Most experienced managers – and the entrepreneurs that preceded them – would agree more companies have failed as a result of unhealthy balance sheets, excessive fixed costs and/or limited financial flexibility, than all other exposures combined. Why is this true?
An “entrepreneur,” as defined in Merriam-Webster’s iconic dictionary, is “one who organizes, manages and assumes the risks of a business or enterprise.” Foremost among these, no doubt, is the viability of the business or enterprise itself. Does it provide goods, services or information other businesses or individuals need or can be convinced they need to operate more efficiently or improve the quality of their lives?
Absent favorable resolution of this question, no other risks need be addressed, for the idea itself should be set aside entirely. But once a business concept has been rigorously considered and fully embraced, the risks that need to be “managed and assumed” by our same entrepreneur – or those overseeing this same business even years later – multiply manifold.
These risks may ultimately include everything from tax and legal liabilities to supply chain concerns, credit and currency exposures, quality control, raw material and shipping costs, business execution and the like. But without question, foremost among them and present at every stage in the life cycle of virtually every business is poorly executed or inefficient financing.
Why have so many businesses, even those built on extremely compelling product ideas or value propositions, struggled to secure efficient financing and intelligently maintain their balance sheets over time? Answers to this question are as varied as the companies to which they apply and may, in certain contexts, be far from straightforward.
For larger private, IPO track or public companies, poorly wrought balance sheets may have less to do with a lack of financial acumen or oversight on the part of those at the controls and more to do with conflicts of interest inherent in the capital-raising process itself.
This is particularly true for companies that obtain financing through investment bank or placement agent channels. Given the breadth of business models and paths to capital, this article focuses on the process whereby companies retain banks or agents to sell equity, convertible or debt securities to investors.
In order to understand the “risks” such well-established funding channels may pose to a company’s “all-in” cost of capital, it is important to examine the process closely and identify the competing interests and dynamics at work within it.
Management teams also need to recognize a significant information and experience “gap” exists between themselves, as infrequent issuers of securities, and the firms they retain to raise capital, which close dozens or hundreds of such deals a year and for whom these transactions are a primary source of revenue.
The decision to raise financing begins internally and is driven by the need to fund growth initiatives or acquisitions or refinance existing obligations. If bank financing is unavailable or inappropriate for such purposes, companies may invite investment banks to present their thoughts on fund raising alternatives and their credentials to lead such transactions.
Information garnered through these bank “pitch books” is then integrated with internal thinking and a financing strategy and deal team is settled upon. Over the ensuing weeks or months, the management team, investment bank(s) and other advisors (legal, accounting, etc.) draft deal documents and marketing materials. Finally, a “go/no go” decision is made, the offering is launched and the process of book building, negotiation and final pricing is set in motion.
Sounds straightforward, but let’s examine several key points in the process and where various allegiances and pressures lie.
Leverage the competitive point
Prior to selecting a deal manager, companies are positioned to benefit from the highly competitive dynamics of banks vying for its financing mandate, and the revenue/market share opportunity it represents. At this point – commonly referred to as the “bake off” or “beauty pageant” – the banks are working aggressively to differentiate themselves and will gladly put all of their considerable analytical capabilities, resources and experience at the company’s disposal. This opportunity should not go wasted.
Savvy management should utilize this competitive point in the process to stress test its internal thinking and the input it has received from the various banks to optimize the structure and strategy of its pending offering.
It should also prepare for a fundamental shift (read: drop) in these competitive dynamics once it selects a deal manager. The reasons for this are obvious, as those firms not selected to manage the offering are no longer “on call” to the company for information or as a competitive “check” on the others.
So, after a rigorous process of financing alternative and deal manager review, which likely included negotiation of fees, a company now has its bookrunner(s) and baseline strategy. It may proceed with a single manager on the entire offering or structure a “deal syndicate,” inviting other banks to participate in the sales process – and fee – in a secondary capacity.
Such syndicates are often structured with fixed economics, arguably dis-incentivizing additional selling efforts, though companies could retain leverage deeper into the process by maintaining discretion over some portion of the deal fees.
The mindset trap
With the financing process now fully engaged, companies need to avoid a common trap – the assumption that since they interviewed and selected the deal managers and are paying the financing fee, these banks have an explicit obligation to serve their interests.
While the banks do represent the company – as issuer/seller of securities – in this process, and highly value this relationship, they also place these securities through their internal sales force, whose allegiance is to its investor client base – as buyers.
Managing the competing interests of buyers and sellers within a single institution jams a wrench into the service-industry adage, “the customer is always right,” restating it as a question – “which customer is right today?”
Add to this dilemma the banks’ own interest in maximizing revenue and the potential for misaligned interests and outcomes is clear.
Any uncertainly regarding banks’ view of the significance of these conflicts can be dispelled by a quick review of the indemnification language they require in engagement letters. Paraphrased, it requires corporate clients to acknowledge that the bank is not acting as a financial advisor, owes them no specific legal obligation, and is not required to disclose any conflicts of interest they have as a function of ancillary businesses or positions.
So how can a company best protect its interests when raising capital through banks or placement agents?
As with so many complex situations – business and otherwise – the first prudent step is full and honest assessment of the playing field, internal resources (and shortcomings) and the interests of all those involved.
Undertaken robustly, such accounting should lead management to conclude it is incumbent upon them to approach the process proactively, seeking information and experienced input, identifying and managing conflicts and employing mechanisms to retain leverage.
For only by approaching the process holistically and making itself a well-informed purchaser of investment bank services can a company hope to optimize the efficiency of its capital structure over time and neutralize the experience/information gap with its bank(s) that so clearly exists.
David Pritchard is co-founder/principal of Aequitas Advisors, which offers advisory services to corporate clients analyzing or engaged in capital raising, exchange or restructuring initiatives. They seek to help clients intelligently manage capital markets activity, preserve financial flexibility and reduce their “all-in” cost of capital. Mr. Pritchard was most recently co-head of Equity Capital Markets at CIBC World Markets. During his career David has had direct responsibility for a broad range of equity, equity-linked and restructuring assignments with a notional value of over $7 billion.