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Everyone is talking about small businesses. In 1993, when it was allowed in Developing countries, more than 90,000 new firms were registered by individuals. Now, less than three years later, official figures show that only 40,000 of them still pay their dues and present annual financial statements. These firms are called "active" - but this is a misrepresentation. Only a very small fraction really does business and produces income.

Why this reversal? Why were people so enthusiastic to register companies - and then became too desperate to operate them?

Small business is more than a fashion or a buzzword. In the USA, only small businesses create new jobs. The big dinosaur firms (the "blue-chips") create negative employment - they fire people. This trend has a glitzy name: downsizing.

In Israel many small businesses became world class exporters and big companies in world terms. The same goes, to a lesser extent, in Britain and in Germany.

Virtually every Western country has a "Small Business Administration" (SBA).

These agencies provide many valuable services to small businesses:

They help them organize funding for all their needs: infrastructure, capital goods (machinery and equipment), land, working capital, licence and patent fees and charges, etc.

The SBAs have access to government funds, to local venture capital funds, to international and multilateral investment sources, to the local banking community and to private investors. They act as capital brokers at a fraction of the costs that private brokers and organized markets charge.

They assist the entrepreneur in the preparation of business plans, feasibility studies, application forms, questionnaires - and any other thing which the new start-up venture might need to raise funds to finance its operations.

This saves the new business a lot of money. The costs of preparing such documents in the private sector amount to thousands of DM per document.

They reduce bureaucracy. They mediate between the small business and the various tentacles of the government. They become the ONLY address which the new business should approach, a "One Stop Shop".

But why do new (usually small) businesses need special treatment and encouragement at all? And if they do need it - what are the best ways to provide them with this help?

A new business goes through phases in the business cycle (very similar to the stages of human life).

The first phase - is the formation of an idea. A person - or a group of people join forces, centred around one exciting invention, process or service.

These crystallizing ideas have a few hallmarks:

They are oriented to fill the needs of a market niche (a small group of select consumers or customers), or to provide an innovative solution to a problem which bothers many, or to create a market for a totally new product or service, or to provide a better solution to a problem which is solved in a less efficient manner.

At this stage what the entrepreneurs need most is expertise. They need a marketing expert to tell them if their idea is marketable and viable. They need a financial expert to tell them if they can get funds in each phase of the business cycle - and wherefrom and also if the product or service can produce enough income to support the business, pay back debts and yield a profit to the investors. They need technical experts to tell them if the idea can or cannot be realized and what it requires by way of technology transfers, engineering skills, know-how, etc.

Once the idea has been shaped to its final form by the team of entrepreneurs and experts - the proper legal entity should be formed. A bewildering array of possibilities arises:

A partnership? A corporation - and if so, a stock or a non-stock company? A research and development (RND) entity? A foreign company or a local entity? And so on.

This decision is of cardinal importance. It has enormous tax implications and in the near future of the firm it greatly influences the firm's ability to raise funds in foreign capital markets. Thus, a lawyer must be consulted who knows both the local applicable laws and the foreign legislation in markets which could be relevant to the firm.

This costs a lot of money, one thing that entrepreneurs are in short supply of. Free legal advice is likely to be highly appreciated by them.

When the firm is properly legally established, registered with all the relevant authorities and has appointed an accounting firm - it can go on to tackle its main business: developing new products and services. At this stage the firm should adopt Western accounting standards and methodology. Accounting systems in many countries leave too much room for creative playing with reserves and with amortization. No one in the West will give the firm credits or invest in it based on domestic financial statements.

A whole host of problems faces the new firm immediately upon its formation.

Good entrepreneurs do not necessarily make good managers. Management techniques are not a genetic heritage.

They must be learnt and assimilated. Today's modern management includes many elements: manpower, finances, marketing, investing in the firm's future through the development of new products, services, or even whole new business lines. That is quite a lot and very few people are properly trained to do the job successfully.

On top of that, markets do not always react the way entrepreneurs expect them to react. Markets are evolving creatures: they change, they develop, disappear and re-appear. They are exceedingly hard to predict. The sales projections of the firm could prove to be unfounded. Its contingency funds can evaporate.

Sometimes it is better to create a product mix: well-recognized brands which sell well - side by side with innovative products.

I gave you a brief - and by no way comprehensive - taste of what awaits the new business and its initiator, the entrepreneur. You see that a lot of money and effort are needed even in the first phases of creating a business.

How can the Government help?

It could set up an "Entrepreneur's One Stop Shop".

A person wishing to establish a new business will go to a government agency.

In one office, he will find the representatives of all the relevant government offices, authorities, agencies and municipalities.

He will present his case and the business that he wishes to develop. In a matter of few weeks he will receive all the necessary permits and licences without having to go to each office separately.

Having obtained the requisite licences and permits and having registered with all the appropriate authorities - the entrepreneur will move on to the next room in the same building. Here he will receive a list of all the sources of capital available to him both locally and from foreign sources. The terms and conditions of the financing will be specified for each and every source. Example: EBRD - loans of up to 10 years - interest between 6.5% to 8% - grace period of up to 3 years - finances mainly industry, financial services, environmental projects, infrastructure and public services.

The entrepreneur will select the sources of funds most suitable for his needs - and proceed to the next room.

The next room will contain all the experts necessary to establish the business, get it going - and, most important, raise funds from both local and international institutions. For a symbolic sum they will prepare all the documents required by the financing institutions as per their instructions.

But entrepreneurs in many developing countries are still fearful and uninformed. They are intimidated by the complexity of the task facing them.

The solution is simple: a tutor or a mentor will be attached to each and every entrepreneur. This tutor will escort the entrepreneur from the first phase to the last.

He will be employed by the "One Stop Shop" and his role will be to ease life for the novice businessman. He will transform the person to a businessman.

And then they will wish the entrepreneur: "Bon Voyage" - and may the best ones win.

Making your Workers Your Partners

By: Dr. Sam Vaknin

Also read these:

The Principal-Agent Conundrum

The Labour Divide - V. Employee Benefits and Ownership

There is an inherent conflict between owners and managers of companies. The former want, for instance, to minimize costs - the latter to draw huge salaries as long as they are in power.

In publicly traded companies, the former wish to maximize the value of the stocks (short term), the latter might have a longer term view of things. In the USA, shareholders place emphasis on the appreciation of the stocks (the result of quarterly and annual profit figures). This leaves little room for technological innovation, investment in research and development and in infrastructure. The theory is that workers who also own stocks avoid these cancerous conflicts which, at times, bring companies to ruin and, in many cases, dilapidate them financially and technologically. Whether reality lives up to theory, is an altogether different question.

A stock option is the right to purchase (or sell - but this is not applicable in our case) a stock at a specified price (=strike price) on or before a given date. Stock options are either not traded (in the case of private firms) or traded in a stock exchange (in the case of public firms whose shares are also traded in a stock exchange).

Stock options have many uses: they are popular investments and speculative vehicles in many markets in the West, they are a way to hedge (to insure) stock positions (in the case of put options which allow you to sell your stocks at a pre-fixed price). With very minor investment and very little risk (one can lose only the money invested in buying the option) - huge profits can be realized.

Creative owners and shareholders began to use stock options to provide their workers with an incentive to work for the company and only for the company. Normally such perks were reserved to senior management, thought indispensable. Later, as companies realized that their main asset was their employees, all employees began to enjoy similar opportunities. Under an incentive stock option scheme, an employee is given by the company (as part of his compensation package) an option to purchase its shares at a certain price (at or below market price at the time that the option was granted) for a given number of years. Profits derived from such options now constitute the main part of the compensation of the top managers of the Fortune 500 in the USA and the habit is catching on even with more conservative Europe.

A Stock Option Plan is an organized program for employees of a corporation allowing them to buy its shares. Sometimes the employer gives the employees subsidized loans to enable them to invest in the shares or even matches their purchases: for every share bought by an employee, the employer awards him with another one, free of charge. In many companies, employees are offered the opportunity to buy the shares of the company at a discount (which translates to an immediate paper profit).

Dividends that the workers receive on the shares that they hold can be reinvested by them in additional shares of the firm (some firms do it for them automatically and without or with reduced brokerage commissions). Many companies have wage "set-aside" programs: employees regularly use a part of their wages to purchase the shares of the company at the market prices at the time of purchase. Another well known structure is the Employee Stock Ownership Plan (ESOP) whereby employees regularly accumulate shares and may ultimately assume control of the company.

Let us study in depth a few of these schemes:

It all began with Ronald Reagan. His administration passed in Congress the Economic Recovery Tax Act (ERTA - 1981) under which certain kinds of stock options ("qualifying options") were declared tax-free at the date that they were granted and at the date that they were exercised. Profits on shares sold after being held for at least two years from the date that they were granted or one year from the date that they were transferred to an employee were subjected to preferential (lower rate) capital gains tax. A new class of stock options was thus invented: the "Qualifying Stock Option". Such an option was legally regarded as a privilege granted to an employee of the company that allowed him to purchase, for a special price, shares of its capital stock (subject to conditions of the Internal Revenue - the American income tax - code). To qualify, the option plan must be approved by the shareholders, the options must not be transferable (i.e., cannot be sold in the stock exchange or privately - at least for a certain period of time).

Additional conditions: the exercise price must not be less than the market price of the shares at the time that the options were issued and that the employee who receives the stock options (the grantee) may not own stock representing more than 10% of the company's voting power unless the option price equals 110% of the market price and the option is not exercisable for more than five years following its grant. No income tax is payable by the employee either at the time of the grant or at the time that he converts the option to shares (which he can sell at the stock exchange at a profit) - the exercise period. If the market price falls below the option price, another option, with a lower exercise price can be issued. There is a 100,000 USD per employee limit on the value of the stock covered by options that can be exercised in any one calendar year.

This law - designed to encourage closer bondage between workers and their workplaces and to boost stock ownership - led to the creation of Employee Stock Ownership Plans (ESOPs). These are programs which encourage employees to purchase stock in their company. Employees may participate in the management of the company. In certain cases - for instance, when the company needs rescuing - they can even take control (without losing their rights). Employees may offer wage concessions or other work rules related concessions in return for ownership privileges - but only if the company is otherwise liable to close down ("marginal facility").

How much of its stock should a company offer to its workers and in which manner?

There are no rules (except that ownership and control need not be transferred). A few of the methods:

The company offers packages of different sizes, comprising shares and options and the employees bid for them in open tender

The company sells its shares to the employees on an equal basis (all the members of the senior management, for instance, have the right to buy the same number of shares) - and the workers are then allowed to trade the shares between them

The company could give one or more of the current shareholders the right to offer his shares to the employees or to a specific group of them.

The money generated by the conversion of the stock options (when an employee exercises his right and buys shares) usually goes to the company. The company sets aside in its books a number of shares sufficient to meet the demand which may be generated by the conversion of all outstanding stock options. If necessary, the company issues new shares to meet such a demand. Rarely, the stock options are converted into shares already held by other shareholders.

Going Bankrupt in the World

By: Dr. Sam Vaknin

It all starts by defaulting on an obligation. Money owed to creditors or to suppliers is not paid on time, interest payments due on bank loans or on corporate bonds issued to the public are withheld. It may be a temporary problem - or a permanent one.

As time goes by, the creditors gear up and litigate in a court of law or in a court of arbitration. This leads to a “technical or equity insolvency” status.

But this is not the only way a company can be rendered insolvent. It could also run liabilities which outweigh its assets. This is called “bankruptcy insolvency”. True, there is a debate raging as to what is the best method to appraise the firm’s assets and the liabilities. Should these appraisals be based on market prices - or on book value?

There is no one decisive answer. In most cases, there is strong reliance on the figures in the balance sheet.

If the negotiations with the creditors of the company (as to how to settle the dispute arising from the company’s default) fails, the company itself can file (=ask the court) for bankruptcy in a "voluntary bankruptcy filing".

Enter the court. It is only one player (albeit, the most important one) in this unfolding, complex drama. The court does not participate directly in the script.

Court officials are appointed. They work hand in hand with the representatives of the creditors (mostly lawyers) and with the management and the owners of the defunct company.

They face a tough decision: should they liquidate the company? In other words, should they terminate its business life by (among other acts) selling its assets?

The proceeds of the sale of the assets are divided (as "bankruptcy dividend") among the creditors. It makes sense to choose this route only if the (money) value yielded by liquidation exceeds the money the company, as a going concern, as a living, functioning, entity, can generate.

The company can, thus, go into "straight bankruptcy". The secured creditors then receive the value of the property which was used to secure their debt (the "collateral", or the "mortgage, lien"). Sometimes, they receive the property itself - if it not easy to liquidate (=sell) it.

Once the assets of the company are sold, the first to be fully paid off are the secured creditors. Only then are the priority creditors paid (wholly or partially).

The priority creditors include administrative debts, unpaid wages (up to a given limit per worker), uninsured pension claims, taxes, rents, etc.

And only if any money left after all these payments is it proportionally doled out to the unsecured creditors.

The USA had many versions of bankruptcy laws. There was the 1938 Bankruptcy Act, which was followed by amended versions in 1978, 1984 and, lately, in 1994.

Each state has modified the Federal Law to fit its special, local conditions.

Still, a few things - the spirit of the law and its philosophy are common to all the versions. Arguably, the most famous procedure is named after the chapter in the law in which it is described, Chapter 11. Following is a brief discussion of chapter 11 intended to demonstrate this spirit and this philosophy.

This chapter allows for a mechanism called "reorganization". It must be approved by two thirds of all classes of creditors and then, again, it could be voluntary (initiated by the company) or involuntary (initiated by one to three of its creditors).

The American legislator set the following goals in the bankruptcy laws:

To provide a fair and equitable treatment to the holders of various classes of securities of the firm (shares of different kinds and bonds of different types)
To eliminate burdensome debt obligations, which obstruct the proper functioning of the firm and hinder its chances to recover and ever repay its debts to its creditors.
To make sure that the new claims received by the creditors (instead of the old, discredited, ones) equal, at least, what they would have received in liquidation.

Examples of such new claims: owners of debentures of the firm can receive, instead, new, long term bonds (known as reorganization bonds, whose interest is payable only from profits).

Owners of subordinated debentures will, probably, become shareholders and shareholders in the insolvent firm usually receive no new claims.

The chapter dealing with reorganization (the famous "Chapter 11") allows for "arrangements" to be made between debtor and creditors: an extension or reduction of the debts.

If the company is traded in a stock exchange, the Securities and Exchange Commission (SEC) of the USA advises the court as to the best procedure to adopt in case of reorganization.

What chapter 11 teaches us is that:

American Law leans in favour of maintaining the company as an ongoing concern. A whole is larger than the sum of its parts - and a living business is sometimes worth more than the sum of its assets, sold separately.

A more in-depth study of the bankruptcy laws shows that they prescribe three ways to tackle a state of malignant insolvency which threatens the well being and the continued functioning of the firm:

Chapter 7 (1978 Act) - liquidation

A District court appoints an "interim trustee" with broad powers. Such a trustee can also be appointed at the request of the creditors and by them.

The Interim Trustee is empowered to do the following:

liquidate property and make distribution of liquidating dividends to creditors
make management changes
arrange unsecured financing for the firm
operate the debtor business to prevent further losses

By filing a bond, the debtor (really, the owners of the debtor) is able to regain possession of the business from the trustee.

Chapter 11 - reorganization

Unless the court rules otherwise, the debtor remains in possession and in control of the business and the debtor and the creditors are allowed to work together flexibly. They are encouraged to reach a settlement by compromise and agreement rather than by court adjudication.

Maybe the biggest legal revolution embedded in chapter 11 is the relaxation of the age old ABSOLUTE PRIORITY rule, that says that the claims of creditors have categorical precedence over ownership claims. Rather, the interests of the creditors have to be balanced with the interests of the owners and even with the larger good of the community and society at large.

And so, chapter 11 allows the debtor and creditors to be in direct touch, to negotiate payment schedules, the restructuring of old debts, even the granting of new loans by the same disaffected creditors to the same irresponsible debtor.

Chapter 10

Is sort of a legal hybrid, the offspring of chapters 7 and 11:

It allows for reorganization under a court appointed independent manager (trustee) who is responsible mainly for the filing of reorganization plans with the court - and for verifying strict adherence to them by both debtor and creditors.

Despite its clarity and business orientation, many countries found it difficult to adapt to the pragmatic, non sentimental approach which led to the virtual elimination of the absolute priority rule.

In England, for instance, the court appoints an official "receiver" to manage the business and to realize the debtor’s assets on behalf of the creditors (and also of the owners). His main task is to maximize the proceeds of the liquidation and he continues to function until a court settlement is decreed (or a creditor settlement is reached, prior to adjudication). When this happens, the receivership ends and the receiver loses his status.

The receiver takes possession (but not title) of the assets and the affairs of a business in a receivership. He collects rents and other income on behalf of the firm.

So, British Law is much more in favour of the creditors. It recognizes the supremacy of their claims over the property claims of the owners. Honouring obligations - in the eyes of the British legislator and their courts - is the cornerstone of efficient, thriving markets. The courts are entrusted with the protection of this moral pillar of the economy.

Economies in transition are in transition not only economically - but also legally. Thus, each one adopted its own version of the bankruptcy laws.

In Hungary - Bankruptcy is automatically triggered. Debt for equity swaps are disallowed. Moreover, the law provides for a very short time to reach agreement with creditors about reorganization of the debtor. These features led to 4000 bankruptcies in the wake of the new law - a number which mushroomed to 30,000 by 5/97.

In the Czech Republic- the insolvency law comprises special cases (over-indebtedness, for instance). It delineates two rescue programs:

A debt to equity swap (an alternative to bankruptcy) supervised by the Ministry of Privatization.
The Consolidation Bank (founded by the State) can buy a firm’s obligations, if it went bankrupt, at 60% of par.

But the law itself is toothless and lackadaisically applied by the incestuous web of institutions in the country. Between 3/93 - 9/93 there were 1000 filings for insolvency, which resulted in only 30 commenced bankruptcy procedures. There hasn’t been a single major bankruptcy in the Czech Republic since then - and not for lack of candidates.

Poland is a special case. The pre-war (1934) law declares bankruptcy in a state of lasting illiquidity and excessive indebtedness. Each creditor can apply to declare a company bankrupt. An insolvent company is obliged to file a maximum of 2 weeks following cessation of debt payments. There is a separate liquidation law which allows for voluntary procedures.

Bad debts are transferred to base portfolios and have one of three fates:

Reorganization, debt-consolidation (a reduction of the debts, new terms, debt for equity swaps) and a program of rehabilitation.

Sale of the corporate liabilities in auctions

Classic bankruptcy (happens in 23% of the cases of insolvency).

No one is certain what is the best model. The reason is that no one knows the answers to the questions: are the rights of the creditors superior to the rights of the owners? Is it better to rehabilitate than to liquidate?

Until such time as these questions are answered and as long as the corporate debt crisis deepens -we will witness a flowering of versions of bankruptcy laws all over the world.

The Inferno of the Finance Director

By: Dr. Sam Vaknin

Sometimes, I harbour a suspicion that Dante was a Financial Director. His famous work, "The Inferno", is an accurate description of the job.

The CFO (Chief Financial Officer) is fervently hated by the workers. He is thoroughly despised by other managers, mostly for scrutinizing their expense accounts. He is dreaded by the owners of the firm because his powers that often outweigh theirs. Shareholders hold him responsible in annual meetings. When the financial results are good – they are attributed to the talented Chief Executive Officer (CEO). When they are bad – the Financial Director gets blamed for not enforcing budgetary discipline. It is a no-win, thankless job. Very few make it to the top. Others retire, eroded and embittered.

The job of the Financial Director is composed of 10 elements. Here is a universal job description which is common throughout the West.

Organizational Affiliation

The Chief Financial Officeris subordinated to the Chief Executive Officer, answers to him and regularly reports to him.

The CFO is in charge of:

The Finance Director
The Financing Department
The Accounting Department which answers to him and regularly reports to him.

Despite the above said, the CFO can report directly to the Board of Directors through the person of the Chairman of the Board of Directors or by direct summons from the Board of Directors.

In many developing countries this would be considered treason – but, in the West every function holder in the company can – and regularly is – summoned by the (active) Board. A grilling session then ensues: debriefing the officer and trying to spot contradictions between his testimony and others’. The structure of business firms in the USA reflects its political structure. The Board of Directors resembles Congress, the Management is the Executive (President and Administration), the shareholders are the people. The usual checks and balances are applied: the authorities are supposedly separated and the Board criticizes the Management.

The same procedures are applied: the Board can summon a worker to testify – the same way that the Senate holds hearings and cross-questions workers in the administration. Lately, however, the delineation became fuzzier with managers serving on the Board or, worse, colluding with it. Ironically, Europe, where such incestuous practices were common hitherto – is reforming itself with zeal (especially Britain and Germany).

Developing countries are still after the cosy, outdated European model. Boards of Directors are rubber stamps, devoid of any will to exercise their powers. They are staffed with cronies and friends and family members of the senior management and they do and decide what the General Managers tell them to do and to decide. General Managers – unchecked – get nvolved in colossal blunders (not to mention worse). The concept of corporate governance is alien to most firms in developing countries and companies are regarded by most general managers as milking cows – fast paths to personal enrichment.

Functions of the Chief Financial Officer (CFO):

(1) To regulate, supervise and implement a timely, full and accurate set of accounting books of the firm reflecting all its activities in a manner commensurate with the relevant legislation and regulation in the territories of operation of the firm and subject to internal guidelines set from time to time by the Board of Directors of the firm.

This is somewhat difficult in developing countries. The books do not reflect reality because they are "tax driven" (i.e., intended to cheat the tax authorities out of tax revenues). Two sets of books are maintained: the real one which incorporates all the income – and another one which is presented to the tax authorities. This gives the CFO an inordinate power. He is in a position to blackmail the management and the shareholders of the firm. He becomes the information junction of the firm, the only one who has access to the whole picture. If he is dishonest, he can easily enrich himself. But he cannot be honest: he has to constantly lie and he does so as a life long habit.

He (or she) develops a cognitive dissonance: I am honest with my superiors – I only lie to the state.

(2) To implement continuous financial audit and control systems to monitor the performance of the firm, its flow of funds, the adherence to the budget, the expenditures, the income, the cost of sales and other budgetary items.

In developing countries, this is often confused with central planning. Financial control does not mean the waste of precious management resources on verifying petty expenses. Nor does it mean a budget which goes to such details as how many tea bags will be consumed by whom and where. Managers in developing countries still feel that they are being supervised and followed, that they have quotas to complete, that they have to act as though they are busy (even if they are, in reality, most of the time, idle). So, they engage in the old time central planning and they do it through the budget. This is wrong.

A budget in a firm is no different than the budget of the state. It has exactly the same functions. It is a statement of policy, a beacon showing the way to a more profitable future. It sets the strategic (and not the tactical) goals of the firm: new products to develop, new markets to penetrate, new management techniques to implement, possible collaborations, identification of the competition, of the relative competitive advantages. Above all, a budget must allocate the scarce resources of the firm in order to obtain a maximum impact (=efficiently). All this, unfortunately, is missing from budgets of firms in developing countries.

No less important are the control and audit mechanisms which go with the budget. Audit can be external but must be complemented internally. It is the job of the CFO to provide the management with a real time tool which informs them what is happening in the firm and where are the problematic, potential problem areas of activity and performance.

Additional functions of the CFO include:

(3) To timely, regularly and duly prepare and present to the Board of Directors financial statements and reports as required by all pertinent laws and regulations in the territories of the operations of the firm and as deemed necessary and demanded from time to time by the Board of Directors of the Firm.

The warning signs and barbed wire which separate the various organs of the Western firm (management from Board of Directors and both from the shareholders) – have yet to reach developing countries. As I said: the Board in these countries is full with the cronies of the management. In many companies, the General Manager uses the Board as a way to secure the loyalty of his cronies, friends and family members by paying them hefty fees for their participation (and presumed contribution) in the meetings of the Board. The poor CFO is loyal to the management – not to the firm. The firm is nothing but a vehicle for self enrichment and does not exist in the Western sense, as a separate functional entity which demands the undivided loyalty of its officers. A weak CFO is rendered a pawn in these get-rich-quick schemes – a stronger one becomes a partner. In both cases, he is forced to collaborate, from time to time, with stratagems which conflict with his conscience.

It is important to emphasize that not all the businesses in developing countries are like that. In some places the situation is much better and closer to the West. But geopolitical insecurity (what will be the future of developing countries in general and my country in particular), political insecurity (will my party remain in power), corporate insecurity (will my company continue to exist in this horrible economic situation) and personal insecurity (will I continue to be the General Manager) combine to breed short-sightedness, speculative streaks, a drive to get rich while the going is good (and thus rob the company) – and up to criminal tendencies.

(4) To comply with all reporting, accounting and audit requirements imposed by the capital markets or regulatory bodies of capital markets in which the securities of the firm are traded or are about to be traded or otherwise listed.

The absence of a functioning capital market in many developing countries and the inability of developing countries firms to access foreign capital markets – make the life of the CFO harder and easier at the same time. Harder – because there is nothing like a stock exchange listing to impose discipline, transparency and long-term, management-independent strategic thinking on a firm. Discipline and transparency require an enormous amount of investment by the financial structures of the firm: quarterly reports, audited annual financial statements, disclosure of important business developments, interaction with regulators (a tedious affair) – all fall within the remit of the CFO. Why, therefore, should he welcome it?

Because discipline and transparency make the life of a CFO easier in the long run. Just think how much easier it is to maintain one set of books instead of two or to avoid conflicts with tax authorities on the one hand and your management on the other.

(5) To prepare and present for the approval of the Board of Directors an annual budget, other budgets, financial plans, business plans, feasibility studies, investment memoranda and all other financial and business documents as may be required from time to time by the Board of Directors of the firm.

The primal sin in developing countries was so called “privatization”. The laws were flawed. To mix the functions of management, workers and ownership is detrimental to a firm, yet this is exactly the path that was chosen in numerous developing countries. Management takeovers and employee takeovers forced the new, impoverished, owners to rob the firm in order to pay for their shares. Thus, they were unable to infuse the firm with new capital, new expertise, or new management. Privatized companies are dying slowly.

One of the problems thus wrought was the total confusion regarding the organic structure of the firm. Boards were composed of friends and cronies of the management because the managers also owned the firm – but they could be easily fired by their own workers, who were also owners and so on. These incestuous relationships introduced an incredible amount of insecurity into management ranks (see previous point).

(6) To alert the Board of Directors and to warn it regarding any irregularity, lack of compliance, lack of adherence, lacunas and problems whether actual or potential concerning the financial systems, the financial operations, the financing plans, the accounting, the audits, the budgets and any other matter of a financial nature or which could or does have a financial implication.

The CFO is absolutely aligned and identified with the management. The Board is meaningless. The concept of ownership is meaningless because everyone owns everything and there are no identifiable owners (except in a few companies). Absurdly, Communism (the common ownership of means of production) has returned in full vengeance, though in disguise, precisely because of the ostensibly most capitalist act of all, privatization.

(7) To collaborate and coordinate the activities of outside suppliers of financial services hired or contracted by the firm, including accountants, auditors, financial consultants, underwriters and brokers, the banking system and other financial venues.

Many firms in developing countries (again, not all) are interested in collusion – not in consultancy. Having hired a consultant or the accountant – they believe that they own him. They are bitterly disappointed and enraged when they discover that an accountant has to comply with the rules of his trade or that a financial consultant protects his reputation by refusing to collaborate with shenanigans of the management.

(8) To maintain a working relationship and to develop additional relationships with banks, financial institutions and capital markets with the aim of securing the funds necessary for the operations of the firm, the attainment of its development plans and its investments.

One of the main functions of the CFO is to establish a personal relationship with the firm’s bankers. The financial institutions which pass for banks in developing countries lend money on the basis of personal acquaintance more than on the basis of analysis or rational decision making. This "old boy network" substitutes for the orderly collection of data and credit rating of borrowers. This also allows for favouritism and corruption in the banking sector. A CFO who is unable to participate in these games is deemed by the management to be "weak", "ineffective" or "no-good". The lack of non-bank financing options and the general squeeze on liquidity make matters even worse for the finance manager. He must collaborate with the skewed practices and decision making processes of the banks – or perish.

(9) To fully computerize all the above activities in a combined hardware-software and communications system which integrates with the systems of other members of the group of companies.

(10) Otherwise, to initiate and engage in all manner of activities, whether financial or other, conducive to the financial health, the growth prospects and the fulfillment of investment plans of the firm to the best of his ability and with the appropriate dedication of the time and efforts required.

It is this, point 10, that occupies the working time of Western CFOs. it is their brain that is valued – not their connections or cunning.

Decision Support Systems

By: Dr. Sam Vaknin

Many companies in developing countries have a very detailed reporting system going down to the level of a single product, a single supplier, a single day. However, these reports – which are normally provided to the General Manager - should not, in my view, be used by them at all. They are too detailed and, thus, tend to obscure the true picture. A General Manager must have a bird's eye view of his company. He must be alerted to unusual happenings, disturbing financial data and other irregularities.

As things stand now, the following phenomena could happen:

That the management will highly leverage the company by assuming excessive debts burdening the cash flow of the company and / or
That a false Profit and Loss (PNL) picture will emerge - both on the single product level - and generally. This could lead to wrong decision making, based on wrong data.
That the company will pay excessive taxes on its earnings and / or
That the inventory will not be fully controlled and appraised centrally and / or
That the wrong cash flow picture will distort the decisions of the management and lead to wrong (even to dangerous) decisions.

To assist in overcoming the above, there are four levels of reporting and flows of data which every company should institute:

The first level is the annual budget of the company which is really a business plan. The budget allocates amounts of money to every activity and / or department of the firm.

As time passes, the actual expenditures are compared to the budget in a feedback loop. During the year, or at the end of the fiscal year, the firm generates its financial statements: the income statement, the balance sheet, the cash flow statement.

Put together, these four documents are the formal edifice of the firm's finances. However, they can not serve as day to day guides to the General Manager.

The second tier of financial audit and control is when the finance department (equipped with proper software – Solomon IV is the most widely used in the West) is able to produce pro forma financial statements monthly.

These financial statements, however inaccurate, provide a better sense of the dynamics of the operation and should be constructed on the basis of Western accounting principles (GAAP and FASBs, or IAS).

But the Manager should be able to open this computer daily and receive two kinds of data, fully updated and fully integrated:

Daily financial statements
Daily ratios report.

The daily financial statements

The Manager should have access to continuously updated statements of income, cash flow, and a balance sheet. The most important statement is that of the cash flow. The manager should be able to know, at each and every stage, what his real cash situation is - as opposed to the theoretical cash situation which includes accounts payable and account receivable in the form of expenses and income.

These pro forma financial statements should include all the future flows of money - whether invoiced or not. This way, the Manager will be able to type a future date into his computer and get the financial reports and statements relating to that date.

In other words, the Manager will not be able to see only a present situation of his company, but its future situation, fully analysed and fully updated.

Using today's technology - a wireless-connected laptop – managers are able to access all these data from anywhere in the world, from home, while traveling, and so on.

The daily ratios report

This is the most important part of the decision support system.

It enables the Manager to instantly analyse dozens of important aspects of the functioning of his company. It allows him to compare the behaviour of these parameters to historical data and to simulate the future functioning of his company under different scenarios.

It also allows him to compare the performance of his company to the performance of his competitors, other firms in his branch and to the overall performance of the industry that he is operating in.

The Manager can review these financial and production ratios. Where there is a strong deviation from historical patterns, or where the ratios warn about problems in the future – management intervention may be required..

Instead of sifting through mountains of documents, the Manager will only have to look at four computer screens in the morning, spot the alerts, read the explanations offered by the software, check what is happening and better prepare himself for the future.

Examples of the ratios to be included in the decision system

SUE measure - deviation of actual profits from expected profits
ROE - the return on the adjusted equity capital
Debt to equity ratios
ROA - the return on the assets
The financial average
ROS - the profit margin on the sales
ATO - asset turnover, how efficiently assets are used
Tax burden and interest burden ratios
Compounded leverage
Sales to fixed assets ratios
Inventory turnover ratios
Days receivable and days payable
Current ratio, quick ratio, interest coverage ratio and other liquidity and coverage ratios
Valuation price ratios
and many others.

The effects of using a decision system

A decision system has great impact on the profits of the company. It forces the management to rationalize the depreciation, inventory and inflation policies. It warns the management against impending crises and problems in the company. It specially helps in following areas:

The management knows exactly how much credit it could take, for how long (for which maturities) and in which interest rate. It has been proven that without proper feedback, managers tend to take too much credit and burden the cash flow of their companies.

A decision system allows for careful financial planning and tax planning. Profits go up, non cash outlays are controlled, tax liabilities are minimized and cash flows are maintained positive throughout.

As a result of all the above effects the value of the company grows and its shares appreciate.

The decision system is an integral part of financial management in the West. It is completely compatible with western accounting methods and derives all the data that it needs from information extant in the company.

So, the establishment of a decision system does not hinder the functioning of the company in any way and does not interfere with the authority and functioning of the financial department.

Decision Support Systems cost as little as 20,000 USD (all included: software, hardware, and training). They are one of the best investments that a firm can make.

Valuing Stocks

By: Dr. Sam Vaknin

Also Read

The Myth of the Earnings Yield

The Friendly Trend - Technical vs. Fundamental Analysis

The Roller Coaster Market - On Volatility and Risk

The debate rages all over Eastern and Central Europe, in countries in transition as well as in Western Europe. It raged in Britain during the 80s.

Is privatization really the robbery in disguise of state assets by a select few, cronies of the political regime? Margaret Thatcher was accused of it - and so were privatizers in developing countries. What price should state-owned companies have fetched? This question is not as simple and straightforward as it sounds.

There is a stock pricing mechanism known as the Stock Exchange. Willing buyers and willing sellers meet there to freely negotiate deals of stock purchases and sales. New information, macro-economic and micro-economic, determines the value of companies.

Greenspan testifies in the Senate, economic figures are released - and the rumour mill starts working: interest rates might go up. The stock market reacts with frenzily - it crashes. Why?

A top executive is asked how profitable will his firm be this quarter. He winks, he grins - this is interpreted by Wall Street to mean that profits will go up. The share price surges: no one wants to sell it, everyone want to buy it. The result: a sharp rise in its price. Why?

Moreover: the share price of a company of an identical size, similar financial ratios (and in the same industry) barely budges. Why not?

We say that the stocks of the two companies have different elasticity (their prices move up and down differently), probably the result of different sensitivities to changes in interest rates and in earnings estimates. But this is just to rename the problem. The question remains: Why do the shares of similar companies react differently?

Economy is a branch of psychology and wherever and whenever humans are involved, answers don't come easy. A few models have been developed and are in wide use but it is difficult to say that any of them has real predictive or even explanatory powers. Some of these models are "technical" in nature: they ignore the fundamentals of the company. Such models assume that all the relevant information is already incorporated in the price of the stock and that changes in expectations, hopes, fears and attitudes will be reflected in the prices immediately. Others are fundamental: these models rely on the company's performance and assets. The former models are applicable mostly to companies whose shares are traded publicly, in stock exchanges. They are not very useful in trying to attach a value to the stock of a private firm. The latter type (fundamental) models can be applied more broadly.

The value of a stock (a bond, a firm, real estate, or any asset) is the sum of the income (cash flow) that a reasonable investor would expect to get in the future, discounted at the appropriate rate. The discounting reflects the fact that money received in the future has lower (discounted) purchasing power than money received now. Moreover, we can invest money received now and get interest on it (which should normally equal the discount). Put differently: the discount reflects the loss in purchasing power of money deferred or the interest lost by not being able to invest the money right away. This is the time value of money.

Another problem is the uncertainty of future payments, or the risk that we will never receive them. The longer the payment period, the higher the risk, of course. A model exists which links time, the value of the stock, the cash flows expected in the future and the discount (interest) rates.

The rate that we use to discount future cash flows is the prevailing interest rate. This is partly true in stable, predictable and certain economies. But the discount rate depends on the inflation rate in the country where the firm is located (or, if a multinational, in all the countries where it operates), on the projected supply of and demand for its shares and on the aforementioned risk of non-payment. In certain places, additional factors must be taken into account (for example: country risk or foreign exchange risks).

The supply of a stock and, to a lesser extent, the demand for it determine its distribution (how many shareowners are there) and, as a result, its liquidity. Liquidity means how freely can one buy and sell it and at which quantities sought or sold do prices become rigid.

Example: if a controlling stake is sold - the buyer normally pays a "control premium". Another example: in thin markets it is easier to manipulate the price of a stock by artificially increasing the demand or decreasing the supply ("cornering" the market).

In a liquid market (no problems to buy and to sell), the discount rate is comprised of two elements: one is the risk-free rate (normally, the interest payable on government bonds), the other being the risk-related rate (the rate which reflects the risk related to the specific stock).

But what is this risk-related rate?

The most widely used model to evaluate specific risks is the Capital Asset Pricing Model (CAPM).

According to it, the discount rate is the risk-free rate plus a coefficient (called beta) multiplied by a risk premium general to all stocks (in the USA it was calculated to be 5.5%). Beta is a measure of the volatility of the return of the stock relative to that of the return of the market. A stock's Beta can be obtained by calculating the coefficient of the regression line between the weekly returns of the stock and those of the stock market during a selected period of time.

Unfortunately, different betas can be calculated by selecting different parameters (for instance, the length of the period on which the calculation is performed). Another problem is that betas change with every new datum. Professionals resort to sensitivity tests which neutralize the changes that betas undergo with time.

Still, with all its shortcomings and disputed assumptions, the CAPM should be used to determine the discount rate. But to use the discount rate we must have future cash flows to discount.

The only relatively certain cash flows are dividends paid to the shareholders. So, Dividend Discount Models (DDM) were developed.

Other models relate to the projected growth of the company (which is supposed to increase the payable dividends and to cause the stock to appreciate in value).

Still, DDM’s require, as input, the ultimate value of the stock and growth models are only suitable for mature firms with a stable, low dividend growth. Two-stage models are more powerful because they combine both emphases, on dividends and on growth. This is because of the life-cycle of firms. At first, they tend to have a high and unstable dividend growth rate (the DDM tackles this adequately). As the firm matures, it is expected to have a lower and stable growth rate, suitable for the treatment of Growth Models.

But how many years of future income (from dividends) should we use in our calculations? If a firm is profitable now, is there any guarantee that it will continue to be so in the next year, or the next decade? If it does continue to be profitable - who can guarantee that its dividend policy will not change and that the same rate of dividends will continue to be distributed?

The number of periods (normally, years) selected for the calculation is called the "price to earnings (P/E) multiple". The multiple denotes by how much we multiply the (after tax) earnings of the firm to obtain its value. It depends on the industry (growth or dying), the country (stable or geopolitically perilous), on the ownership structure (family or public), on the management in place (committed or mobile), on the product (new or old technology) and a myriad of other factors. It is almost impossible to objectively quantify or formulate this process of analysis and decision making. In telecommunications, the range of numbers used for valuing stocks of a private firm is between 7 and 10, for instance. If the company is in the public domain, the number can shoot up to 20 times net earnings.

While some companies pay dividends (some even borrow to do so), others do not. So in stock valuation, dividends are not the only future incomes you would expect to get. Capital gains (profits which are the result of the appreciation in the value of the stock) also count. This is the result of expectations regarding the firm's free cash flow, in particular the free cash flow that goes to the shareholders.

There is no agreement as to what constitutes free cash flow. In general, it is the cash which a firm has after sufficiently investing in its development, research and (predetermined) growth. Cash Flow Statements have become a standard accounting requirement in the 80s (starting with the USA). Because "free" cash flow can be easily extracted from these reports, stock valuation based on free cash flow became increasingly popular and feasible. Cash flow statements are considered independent of the idiosyncratic parameters of different international environments and therefore applicable to multinationals or to national, export-orientated firms.

The free cash flow of a firm that is debt-financed solely by its shareholders belongs solely to them. Free cash flow to equity (FCFE) is:

FCFE = Operating Cash Flow MINUS Cash needed for meeting growth targets

Where
Operating Cash Flow = Net Income (NI) PLUS Depreciation and Amortization

Cash needed for meeting growth targets = Capital Expenditures + Change in Working Capital

Working Capital = Total Current Assets - Total Current Liabilities

Change in Working Capital = One Year's Working Capital MINUS Previous Year's Working Capital

The complete formula is:

FCFE = Net Income PLUS
Depreciation and Amortization MINUS
Capital Expenditures PLUS
Change in Working Capital.

A leveraged firm that borrowed money from other sources (even from preferred stock holders) exhibits a different free cash flow to equity. Its CFCE must be adjusted to reflect the preferred dividends and principal repayments of debt (MINUS sign) and the proceeds from new debt and preferred stocks (PLUS sign). If its borrowings are sufficient to pay the dividends to the holders of preference shares and to service its debt - its debt to capital ratio is sound.

The FCFE of a leveraged firm is:

FCFE = Net Income PLUS

Depreciation and Amortization MINUS

Principal Repayment of Debt MINUS

Preferred Dividends PLUS

Proceeds from New Debt and Preferred MINUS

Capital Expenditures MINUS

Changes in Working Capital.

A sound debt ratio means:

FCFE = Net Income MINUS
(1 - Debt Ratio)*(Capital Expenditures MINUS
Depreciation and Amortization PLUS
Change in Working Capital).

The Process of Due Diligence

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