Why business owners should consider ESOPs when exiting their business

Every privately held company, whether owned by individuals, a family or private equity firm, must go through ownership transition at some point. When the time comes, an owner has several options: create liquidity via a leverage recapitalization using a debt-funded dividend to owners; sell control to a strategic or financial buyer; or sell a minority or majority stake of the company to an Employee Stock Ownership Plan (ESOP).

“An ESOP is a qualified retirement plan designed to give employees an opportunity to own employer stock,” says Jim Altman, Middle Market Pennsylvania Regional Executive at Huntington Bank. “ESOPs are the only retirement plan allowed to borrow money to purchase employer stock. Once purchased, the employer stock is allocated to accounts for individual participants so that, when they retire, they can either receive cash or shares, which are then sold back to the ESOP.”

Altman says an ESOP is considered a Qualified Defined Contribution Retirement Plan that is invested primarily in company stock. It’s a flexible tool for owners to sell all or part of a privately held business.

“In this arrangement, the business owner controls the timing and extent of his or her exit, but may still maintain company control or use the tax advantages to help fund its sale.”

Smart Business spoke with Altman about ESOP viable options and potential benefits the structure provides owners and their companies.

What are the characteristics of companies that are typically found to use ESOPs successfully?

ESOP plans work well for companies with:

  • Strong cash flow.
  • A history of stable sales and profits.
  • Taxable income.
  • A capable management team in place that will remain after the sale.
  • An annual payroll of $1 million or more.
  • An owner who has a significant portion of his or her net worth invested in the value of the business.
  • Valuable employees.

Industries considered suitable for ESOPs include:

  • Manufacturing.
  • Financial Services.
  • Construction.
  • Professional Services.
  • Wholesale Trade and Distribution.

What advantages does transferring ownership to an ESOP offer?

Significant tax advantages come with ESOP ownership as selling to an ESOP is a tax advantaged transfer of ownership. The seller’s proceeds can potentially be tax-free via 1042 rollover. There are income and estate tax savings for sellers, management and the company. If the business is structured as a 100 percent ESOP-owned S-Corp., the company will not pay federal income tax.

Also, an ESOP can deduct the transaction price over time, enhancing cash flow and improving credit metrics.

Among the advantages to a seller when transferring ownership to an ESOP is liquidity — the seller gets more money after tax for the sale of closely held stock than for the sale of assets to a third party. The seller enjoys a rate of return via the seller notes, which is far superior to any return available on an alternative investment with fully understood risk and within the seller’s control to manage.

Selling to an ESOP offers flexibility as an owner may sell between 30 to 100 percent of the shares either all at once or gradually over time to accommodate multiple seller exit scenarios. It also creates the option for the seller to maintain control over his or her company, or allow the previous management team to maintain control and management of the company. Warrants and stock appreciation rights may be used to provide incentives to key managers.

How does the transition to an ESOP affect the employees who remain at the company?

There are indications that transitioning to an ESOP improves employee performance as a result of having an ownership interest in company and the accompanying enhanced retirement benefits.

ESOPs can provide advantages to owners transitioning out of their companies, as well as employees. For the right companies, it can be worthwhile to explore an ESOP option.

Insights Banking & Finance is brought to you by Huntington Bank

Find a bank that believes in your company’s business model

Companies that have built and maintained a strong relationship with their bank are in a much better position to overcome financial hardships, says Rick Hull, Executive Vice President and Regional President at Home Savings.

“Let’s say your business is strong, but you have a bad quarter or even a bad year and you’re showing a loss on your financial statement,” Hull says. “Now it’s time to renew your line of credit at the bank. If you have someone at the bank who is an advocate for your business and has the ability to tell your story to the bank’s credit committee or to regulators, you have a better chance to get the benefit of the doubt. You need someone at the bank who believes in you and believes in your business.”

When those relationships begin to fade and the connection you feel to your bank weakens, it may be time to consider other options.

“When you’re no longer being treated like a prospect or a valued client and you start to feel neglected to the point that you have to pick up the phone and make the call to maintain the relationship, that’s a clue that you should start looking for a new bank,” Hull says.

Smart Business spoke with Hull about how to recognize when it’s time to look for a new bank.

Where do things tend to go wrong in the relationship between a business and a bank?
One potential trouble spot is when your primary contact at the bank is continuously changing. This gets back to the idea of building relationships with someone who can tell your story. If you have to keep bringing a new person up to speed with what you do and how your business works, that’s taking time away from focusing on your business.

Or, your business may not be getting the attention you need because your banker doesn’t understand your business and has no authority to make local decisions, so he or she is unable to advocate for you. You may need a bank that is willing to visit your company, understand your needs and put together a plan that works for you and the bank, then get answers for you quickly.

It also may be that your business has expanded significantly or your needs have changed and your bank doesn’t have the capacity from a capital standpoint to maintain the same relationship that it once had with you.

Change is always going to happen, both in your business and with your bank. When the change becomes uncomfortable for you and/or more than an isolated incident, that’s when it’s time to be concerned.

What’s the best approach to find a new bank?
You want to evaluate your banking situation with some frequency. If you’re going to make a change, you want to be the one driving the change. This puts you in a much stronger position than would be the case if your bank is the one asking you to leave.

In reality, it’s a good idea to have a relationship with two banks. Certainly, one bank will be your primary bank.

But if something goes wrong there, you have the second bank that knows who you are and would be in a position to take your business. This bank might be willing to take a lesser role in hopes that one day it will become your primary bank.

The key is to operate from a position of strength and to not wait until you’re forced to make a move out of desperation.

What materials should you bring when you’re meeting with another bank?
Everybody is going to want to see your tax returns from the last couple years, your profit and loss statement and your personal financial statements. What was your budget last year, how did you perform against expectations and what are you projecting for the near future?

Another key point is that you need to have a succession plan. A majority of privately owned companies in Ohio are owned by people over 60. What’s the future of your business? Your bank should have confidence that you’re going to be there for a while and understand the plan for when you decide to move on.

If you’re open with the bank and the bank is open with you, it’s a good start to a positive relationship for your business.

Insights Banking & Finance is brought to you by Home Savings

Treasury management services provide options for a more efficient business

Treasury management services offer valuable tools to help your business run more smoothly, but it’s not a one-size-fits-all approach, says Kurt Kappa, Senior Vice President and Market Leader, Cuyahoga County, at Westfield Bank.

“Just because you have two businesses in manufacturing doesn’t mean they’re both going to have the same treasury needs,” Kappa says.

“It depends on the business owner and how he or she chooses to operate. With that thought in mind, you don’t want a bank that is simply looking to take your order. It’s best if your bank is taking steps to get to know you, offering input and making suggestions that it believes will help create efficiencies for your business and the people who run it on a daily basis.”

Tools such as automatic clearinghouse check payments and credits (ACH), line of credit sweeps and Positive Pay can be quite helpful, but only if they are a fit for what your company is trying to do.

Smart Business spoke with Kappa about treasury management services and how to work with your bank to determine which products and services are right for your business.

What are the primary benefits of treasury management services?
There are a couple advantages that stand out. Everything in today’s world, especially with technology, is about timing. Technology allows you to collect payments faster. If you want to go out and collect a payment via ACH, you can do it the next business day.

Soon, you’ll be able to do it the same day, since the Federal Reserve is implementing same-day ACH processing in three phases over the next two years. (It’s already available for credits and non-monetary entries.)

It’s not only being able to collect the payments faster; you are able to optimize the timing of those payments so you can hold on to your cash longer. Instead of having to send a payment a little earlier, you can hold on to it and send it the day before it’s due. This allows you to have better control over your funds. If you are using remote check capture, you are able to make a deposit right from your office.

The fact that you don’t have to leave the office saves you time and gives you flexibility since you don’t have to worry about getting to the bank during normal banking hours. You can do it at 5:30 in the morning or at 6 at night. Flexibility creates efficiency and saves you, the business owner, both time and money.

What are some services that tend to be underused?
Positive Pay is a fraud prevention tool that allows you to upload data pertaining to the payments you’re about to make for payroll, vendor payments or whatever it might be. You upload the check number, who it’s made payable to, the date it was issued and the amount for each check, and upload it to a Positive Pay site.

As those checks clear the bank, each one has to match up with the data in that file. If a check is made payable for $500 and a bank is trying to clear that company’s account for $1,000, it creates an exception because it doesn’t match up with what is in the file. You would get an email notification saying that you have pending exceptions that you need to go in and look at.

In some cases, it may not be an instance of fraud, but rather an unintentional mistake that gets flagged. The benefit of the service is that you find out about it and have an opportunity to address it before it is processed.

Another fraud prevention tool is dual control. One user needs to initiate a payment and another user needs to approve the payment in order for it to be processed. This makes it more difficult for a fraudster to get in and move money out.

What’s the key to finding the right level of service for your business?
Talk to your bank about what other companies in your space are doing. That doesn’t mean you need to or should do the same thing, but it gives you a starting point. Treasury management services are meant to help a business operate more efficiently. If you approach it from that mindset, you should be able to find what you need.

Insights Banking & Finance is brought to you by Westfield Bank

Treasury management services provide options for a more efficient business

Treasury management services offer valuable tools to help your business run more smoothly, but it’s not a one-size-fits-all approach, says Jarrod Long, Vice President and Treasury Management Officer at Westfield Bank.

“Just because you have two businesses in manufacturing doesn’t mean they’re both going to have the same treasury needs,” Long says.

“It depends on the business owner and how he or she chooses to operate. With that thought in mind, you don’t want a bank that is simply looking to take your order. It’s best if your bank is taking steps to get to know you, offering input and making suggestions that it believes will help create efficiencies for your business and the people who run it on a daily basis.”

Tools such as automatic clearinghouse check payments and credits (ACH), line of credit sweeps and Positive Pay can be quite helpful, but only if they are a fit for what your company is trying to do.

Smart Business spoke with Long about treasury management services and how to work with your bank to determine which products and services are right for your business.

What are the primary benefits of treasury management services?
There are a couple advantages that stand out. Everything in today’s world, especially with technology, is about timing.

Technology allows you to collect payments faster. If you want to go out and collect a payment via ACH, you can do it the next business day. Soon, you’ll be able to do it the same day, since the Federal Reserve is implementing same-day ACH processing in three phases over the next two years. It’s already available for credits and non-monetary entries.

It’s not only being able to collect the payments faster, you are able to optimize the timing of those payments so you can hold on to your cash longer. Instead of having to send a payment a little earlier, you can hold on to it and send it the day before it’s due.

This allows you to have better control over your funds. If you are using remote check capture, you are able to make a deposit right from your office.

The fact that you don’t have to leave the office saves you time and gives you flexibility since you don’t have to worry about getting to the bank during normal banking hours. You can do it at 5:30 in the morning or at 6 at night. Flexibility creates efficiency and saves you, the business owner, both time and money.

What are some services that tend to be underused?
Positive Pay is a fraud prevention tool that allows you to upload data pertaining to the payments you’re about to make for payroll, vendor payments or whatever it might be. You upload the check number, who it’s made payable to, the date it was issued and the amount for each check, and upload it to a Positive Pay site.

As those checks clear the bank, each one has to match up with the data in that file. If a check is made payable for $500 and a bank is trying to clear that company’s account for $1,000, it creates an exception because it doesn’t match up with what is in the file. You would get an email notification saying that you have pending exceptions that you need to go in and look at.

In some cases, it may not be an instance of fraud, but rather an unintentional mistake that gets flagged. The benefit of the service is that you find out about it and have an opportunity to address it before it is processed.

Another fraud prevention tool is dual control. One user needs to initiate a payment and another user needs to approve the payment in order for it to be processed. This makes it more difficult for a fraudster to get in and move money out.

What’s the key to finding the right level of service for your business?
Talk to your bank about what other companies in your space are doing. That doesn’t mean you need to or should do the same thing, but it gives you a starting point. Treasury management services are meant to help a business operate more efficiently. If you approach it from that mindset, you should be able to find what you need.

Insights Banking & Finance is brought to you by Westfield Bank

Mezzanine capital serves a purpose for those who know how to use it

Mezzanine capital is the portion of a company’s capital that sits between the senior debt and common equity and typically is in the form of subordinated debt. Mezzanine debt can provide flexible, longer term capital, which is less expensive and dilutive than equity.

Smart Business spoke with Jim Altman, Middle Market Pennsylvania Regional Executive at Huntington Bank, about mezzanine capital, the situations in which it can be leveraged as well as what criteria those who borrow mezzanine capital must meet in order to qualify for it.

Mezzanine capital is referred to as subordinated debt. What does this mean, and how does it affect when it is used and who uses it?

The senior debt has priority to all payments and collateral. The subordinated debt has priority before the common equity stakeholders. Mezzanine capital/subordinated debt can be used in order to fund acquisitions and as growth capital, and it also has applications in situations such as management buyouts, debt restructuring and succession planning, and can be used to leverage recapitalization.

Mezzanine capital providers are looking for certain criteria when providing this type of debt. For instance, lenders want companies with a solid, proven track record, good cash flow and solid management. Mezzanine capital is not, however, available for startups, companies that have a high exposure risk to commodities, or companies that have narrow customer concentration.

In what ways can mezzanine capital be used to as a tool to help finance an acquisition?

In an acquisition, mezzanine capital can certainly provide a portion of the capital stack. The utilization of mezzanine debt along with senior debt can provide a cost-effective solution for expansion-minded companies and provide the ability to raise less outside equity for the acquisition.

What are the potential risks or the downsides of acquiring mezzanine capital?

Borrowers may see covenants that restrict the ability for additional borrowings and refinancing, and may require quarterly or annual measurements of financial performance. In addition, spending including compensation and dividend payouts may be restricted. The cost of mezzanine capital is higher than that of senior debt.

What misconceptions are there around mezzanine capital that might mean it’s a product that goes unexplored?

The misconception certainly could be that mezzanine capital is not really a well-known product, but is certainly a viable source for companies to access capital for a variety of reasons:

  • Mezzanine capital can support a company’s long-term growth and increase the value of current shareholders, and in some cases allow the owner/shareholder to receive liquidity.
  • Mezzanine capital providers have the ability to continue to invest in a company to support future growth needs or assist in ownership transitions.
  • Mezzanine providers are making a five-year plus investment and certainly have the ability to provide advice and support in the operation of the business over a longer time period.

Mezzanine financing can be particularly advantageous for companies that are going through ownership transition, recapitalization, internal aggressive growth or an acquisition growth strategy

This type of financing is just another arrow in a borrower’s finance quiver. For those who haven’t heard of mezzanine capital or who aren’t aware of the ways in which it can be used, it’s certainly a product that is worth exploring.

Insights Banking & Finance is brought to you by Huntington Bank

Take steps to find a bank that can help your company grow

The banking industry is ever changing. In 2016 alone, banks saw more integrative technology, a changing physical landscape and an increase in mergers and acquisitions.

“As these changes cause customers to re-evaluate their banking relationship, many institutions are also being proactive about customer retention,” says Donna Dolezal, Vice President of Commercial Lending at Northwest Bank.

“As we look into 2017, innovation, product and service improvement and exemplary customer service will continue to be a critical piece for banks and their efforts to retain current customers and remain competitive in their respective markets.”

As your business assesses its own future, it’s important to find a bank that can provide a level of service that meets your own unique needs.

Smart Business spoke with Dolezal about what to consider when assessing the compatibility of potential banking partners.

What signs might indicate it’s time for your business to look for a new bank?
Many issues stem from poor communication. This can be an issue if you’re planning on growth that will require funding to make it work. It’s also a problem if your trusted banker leaves for a new opportunity. No matter the problem, if you’re committed to invest time, money and resources in your growth plan and you’re uncertain as to whether you have the right partnership to meet those needs, it might be time to look for a new bank.

What’s the best approach to take as you explore your banking options?
Take time to think about your trusted advisers. Who are they? Hopefully your accountant and attorney come to mind. Also consider business advisers you work with. You can even speak with employees who deal with banks to provide suggestions for better solutions. They can also make introductions to other banks and bankers.

Don’t forget to consider the banker who calls on you regularly and has expressed interest in your business or introduced you to solutions before your own bank did. You may want to list the products and services you currently use on a spreadsheet.

Add information like rates, fees and terms. When you meet with other banks, add in details for comparison. You may also want to add other suggested services and their cost into the conversation.

What if you have concerns about the transition and process involved in switching banks?
The transition process is a little more complicated than opening a new account. Most clients have multiple services, including deposits, treasury and credit facilities. These services need to be set up and people need to be properly trained. This often requires other bank employees to be involved and committed to the transition.

As you think about the change, refer to your spreadsheet and create a new column of concerns. Have a conversation with your new bank before you transition to share your thoughts. Have employees involved with banking matters at your company identify and share their perspective with you.

Share this feedback with your new bank and work together to create a transition plan. Everything should be addressed so the changeover is as smooth as possible. To that end, consider the personnel involved and the timeline for completion, along with who to contact if something goes wrong. It’s also important to communicate with your existing bank and provide notice that you’re leaving.

What can a company do internally to create a stronger partnership going forward, whether it’s your current bank or an existing bank?
Involve your CFO/controller and employees who interact with the bank regularly. Invite these key individuals to attend meetings as you interview other banks or meet with your current bank. They can aid in the internal due diligence to determine the best fit in a banking relationship.

There are many great banks and bankers out there. But there is always the potential for change. It’s never an easy process to change, especially when it concerns such an important partner in your business as your bank. The long-term goal is to gain a trusted banking adviser who adds value to your company by providing the right solutions.

Insights Banking & Finance is brought to you by Northwest Bank

Strategies companies can use to mitigate the effects of interest rate risks

With interest rates just off record lows, now may be an opportune time to lock in rates on variable long-term debt, especially given the backdrop of potential rate increases by the Federal Reserve.

“Right now the market is predicting that the Federal Reserve will increase short-term interest rates at least a twice this year,” says Jim Altman, Middle Market Pennsylvania Regional Executive at Huntington Bank. “The truth, however, is that no one knows what will happen, not even the Federal Reserve.”

Traditionally, companies would mitigate interest rate risk by choosing a fixed rate loan. In today’s market, a company can employ a more customized strategy using interest rate swaps that can actively manage potentially rising interest rate costs.

Given the inherent uncertainty and volatility with the interest rates going forward, managing interest rate risk by using an interest swap or securing a traditional fixed rate are examples of commonly used risk mitigation tools. But companies should form their own risk management strategy that is developed based on their view of the market and their unique risk tolerance level.

“It should be a strategy that says, ‘This is our view of what may happen to interest rates and these are the risks we’re willing to take.’ And companies should adhere to it regardless of what rates do.”

Smart Business spoke with Altman about strategies businesses can use to mitigate the risk of interest rate increases.

What should companies consider as they create a plan to mitigate the effects of an interest rate increase?

Risk mitigation strategy is based on a company’s risk tolerance, the amount of debt it holds and its perspective of the market. Interest rate predictions offered by market analysts shouldn’t be the only consideration because no one really knows what will happen next. The economy is global and issues outside the U.S. impact the domestic market. So companies must operate within their set risk strategy, which is based in part on what their business can handle if rates were to change.

With the company’s expected debt levels and associated finance terms in mind, determine what risks can be absorbed. The questions to ask are:

  • What is the risk to the business if rates increase?
  • What is the effect at each stage of an escalating increase?
  • How high could interest rates rise before it becomes a problem?
  • Is the company willing or able to risk that its costs will increase to that level?

Most customers do not delve this deep into the impact of interest rates, and it’s a simpler question: Do I prefer a level of certainty of interest cash flows or am I comfortable with the uncertainty of the future?

Once those questions are answered, then determine how to keep risk within manageable levels. Once a strategy is formed, execute on it.

How do businesses benefit from using interest rate swaps to hedge against interest rate increases?

It’s really about managing interest rate exposure. An interest rate swap is an alternative way to manage variable rate exposures and gives the borrower an opportunity to customize that exposure and risk tolerance to fit the borrower’s strategy. Whereas in a traditional fixed rate loan, the company would fix the rate on the entire loan amount, the interest rate swap allows a company to set how much floating rate exposure it wants, determine when the hedge will start, and how long it will be in place. For example, if a company is building a new facility and will take 12 months to do so, the company has the ability to set a fixed rate at closing to begin when the construction loan matures and the permanent loan begins 12 months from now, eliminating the interest rate risk between the start and end of the project.

There’s a benefit to having interest rate protection, whether that is through an interest rate swap or traditional fixed rate loan. It provides a level of certainty and allows businesses to focus on their day-to-day operations. Businesses need to think about their risks and have a strategy to protect themselves. Develop that strategy, implement it and stay true to it irrespective of what’s happening in the market.

Insights Banking & Finance is brought to you by Huntington Bank

How working with your bank can bring you closer to your goals

Banks can play an integral role in the long-term success of your business, says Michael Benson, Vice President/Akron Metro Manager at Consumers National Bank.

“While banks are always interested in lending to businesses, they are required to do so to healthy companies that have a high probability of repaying their loans,” Benson says. “So, the banker has a vested interest in the success of your company and doing what it can to put you in a better position to achieve your goals.”

When you take the time to review quarterly financial statements and talk about what’s happening in your business or to ensure that your banker and CPA know each other, it can help you in good times and when times turn tough.

Smart Business spoke with Benson about how to build a stronger partnership with your bank.

What are some key points to consider when choosing a method to fund your business?

When you’re ready to look at the various options to fund your business, it’s helpful to focus on three key areas:

  • Purpose of funds — This will drive the type of borrowing that is needed. For example, if you need to fund operations as part of your normal cash flow cycle, then a line of credit is the most appropriate tool. Banks expect that you will use a line of credit to fund short-term working capital needs such as payroll, materials and other short-term expenses, and then pay down the line as you get paid for finished goods. If you need equipment, vehicles or other fixed assets, a term loan should be used. Generally, term loans will have a three- to five-year payback period for most equipment and vehicles. However, very large pieces of equipment are sometimes financed up to seven years.
  • Availability of cash — Even if your business is flush with cash, you should always make sure you have sufficient reserves, as it is possible for sudden growth to eat away at those funds. If arrangements aren’t made for a backup (line of credit), it is possible to grow the business out of existence. When you seek financing, the bank is always interested in your cash reserves to provide reassurance that your business could survive a downturn. There are also times that a business may present the idea of a significant down payment on a fixed asset, but the bank recommends a lower cash investment. This happens in cases where the bank does not want to see the business deplete all of its reserves.
  • Expected return — Finally, you must consider whether it is likely that your business will get a big enough return from the investment. Not only should you do financial projections on expected revenue and expense changes, but you should also work to make sure these projections are as realistic as possible. Thinking in terms of ‘worst-case scenario’ helps you to anticipate difficulties and plan ahead for them.

How do factors such as the size and status of your business affect this decision?

Exercise restraint when taking on new clients in high-growth conditions. If you add equipment and labor costs, these expenses will have to be confronted in a slowdown.

Conversely, if your company’s growth is stagnant, you should work to keep costs down, be as efficient as possible and be disciplined about your line of credit usage.

There is sometimes a temptation to use the line instead of dealing with cost cutting. This results in an embedded line, with no availability of cash for future working capital needs.

Regardless of the growth opportunity, a smart business takes on growth in a slow and careful manner. Otherwise, you increase your cost structure and put yourself at risk in the event that the growth is not sustained. You need a vision that is rooted in a path for success. When you take the time to forge a good working relationship with your bank, you’ll typically gain a partner that can help you plan for success, as well as take a vested interest in your success.

Insights Banking & Finance is brought to you by Consumers National Bank

Are you overlooking your foreign currency risks?

Nearly all S&P 500 companies discuss foreign currency risk and hedging activities. However, any business that is competing, buying or selling services and/or products internationally, regardless of its size, faces some form of economic risk attributed to currency movements. Even if companies are transacting internationally in U.S. dollars only, they are still subject to foreign exchange risk.

“One of the biggest challenges companies face is the ability to identify and quantify their foreign exchange risk exposures,” says Jim Altman, middle market Pennsylvania Regional Executive at Huntington Bank. “This is particularly true of economic risk — the competitive advantage or disadvantage resulting from exchange rate fluctuations that impact the value of a firm. Even those that can identify their exposures face the issues of optimizing their hedging strategies or forecasting their future exposures.”

Smart Business spoke with Altman about foreign exchange risk and strategies to hedge against it.

What are the first steps to hedging the impact of foreign currency fluctuations?

An effective strategy is to lock into a forward contract or enter into an option contract. These strategies allow companies to lock in exchange rates today to settle contracts in the future and can mitigate currency exposures currently on the books or expected future exposure. Hedge accounting rules may also play into companies’ hedging policies, if applicable.

What are the more common hedging strategies?

Most companies implement a foreign exchange risk hedging program to reduce earnings or cash-flow volatility. Given this objective, it’s wise to create and implement a formal hedging program, which includes establishing a foreign exchange policy.

For example, the program may seek to hedge 100 percent of foreign currency receivables/payables currently listed on the balance sheet. Additionally, the company may also forecast foreign exchange risk exposure out one year. However, if the company does not wish to hedge all exposure, as many do, the plan may include hedging 75 percent of anticipated exposures less than six months out and 50 percent of anticipated exposures six to 12 months out. This is called a tiered hedging approach.

Often companies ask if it is best to hedge all known exposure at one point in time, called a static approach, or if they should layer on hedges — a dynamic approach — throughout a defined time period while blending the varied rates. It is important to consider the level of confidence in forecasted payables and receivables to decide which strategy is best. When considering an approach, it is important to define what percentage of ‘core’ hedges should be locked-in vs. the percentage that should be ‘tactical’ or market driven hedges.

What should companies know and understand before hedging their foreign currency risk?

Throughout the risk management process, the most challenging step can be exposure identification. Foreign income translation can be challenging to hedge, but it may be the cause for unwanted cash-flow fluctuations. Meanwhile, other foreign exchange risk exposures may go completely unnoticed. For example, a company that sells internationally in USD would be extremely vulnerable on a competitive scale if the U.S. dollar rallies broadly. Conversely, if a U.S. company is sourcing overseas in U.S. dollars, it may be over-paying, prompting price concessions.

It is also important for a company to know and understand their tolerance for foreign exchange risk. It is not always advantageous for a company to hedge all of its exposures. Comfort with a specific earnings-at-risk or cash-flow-at-risk will help prevent over-hedging.

Developments in technology and globalization mean the world is increasingly becoming a single market. Often, companies grow faster than their comfort level in managing associated foreign currency risks. Fortunately, the foreign exchange risk market is extremely accessible to businesses of any size, and banks’ foreign exchange risk advisory teams can help tailor risk management solutions that best fit companies’ ever-changing needs.

Insights Banking & Finance is brought to you by Huntington Bank