Restructuring your capital

As some of you may know, when I first left University, I took up work with a company called Field Associates. It was a small business which positioned itself in the market as a \’growth consultancy and business brokerage\’. What I came to learn was that this company handled a range of small business opportunities in everything from acquisitions and sales through to growth of revenue with a goal of eventual exit for an owner. To a recent graduate, it was an exciting role and gave me a range of experience with a lot of small businesses and an interesting look into the way they were structured.

From my time at business school, I had gained an understanding of different types of capital and financing which were available; everything from loans to common stock, but a lot of it seemed rather remote and theoretical until we came into contact with one business who was trying to re-structure their capital base.

The business was moderately successful, but had developed significant outgoings to a number of capital owners; when the recession hit, incoming revenue had started to dry up with the consequence that expenses were now starting to drain the company\’s reserves. When a liability from HMRC was incurred, the business suddenly found itself unable to make payment, and so a plan was needed to either reduce expenses or increases revenue to allow for repayment of the monies owed to HMRC.

Coming back to our company, I remember asking how we could reduce liabilities or increase revenue – surely we weren\’t about to propose some untried marketing scheme, and were unlikely to understand their market better than the owners of the company.

In response, my mentor asked me what I knew about capital structures – I replied that a business has a number of ways in which it can structure its capital base; two of the most commonly known are \’common shares\’ and \’loans\’. With the first of these, an investor gives cash to the company in return for equity, or partial ownership of said company, banking on the idea that their \’share\’ of the company will increase in value and that they will receive dividends, which are payments received from a share of any profit the company makes. With the latter, they provide cash in return for interest, but without an equity stake.

I was also vaguely aware of things called \’preferred stock\’ and \’bonds\’, although I had less of an idea what exactly these were, and I couldn\’t draw a line between these concepts and revenue in any meaningful way.

To help clarify, my mentor asked me to picture a plane with four sections; First Class at the front of the plane, followed by Business, Standard and Cargo classes. This particular plane was different, in that it only had a single entrance through First Class. He asked me to imagine that this plane represented the business we were working with, and that each \’class\’ represented a different type of capital. First Class was Loans, Business Class was Bonds, Standard Class was Preferred Stock and Cargo Class was Common Stock.

In the event of the plan needing to ditch or the passengers needing to evacuate, the first people off the plane would be those closest to the door; those in First Class (individuals who had given loans to our client). Next off would be the Business Class, or bond holders, followed by Standard Class (Preferred Stock) and finally the cargo (or Common Stock holders).

Loans and Bonds provide no equity in a company in exchange for capital, but come with a guarantee of regular repayment. In the event of default, the creditor of the Loan or Bond is able to make claim upon assets held by the company in order to recoup their money. Preferred Stock is similar, but also comes with an equity stake in addition to a small regular payment. Common stock holders have equity, but are only entitled to dividends when voted for by the board, and so represent a smaller expense to maintain.

In the case of our client, my mentor pointed out that they could petition the holders of Bond and Preferred Stock to swap their securities in exchange for Common Stock. As the business was \’going down\’ – i.e, struggling to maintain their liabilities with the reduced income they now had, there was a very real change that they could be declared bankrupt. In this event, \’bail-outs\’ would be paid in the same order as people leaving our metaphorical plane – Loans are repaid first, followed by Bonds, Preferred Stock and finally Common Stock. If the value of the assets the business held were insufficient to repay all liabilities, there was a very real chance that many capital owners could end up losing parts (if not all) of their capital.

In order to reduce the risk of this eventuality, they could instead agree to swap their Bonds and Stock, reducing the outgoing payments and hopefully helping to stabilise the company and thus protect their original investment.

This was a lesson which spoke volumes to me, as I\’ve met a number of individuals over the years who have been unwilling to \’compromise\’ what they see as their right, and in doing so \’went down with the plane\’ rather than reduce their sense of entitlement. Being strong in the face of adversity is an important part of who I am, but being flexible in the face of a challenge is just as important. When a stubborn will meets an immovable conclusion, disaster is often the outcome; don\’t be afraid to change to stay in the game.

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