for my company. They had already spoken to my two biggest shareholders, who had signed irrevocable commitments to vote their shares in favour of the offer. Since their combined shareholding was pretty much 50%, the chairman explained, it was just a matter of us handing over the due diligence they required, and the deal would be done. This is what is known in polite terms as a ‘bear hug’, and would be classed as an unfriendly approach.

Friendly or unfriendly?

The tone for an offer will inevitably be set by the offeror’s first contact with the target. That initial approach could be direct to your chairman or indirectly via your advisers. It can be made on an exploratory, friendly basis; such as, “We think that this is a good idea. Would you be interested in exploring it further?” It could be on a firm, but friendly basis; as in “Here is an offer at X pence per share. Would you consider it and perhaps we can talk about it further?” Or it can be delivered as an unfriendly ultimatum. A ‘bear hug’ is where either the initial price is a knock-out one or sufficient target company shareholder support has already been secured behind the board’s back. In either case, the offeror aims to position the target board so that it has no option but just to accept the offer.

So why do some offerors start off unfriendly? There are a number of possible reasons;

  1. The offeror believes that the target board will not act rationally in the interests of its shareholders. There is therefore no point in trying to be friendly.
  2. The offeror believes itself to be in such a strong position, through a high price or shareholder support, that it does not need to be friendly.
  3. Either the offeror or its adviser is innately aggressive and believe that being unfriendly is a good tactic.

In my experience, none of these reasons are very good ones. Most boards will, in the end be rational, and will be urged to be so by their advisers, acting in their own view of shareholder interests. A powerful offer is not weaker for being friendly. In this example, I think that the competitor believed it was in an unassailable position, and it was counselled by poor quality advisers to deliver the offer as an ultimatum.

What are irrevocable commitments?

To the man in the street, an irrevocable commitment is one that you cannot get out of. However, in the streets of the City, nothing is ever that simple. It is imperative therefore, that the target board gets hold of either the actual irrevocable document or an impartial summary. From my experience, you cannot rely on a summary produced by the offeror or its advisers.

The key point is that an irrevocable commitment can have conditions attached to it, ie actually be revocable.   The UK Takeover Panel, which tends to take a legalistic approach, will even allow a revocable agreement to be called ‘irrevocable’ in public announcements. However it can take a tougher line if an announcement adds more detail to the ‘irrevocable’ without also giving any explanation of material conditionality.

In my example, one of the ‘irrevocables’ was conditional on my board actually recommending the offer. This was not therefore a true ultimatum, as the board duly rejected the offer and the irrevocable fell away. The stranglehold that the offeror thought it had was dependent upon not revealing the true nature of the shareholder commitment.

Cash and shares

A cash offer has a value, which should be unchanging and clear. However, if the offer is in shares, neither of those may be true;

  1. The offeror’s share price may move on the announcement, either up or down, depending upon shareholders’ views of the attractiveness of the bid.
  2. The offeror’s share price may move during the process as a result of market moves or new developments.
  3. If the offeror’s shares are trading at a premium, the target board will need to consider what the ‘true’ value of their shares is.

A share offer is therefore inherently uncertain. Furthermore, if the nominal share offer is increased, it may not result in a higher effective price. For example, if an offer in stock is increased, but the offeror’s shareholders think that this is too high, then the offeror’s share price may fall. This then reduces the value of the offer.

The relative share-price premia need to be considered. Take a property company offering for another very similar one. The offeror is likely to feel strong enough to make the offer because it has a healthy premium to its net asset value. Let’s say that it has a 20% premium, whereas the target trades at NAV. The offeror may offer a 10% premium for the target’s shares, but in practice the target shareholders would still be left owning a lower NAV per share than before. The same could be true of earnings per share, but synergies may soften this.

Advisers

A board should ensure that it has good advisers. There is no substitute for good, experienced advice, and preferably from more than one source. The best chance of getting a deal done is also for the other side to have good advisers too. I have known situations where one side even recommended particular advisers to the other party. The worst situations are always when the other party (offeror or target) has inexperienced, out of their depth or macho advisers.

Summary

  1. If an offer comes in on an unfriendly basis, there is a good chance that it will end up hostile.
  2. Keeping the process ‘friendly’, at least initially, should be in everyone’s interests.
  3. ‘Irrevocable’ commitments can be anything but. Make sure that you know the full facts.
  4. Be especially careful of offers in shares and what they really mean for value.
  5. Employ good advisers, preferably more than one, and hope that the others do too.
  6. Whatever happens, stay rational and do what’s right for your shareholders.

My next article will run through what tends to happen next following the receipt of an offer.

What if you get an unsolicited approach for the company?

Dangerous gamesI was having a good day, sitting in my office sorting a few things out. Then, late afternoon, the phone rang. It was the Chairman of one of our competitors. I hadn’t spoken to him before, but this was no comfort, as he revealed that they were about to make an offer for my company.

As a non-executive, the first you may hear of an approach like this is when an urgent board meeting is called. There will probably be bankers, possibly lawyers too, at this meeting advising the board on its responsibilities, but this article will cover the basics so that you know what to expect and what questions to ask. It is a practical guide for non-execs, not a legal one, and based on the UK system.

An unsolicited approach

This is exactly what it says. An approach to the board, to make an offer for the company, that was not requested by that board. It may be out of the blue, as in my case, or there may have been some suspicions that it would happen. Some commentators describe every such approach as ‘hostile’, but this is not right.

An unsolicited approach may not be unwelcome, you just didn’t ask for it.

The first task is to assess whether the approach is genuine. This may seem strange, but fake takeover bids have been made. In 2015 a small unheard of company launched a takeover offer for cosmetic giant, Avon, but this subsequently appeared to have been merely an attempt to manipulate the share price. Assuming that the approach is genuine, the next step is to consult your advisers.

The “Rule 3” advisers

The board will need to get advice from its independent advisers (“Rule 3 advisers”). They should give you independent advice on how to proceed. Importantly they will give you a view on the ‘value’ of your company and therefore if any offer is worth serious consideration (“recommendable”).

It is worth at this point making sure that you know the fee structure for your advisers. This should be reviewed and approved by the Audit Committee, but if this offer is a surprise this may not yet have happened. One of the oddities in this process is that the Rule 3 adviser is often heavily incentivised to get a deal done, typically at a higher price than the initial offer. They may get a fee only if a deal happens, or if not, almost certainly an extra fee if a deal actually completes. Against that, a successful takeover may mean that they lose a client. The adviser is usually, on balance in the short-term, financially better off from getting a deal done.

How do they value your company?

The advisers will bring a pack full of numbers. There are two basic ways of measuring; comparables and absolute. The comparables will be using measures such as PE ratios, EV (value of shares plus net debt)/Ebitda, and market cap/net asset value. These may be based on trading multiples in the market or comparable takeover or merger offers. All of these are useful.

Absolute measures will include net present value (NPV) or net asset value (NAV). The NAV will be most useful if the company is a property company, where an acquirer is most interested in just getting its hands on the assets. The NPV is pretty useless. This is because it will tend to be based on management’s forecasts of profit and cash, discounted at an estimate of the company’s weighted cost of capital (WACC). However it generally takes no account of risk, so it’s the value if everything goes to plan (and show me a company in which everything goes to plan). Some will like the NPV valuation as, not surprisingly, it tends to show a value much higher than other forms.

The control premium

You expect an acquirer to offer a price above the current share price. The question the board will face is how much higher should it be to be recommendable? This is the ‘control premium’; the extra an acquirer should be expected to pay to get control of the company, as opposed to just buying some shares. The starting point is generally a premium of 30% above the current share price. This is just a custom and practice benchmark, but nevertheless an important one.

In some sectors, such as property, 30% may be rather high as the bidder may be looking largely just to acquire assets. The comparables of similar deal premia will be helpful as context.

The current share price is usually taken as the price at the close on the day before the Offer is received or announced. However this can be very misleading if the short-term share price has been volatile. It may be better to look at the 3 month average in that case. However, like it or not, markets get very focussed on the spot price.

The Board decision

“Advisers advise, but directors decide.” This is one of the most important aphorisms for corporate governance. The advisers are likely to say, if pushed, whether an Offer is “capable of being recommended”, largely based on the above comparison ratios. The board will then have to decide whether it will recommend. It will want to discuss its own private views of the company’s prospects. Some directors may not believe management’s forecasts are achievable or others may think them too conservative. Some may believe that the company is still undervalued because they see strategic developments that could increase value in the future, while others may believe that there will be trends that will put pressure on value in the future.

The board should always be putting the interests of their shareholders as a whole at the forefront. There may be some shareholders however, who would prefer a deal for other reasons, such as their desire to be bought out. The board should be aware of these individual interests, but keep referring back to the overwhelming interests of all shareholders.

No director would be human if they didn’t think about their own position. An acquired board would be likely to be dismantled and both executives and non-executives may become redundant. Directors should try to ignore their personal interests, however difficult this may be.

The board will also want to consider whether the Offer is really likely to be deliverable. Is the offeror credible? The Offer letter should have details of how they intend to finance the bid; by new equity issued for cash or swapped for the target company’s shares, loan facilities (that should already be lined up) or some combination. What shareholder approval do they need from their side and have they already got support from major shareholders? Are their anti-trust issues, if the offeror is a competitor, supplier or customer to the target?

Do not assume that just because an Offer is being made that the other side can actually deliver on it.

Recommended or hostile?

If the first you hear about an Offer is when it is an RNS or leaked in the media, then it will be difficult to avoid it being hostile. The board will be on the back foot and, unless it is at a knockout price, the board will want at the very least to get the price up.

However, most Offers will come, as mine did, in a private approach. This gives the board time to consult with advisers and consider the matter out of the glare of publicity. The Offeror may apply certain constraints, for example. They may give a deadline for a response, with the threat of going public or withdrawing the Offer if not accepted in time. The former is a very aggressive tactic applied by a party that thinks this will go hostile. The latter is only likely to work if the price offered is a very full one.

In general, however the initial offer will probably not come with threats, so the board is not required to make an immediate response. However, the board may be advised to have a response ready within a week or so to avoid the impression that it is not taking it seriously.

The board’s response can be to;

  1. Accept the first offer, perhaps with conditions. This is only likely if the price is a knock-out one. Conditions could be that subsequent due diligence is completed quickly, cash facilities are verified and that no leaks occur.
  2. Reject, indicating that the price is unacceptable. This is opening the door to further negotiations with the offeror, but only at a higher price.
  3. Reject the offer, saying that the time is not right. This is more of a brushoff, perhaps because the starting share price is unusually low or new management is only just coming on board.

The offeror must now decide whether to give up, to negotiate further on price or conditionality or to go hostile. Unless they do go away, battle will commence. My next article will take you through how the battle lines are drawn and what to expect from there.

Summary;

  1. An unsolicited offer is not necessarily hostile. It becomes hostile when the offeror persists against the target board’s wishes.
  2. Confirm that the offer is genuine and the offeror has the resources to carry it through.
  3. Place great reliance on your Rule 3 Advisers, but don’t take everything they say as gospel. Advisers advise but directors decide.
  4. Use comparables, both relative and absolute, plus the board’s private view of its prospects to decide what value you put on the company.
  5. Expect a control premium to be paid by an offeror.
  6. Try not to let the personal situations of either yourself or other directors influence your position.
  7. The initial offer is very likely to be rejected as too low. The offeror will expect this.
  8. The big decision initially is whether to reject but leave the door open to a higher offer, or whether to try to make the offeror go away.

What are pre-emption rights and why do they matter?

Share certificate

The board is contemplating an equity raise. The brokers and CFO talk in respectful terms about preserving pre-emption rights and what this means for how they raise the new capital. Maybe you, as a new non-exec, are sitting there wondering what is this all about and why is it so important?

However all directors should understand these issues, particularly as shareholders take this very seriously, and may well hold the whole board to account on this.

This article focuses on publically listed companies, as most private companies will have tighter rules on bringing in new shareholders anyway.

What are pre-emption rights?

Pre-emption is simply the right for existing shareholders to buy new shares before others can. For a private company, this would ensure that the board couldn’t issue a large tranche of shares to another party and so dilute an existing shareholder’s holding and voting rights without the latter’s approval.

For a liquid publically listed stock, shareholders will expect pre-emption rights for any significant share issue. Usually the focus is on any price discount being offered on the new shares. Take an example: A company with a share price of 400p places a 1 for 2 share issue at 300p (a 25% discount), without first offering it to existing shareholders. On a pro-forma basis, the existing shareholders would lose 8% of the value of the holdings as the price moves to the blended average price of £3.67. Meanwhile the new shareholders get an immediate gain of 22%. So you can see why the existing shareholders would be pretty cross about it.

Pre-emption rights mean that any significant new share issue for cash should be offered first to existing shareholders in proportion to their current holdings. This means that if they take up these rights, they would not be disadvantaged, as they would get their fair share of any discounts offered.

A new share issue might also be launched in order to provide equity (as opposed to cash) for an acquisition, with the new shares being offered to the target company shareholders. In this case pre-emption would be impractical, so the issue is likely to be whether the price effectively being paid is a reasonable one.

Rights Issues, Open Offers and Placings

Rights issue: All shareholders are offered the new shares in proportion to their holdings, usually at a significant discount to the prevailing share price. In the above example, a 1 for 2 rights issue would simply mean that all shareholders are offered 1 share for every 2 shares they currently hold. This delivers perfect pre-emption, and so is the more popular mechanism for shareholders. A shareholder who doesn’t take up their rights can receive some of the discount value without investing more cash, as their allocated shares are then sold on the market and the price difference remitted back to them. For these reasons, the rights issue is generally the default mechanism for boards when they consider raising equity.

Open Offer: This is similar to a Rights Issue, but any shareholders who do not participate won’t receive any value for any allocated shares that they do not take up. It therefore adds more incentive to existing shareholders to participate whilst retaining full pre-emption.

Firm placing: This offers no pre-emption. The company will have presold the shares to one or more new investors, likely at a discount. This means that other shareholders will not be able to access any of the discount and may feel aggrieved. However, it enables a company to bring in new investors to the equity issue, which is important if it believes that existing shareholders would not be prepared to provide all the extra capital requested.

Placing and Open Offer: This retains partial pre-emption but also enables a company to bring in new investors as well. Existing shareholders are offered a proportion of the new shares in the open offer (pro rata to their holdings), but can also apply for more shares. If demand from existing shareholders exceeds the total allocated in the open offer, then the company may claw back some of the shares allocated to the placing. This therefore gives full pre-emption in the open offer, and partial pre-emption in the placing.

There are other mechanisms and this can become much more complex than this, but these are the essentials.

How does a board decide which mechanism to use?

The key issue is generally whether the board is sure that existing shareholders will buy all, or nearly all, of the new shares. A board needs to take account of pre-emption, but is even more focussed on making the share issue a success. It is not generally in shareholders’ interests for an equity issue to fail, with all the question marks that this would raise about the company.

You might say that companies usually get an equity issue underwritten, so they are sure of receiving the cash. However, by definition, underwriters will only support an issue if they think it will be almost fully subscribed. It is an insurance policy not a subsidy! The underwriters may also force an even bigger discount in the offer/rights share price in order to reduce their risk.

So if a company feels that it needs to bring new shareholders in to make the issue a success, then it is likely to move towards some variant of a placing, possibly combined with an open offer to provide some pre-emption. The board has to reconcile the desires of some shareholders, who insist on preserving pre-emption, with its need for certainty that the shares will be pretty much fully subscribed.

What do shareholders want?

In the UK, the Pre-Emption Group (representing listed companies, investors and intermediaries) clarified its principles in March 2015;

General authority: General meeting resolutions to give the board a general authority to disapply pre-emption are looked upon favourably only for share issues;

  • For up to 5% of the total share capital; and
  • For up to 10% of the total share capital, provided that anything over 5% is for a specific acquisition or capital investment (fully disclosed at the time).

Subsequent share issues:

  • These should be for no more than 7.5% of total share capital over a rolling 3 year period; but
  • If more than 7.5% then only if either shareholders have been consulted, or the reason for the raise was stated with the last general meeting resolution.
  • The 7.5% restricts only the non-pre-emptive element of any share issue. If there is a mix of pre-emptive and non-pre-emptive elements, it applies only to the latter.
  • Any discount offered to shares issued non-pre-emptively is a matter of concern and, except in exceptional circumstances, should be limited to 5%.
  • The 5% discount may be larger for underwriting provided that it is believed to be a backstop, which will not be drawn upon.

Requesting a specific disapplication:

Companies are expected, if possible, to inform shareholders and to discuss with them, any intention to initiate a cash raise, particularly if it is to be non-pre-emptive. Shareholders will expect a strong business case for the raise, covering alternative sources of finance, consideration of the cash raising mechanism, requirement for avoiding pre-emption, and demonstration of good corporate governance and value enhancement.

Consulting shareholders:

Clearly not all shareholders can be consulted, so there is recognition that this is really aimed at large, usually institutional, shareholders. Care needs to be taken as to when any consultation effectively gives the shareholders inside information.

Shareholder voting:

Some shareholders adopt a very purist line on pre-emption. Their corporate governance team may vote their shares against any capital raise which is not almost completely pre-emptive. This can be despite the fund manager being supportive of the board, having understood the need to get new shareholders and to ensure the issue is a success. They may well still buy the shares, even in a non-pre-emptive element. A vote against therefore may be largely symbolic, but given that this is a special resolution, requiring 75% majority, it wouldn’t take many symbolic votes to threaten the issue.

Conclusion

Pre-emption is all about making sure that existing shareholders are not disadvantaged by equity being issued cheaply only to certain shareholders or new investors. This is a highly complex area, and this article summarises only the key points. In a real situation, lawyers and bankers will be on hand to advise in detail. The key point is for boards to be aware that shareholders take a very close interest in pre-emption and directors should understand how the different equity raising mechanisms affect this.

Summary

  1. Pre-emption is about protecting existing shareholders from issuing new shares to others without themselves being offered those shares, particularly when the offer is at a discount.
  2. Rights issues are the most perfect form to offer pre-emption, but are less appropriate if the company believes that it needs new investors.
  3. Placings can enable companies to bring in new investors, and can be combined with, at least partial, pre-emption.
  4. There are quite specific rules on how a company can disapply pre-emption, both as a general authority and for a specific fund raise.
  5. Large shareholders like to be treated properly and consulted as far as is practical, preferably in advance of any final decisions on a capital raise.
  6. Although these rules are mostly applied to share issues for cash, increasingly shareholders are concerned about acquisitions for shares being value-generative. Boards should ensure that these are well justified and backed by good governance.

What’s all the fuss about cash?

Purse

Companies differ very much in their attitude to the importance of cash. If a business is private equity owned, highly geared (ie has a lot of debt) or has not a lot of headroom against its overdraft or debt covenants, it is likely to be very focussed on cash. Others, especially subsidiary boards, may look almost exclusively at profit.

All boards should take cash very seriously. This is because profit is a theoretical concept, whereas you can only pay employees, suppliers and shareholders in cash. You should take particular notice when a profitable business is using cash. If this is because it is in an investment phase, and it in spending capital to expand, then this may be absolutely fine. However, be very aware of negative movements in working capital. This is often a tell-tale sign of bigger problems.

Net debt

This is exactly what it says. It is the net of all bank borrowing less any cash deposits. If cash held exceeds debt, then the company has net cash, rather than net debt. It is a vital indicator of how the business is faring. Its absolute level tells you how much of the business is being funded by borrowing, and movements in net debt tell you whether the business is generating or using cash.

Ensure that net debt and its movement are reported in board packs. The Cash Flow Statement required by accounting standards is pretty useless to management (and if truth be told, to everyone else too). This is because it adds down to movements in ‘cash and cash equivalents’ (which are generally irrelevant as they exclude debt), and mixes up lots of different activities. Ask instead for an explanation of movements in net debt; staring with EBIT, adding back depreciation (which gives you Ebitda), less working capital movements, less capital expenditure, plus disposals, less interest, less dividends.

Working Capital

The three main constituents of working capital are stocks, creditors and debtors;

Stocks: A significant increase in stocks, in the absence of a similar increase in sales, should be something to look at carefully. It may indicate that the business has problems in its supply chain and demand forecasting, or worse perhaps is producing stock just to enhance profit (because some overheads may be capitalised in the stock valuation and thus costs are apparently reduced). It’s worth asking whether this is happening and also how large any provisions are against the stock valuation. Both the size and movement may be significant.

Creditors: Trade creditors are what the company owes its suppliers. An unexplained increase in such creditors may show that management is conserving cash by lengthening payment terms or just not paying its suppliers to terms. Other creditors can include taxation, social security, and accruals/provisions. An unusual movement in deferred income and provisions is definitely worth querying. If a company wishes to hide profit for a while, increased provisions would be one place where that would show. Similarly a rapidly reducing provisions line might show that the company is drawing on previous reserves.

Debtors: Trade debtors are amounts owed by customers to the company. Again, watch for any movement in this line that seems out of step with sales. A step up may mean that management has lost focus on debt collecting or even that, in its desire to maintain sales, it is offering customers longer payment terms. It is worth asking if payment terms are changing and, if so, why.

Borrowings/cash: These may be appear to be working capital as they are put in current assets and liabilities in a statutory balance sheet, but it is important to exclude them.

Ratios to help watch movements in working capital are;

Stock: Days stock held (stock divided by daily throughput) or stock turnover (annual throughput divided by stock).

Debtors: Debtor days (debtors divided by daily throughput) or debtor turnover (annual through divided by debtors).

Creditors: Creditor days (creditors divided by daily throughput) or creditor turnover (annual through divided by creditors).

Derivatives: This is an area that causes even qualified accountants to break out into sweat. However, do not just assume that financial people have got it right. Twice in my career, I have come across derivatives that the CFOs thought were fine, and explained them to me in highly complex, bankers’ language. However both of them were in fact toxic and nearly brought both companies down.

Leaving aside financial services companies that may create and trade in derivatives, for most companies they have a sole purpose: to reduce risk. If the business is exposed to varying interest or foreign exchange rates, it may choose to hedge against them. Note that this is a choice, not a necessity (although a lender may insist on it as part of its funding arrangements). There are two basic questions to ask management here;

  1. If we don’t purchase the derivative what’s the worst that can happen? You may want to tolerate some risk, for example, if the worst case still wouldn’t have a serious impact on overall profit or cash. Companies may choose to hedge only a proportion of their exposure.
  2. If we do purchase the derivative, what’s the worst that can happen? If the worst case with a derivative is not very different to that without, then maybe the instrument is not actually reducing risk.
  3. Is the derivative actually reducing our risk? A hedge is designed to provide a cap or offset to a financial risk on another asset or liability. Where companies typically have got into trouble is when they have taken out a hedge that is not a mirror image of the target risk. Mitchells & Butlers took out an enormous interest rate swap to ‘fix’ the rate on a number of debt instruments (ie loans). However it did this before the loans were signed off and they were never actually taken out. It therefore had a massive swap exposure to interest rate movements on debt it didn’t have. This ultimately cost the business over £400m.

The basic check is that any hedge is carefully (in amount, terms and length) matched to the exposure that it is trying to hedge. If this is not the case, the hedge may well increase risk, not reduce it. Also be very careful that termination conditions are similar for both the original instrument and its hedge. A number of banks made good profits from selling long-term interest rate swaps to very small businesses that found subsequently that, although they were able to pay off the associated loans early, the swaps had a fixed life. With falling interest rates, those swaps became massive liabilities for those businesses.

Do not assume that the banks, or whoever else is offering the security, are working in your best interests. In general, they will sell off the derivative straight away and book their profit. You meanwhile have the financial cost of the derivative for its entire life.

Theoretically a hedge will be accounted for as a hedge ie all gains/losses are set off against the underlying gain/loss to give a neutral profit effect. If this happens, it is a good indicator that the hedge is fine. However the accounting rules are so stupidly tight, that many perfectly good hedges are not treated as such. So even if the accountants don’t treat them as a hedge, this doesn’t of itself mean that the derivative is not a good one.

Swaps or caps? A common issue for boards is whether to hedge an exposure by either a swap or a cap. In simple terms, a swap attempts to provide a mirror image of the original exposure. For example, if a variable-rate loan increases its interest rate, the hedge pays out a similar amount to offset this extra cost, and vice versa. A cap however will only pay out if the interest rate goes above a certain threshold set at the beginning. It therefore caps exposure, acting rather like an insurance policy with a big excess.

If interest rates fall, a cap simply costs what you originally paid for it. However, a swap becomes an open-ended liability, and you have to make payments to the provider. This is why it was swaps that brought companies into such difficulties, when global interest rates fell following the financial crisis.

Ask management for the financial impact (P&L and cash) of both under different scenarios to help show which looks more attractive at the time. But always be careful about any risk around differing maturity and early termination conditions.

Conclusion

Boards generally pass over the Balance Sheet quickly, partly because non-financial people, and quite a few financial ones too, are afraid of its complexity. However this is a mistake, as most skeletons, if they exist, will be sitting in that balance sheet. Additionally, there are many indicators of possible issues with the business that stand out in a balance sheet, if you go looking for them, just as clearly as other issues show in the P&L. The Balance Sheet can be your friend.

Summary

  1. Don’t be afraid of the balance sheet and ask questions about significant movements on it.
  2. Take cash very seriously. Ensure that reports explain movements in net debt.
  3. Do look particularly at working capital movements both year-on-year and against budget.
  4. Take an interest in any new derivatives that are taken out. Ask whether they really reduce risk in all circumstances.
  5. Be particularly vigilant on swaps and ask to see clearly the instrument that they are hedging against. Check they are similar amounts and maturities, watching our for early termination issues.
  6. Don’t assume that a derivative must be the right thing just because the CFO proposes it.
  7. Remember that the skeletons are usually hiding in the balance sheet.

What if you join a board, but have no financial experience?

Bank of EnglandOne mistake that non-financial people often make is to assume that financial people both know what they are talking about and understand all the financial issues. Once you realise that neither of these may be true, you will feel less cowed by financial jargon and able to participate more freely.

I have twice in my career come across toxic derivatives held by companies that the financial team believed to be sensible and prudent. The other board members took their lead from them. However, this nearly brought both companies down. Asking apparently silly, basic questions could have unearthed the issues. Non-execs should sometimes challenge whether the Emperor is actually wearing any clothes.

It can be daunting joining a board for the first time, and possibly being asked to join the audit committee too, when you have no financial background. There are some courses around to give an introduction to finance, which would be very worthwhile if you feel that your understanding of basic finance is poor. This article cannot provide such a foundation course in finance, but it can provide some pointers to things to watch out for.

The Budget

Every business is likely to have a budget or plan, probably an annual one. This is likely to be set at the beginning of the financial year and to be the benchmark for financial bonuses. The executives may well propose reforecasts during the year, but these are very unlikely to be used to reset bonus levels. Shareholders tend to be very sniffy about any attempts to do this.

It is difficult for an NED to really evaluate whether a budget is set at the right level: Too low and it makes it too easy for the executives to be seen as heroes, too high and it will be unachievable and demotivating. One benchmark will be ‘City expectations’ or ‘consensus forecasts’. You should expect the budget to be set, at least in profit terms, a little ahead of the City benchmark. This gives room for life being a little tougher than expected and still meet expectations. How much of a ‘cushion’ is needed will vary from business to business. Ask for a schedule of full year profit variances against each year’s budget for the last few years. This will give you an idea of the accuracy of budget forecasts.

The budget may also have a ‘discount’ or ‘cushion’ already built in. This is sensible, as most budgets are set initially with a ‘can do’ mentality that ends up with an ambitious number. Discounting this back gives a more balanced target. You might compare the discount to the historic budget variances to get an idea as to how adequate it is.

Profit

Most board attention is focussed on profit, usually profit before tax (PBT), which is before tax but after interest. If attention is focussed on operating profit (also called Ebit: Earnings before interest and tax), then it may be that the executives are not focussing on the importance of cash.

Ebitda is simply Ebit before subtracting depreciation and amortisation. It shows you, broadly, ‘cash earnings’. This is the basic cash flow from which everything else, such as capital expenditure for example, gets paid. It is always worth thinking hard about the level of such investment if capital spend is very different to the booked depreciation.

There may be a number of complicating factors;

Profit from associates and joint ventures: These are just another source of profit from part-owned bits of the business.

Amortisation: This is the writing off over a period of a cash spend in the past. Some companies may exclude it from their PBT shown in management accounts, as they see it as an accounting entry, which has no relevance to today’s profit.

Constant Currency: In a multi-currency business, the board will want to know how that business is doing, free from distortions from movements in exchange rates through which foreign units are being reported. Constant currency therefore reports every unit at a set currency rate, probably the budget one. Boards will want to see the actual currency version as well, as this is ultimately what the value is in the home currency.

Non-underlying adjustments

In the good old days, one-off items, usually losses, were treated separately as extraordinary, and then later as exceptional items. Nowadays, the rules are much tighter so CFOs have to be more creative.

Boards understand that there are circumstances in which you have to adjust for one-off items to understand the true underlying profit movement. Regulators however have reacted in a simplistic way to abuse of the exceptional line, by making it more difficult for a company to show investors what it believes underlying performance to be. It’s a bit like the government announcing that it believes sick leave is being abused, so it will in future ban sick pay.

The internal management accounts may well have ‘exceptional items’ beneath PBT, which are usually helpful for a board to understand underlying performance. However the published accounts may put ‘non-underlying items’ in a separate column, so companies can show the P&L with and without them.

Boards do need to be vigilant that adjustments to underlying profit are valid. They will tend of course to be losses rather than profits! It takes no financial knowledge to challenge a cash cost adjustment (ie not amortisation), so all directors should be sceptical of these. This is especially true when management is trying to exclude a cost from the profit used to determine their bonuses.

These are the absolute basics for a financial understanding for non-execs. I haven’t forgotten to discuss cash or derivatives yet, but these deserve an article to themselves.

Summary

  1. If you know really nothing about finance, try to get short course on the basics. The company may well pay for this.
  2. Don’t assume everyone knows more than you or that the finance team have got it right. Ask apparently simple questions, you may be surprised at the answers. If you are worried about looking stupid, ask the questions privately to either the CFO or Chair of Audit.
  3. Try to assess how realistic the budget is by past performance and the size of any discount included.
  4. Even if the CFO talks to Ebit or Ebitda, keep a very careful eye on PBT.
  5. Look hard at exceptional or non-underlying adjustments. At best, they help to understand real underlying performance. At worst, they just give PBN (profit before bad news).
  6. Be very wary of attempts to restate or change the budget during the year.
  7. Always keep an eye on cash.