How to get back on track

Debt can be a useful tool in building a business, as long as you don’t spread yourself too thin trying to repay the debt, says Rob Lake, senior vice president and head of Life Sciences at Bridge Bank.

“You get to a point where it becomes challenging to raise equity,” Lake says. “Now you have all this debt and you have potential equity providers who are leery of working with you because they don’t want their money to just be used to pay back debt.”

Biotech and life sciences companies are big business in today’s economy, but getting off the ground and beyond the early-stage growing pains can be a challenge.

Smart Business spoke with Lake about the consequences of being overleveraged and what you can do to get back on track toward achieving your goals.

What are some clues that your company may be overleveraged?
There are a couple clues that offer evidence that your company may have taken on too much debt.

Typically, biotech and life sciences companies will utilize a venture debt structure that includes an interest only (IO) period that ranges anywhere from 12 to 24 months. During this period, you only pay interest, not principal.

It’s an effective way to reduce the cash burn at least on a temporary basis. And it’s understandable when businesses look to prolong this period to avoid having to pay both interest and principal for just a little bit longer.

If you are struggling to find debt providers willing to refinance your loan and enable you can extend the IO period, however, that’s a sign that you may have taken on too much debt.

Another clue that you may be overleveraged is if you’re at a point where equity providers don’t want to make any additional investments until you restructure or refinance the existing loan in an effort to reset the IO period.

It’s really challenging if you find it difficult to refinance your existing debt and at the same time are unable to attract additional equity capital.

What can an overleveraged company do to turn things around?
If you want to continue to fund the business, you may have to do a very dilutive transaction, meaning you take on some equity at a lower valuation.

Existing shareholders may get diluted because you typically have the next round of equity with a new investor that will look to lower the valuation of the company.

From a lender’s perspective, right-sizing the debt is more art than science. There isn’t a formula that you can put all the numbers into and get an ironclad solution.

Yes, there are financial metrics that can be used to help determine the right amount of debt for a business, but those metrics are still based on variables and data that may not be as reliable as you would like.

As an early-stage company, it’s hard to pinpoint the true value of the company. Determining the appropriate amount of debt based on the current value of the company is not always accurate.

What’s the key to boosting optimism with your stakeholders?
You need to be collaborative and get everyone around the table to explain the situation. Have your investors reconfirm their support for your business. This will help put your lender at ease.

Talk to your debt provider about an additional IO period or a refinancing/restructuring of the loan. This will help put your investors at ease and may entice them to put in additional equity capital.

Lenders like it when a company has a collaborative attitude and is forthright with a challenging situation. Good management teams are able to coral all of the stakeholders, get everyone to work together and get the company out of a precarious situation.

Demonstrate that you have a plan and work with your investors, lenders and business partners to make it happen. ●

Insights Banking and Finance is brought to you by Bridge Bank

A look at what’s in store for the business community in 2016

Two hot topics California businesses will be thinking about as 2016 gets going are a minimum wage increase and a split property tax proposal for businesses that own real estate.

Whether you view these changes as opportunities or challenges depends on your point of view, says JC Timmons, senior vice president, Southern California Corporate Banking, at Bridge Bank.

“This minimum wage escalation and the attendant politicization is only in the beginning cycle, so it’s likely not going to go away,” Timmons says. “But this is clearly a 2016 and beyond item that companies are budgeting for, factoring not only into their profit margins, but also into their supply chains.”

Cost increases along that supply line in California could lead to some difficult decisions on labor and managing to those relationships is important, Timmons says.

“If you’re doing business across state lines with different wage thresholds, those pressures in the supply chain need to be watched carefully,” Timmons says.

Smart Business spoke with Timmons about the split property tax proposal and other factors that will affect businesses in 2016.

What is the split property tax proposal?
California has Proposition 13, which limits the assessed value of properties to no more than a 2 percent increase per year, as long as the property is not sold.

Senate Constitutional Amendment No. 5 (SCA-5) would leave residential real estate untouched, but it would single out commercial and industrial property ownership, opening those properties up to greater annual valuation and tax increases.

This proposal has not been met warmly in California’s business community as it would be a disadvantage for businesses in the state.

It’s easy to think of the massive, well-capitalized Fortune 1000 firms in the state that can roll with this, but there’s another element to it.

Many small businesses sign triple net leases and by the nature of those leases, tax obligations flow back to the tenant. So you’d see monthly lease payments increase by a significant amount in those instances. In short, a split-roll property tax would increase operating costs with negative consequences.

This is an important policy that the business community is going to be watching and certainly making capital budgeting decisions around if it ever gets legs through the legislature.

What about any specific industries to watch this coming year?
In California, we’ve seen nice comebacks the last few years in health care, hospitality and professional services.

Certainly technology companies continue to thrive, as do any providers making or moving a tangible product.
Themes or common traits emerge with the most successful firms. One of the most common themes is that the owners and managers care deeply for their businesses.

Oftentimes a large percentage of personal net worth is tied into these businesses, and if that’s not the case, as an executive, the day-to-day business needs are very time-consuming, thereby important.

Lenders and depository institutions like to serve in as much of an advisory role as is possible and this begins by understanding the ultimate objectives of the company and its management team and creating value within that context.

What are some examples of creating value from a banking perspective?
The most highly pursued answer is oftentimes credit, and in situations where it is applied appropriately, strong value can be created.

For example, if there is a way to generate a loan facility accretive to the objectives of the company, or a structure to create additional free cash flows or other specific deal points personal to ownership, a bank aims to do that.

But a loan is not always the priority. Oftentimes there are solutions determined with foreign exchange experts on international commerce that still get overlooked by the folks down the street. Other times, it’s an introduction to another expert that can help solve a problem, or prevent one from occurring in the first place.

The focus is always on improving business value that even an objective third party would see, and in doing so, a business realizes the maximum benefits of business ownership. ●

Insights Banking & Finance is brought to you by Bridge Bank

SBA loans can help your business in more ways than you might think

Small Business Administration (SBA) loans can be a great resource for businesses that are struggling to obtain funding from traditional lenders, but they should not be viewed as a loan of last resort, says Ken Mannina, senior vice president and regional sales manager at Bridge Bank.

“The participating lenders that provide SBA financing get a credit enhancement from the SBA,” Mannina says. “However, the credit enhancement does not mitigate all risks for an applicant with poor credit, an operating company that has a history of losing money or a property that provides weak collateral support for the loan.”

SBA loans are a great tool for small business owners where debt is typically not otherwise available from conventional institutional sources. However, looking beyond the loan request and evaluating the business and its specific needs, the following should be considered.

“Some capital requirements are best served with debt, others with equity,” Mannina says. “However, most will require a combination of both.”

Smart Business spoke with Mannina about SBA loans and how to best position your business to secure the funding it needs.

What are some common misconceptions about how the SBA can help a business?
One of the most common misconceptions out there in the business community is that SBA loans are actually small.

The definition of ‘small business’ is very broad. Most businesses are eligible based on size. SBA loans go up to $5 million and can accommodate an owner-occupied commercial real estate purchase of up to $15 million.

Another misconception is that you have to be in business for several years to get the SBA loan. SBA loans can be made to startup or recently started businesses, however, there will likely be collateral requirements. Many applicants have only one full fiscal year of tax return reporting at the time they seek SBA funding.

There is also a belief by some business owners that SBA loans take a long time both to approve and to fund. In reality, many SBA loans we work on are funded in 60 days or less.

Business owners should also know that SBA loans can be used for more than just working capital, which should dispel another myth about the program. SBA loans can be used for working capital, but also for the purchase of equipment, business acquisition, debt refinance, partner buyout, or purchase and construction of owner-occupied commercial real estate.

What’s the key to identifying your greatest need and using that knowledge to secure the necessary funding?
The key to identifying your greatest need starts before you apply for the loan, at the time you are initially formulating the reason you need capital and/or are starting your business. You need to determine the best financing option to manage that need. Is it debt or equity?

Business owners want capital so they apply for a loan, but thought and due diligence needs to be applied before this decision is made.

Consider the ratio of debt to equity. What is a good structure that fits your needs and comfort level in terms of the resources at your disposal, the feasibility of your business, how it will have the best possibility of succeeding and how much you expect the business to grow?

Capitalizing the business with adequate equity at the beginning will be a key factor in the early stages of the business. Equity is defined as non-borrowed funds that are injected by the business owners. This could be money that you have been setting aside in a personal account for the express purpose of growing and supporting your business or it could be a gift from a family member.

What do SBA lenders want to see that will encourage them to want to support your business?
First and foremost, SBA lenders want to see repayment ability. They want to see historical cash flow from operations that is adequate to repay the loan.

Beyond that, the SBA lender will want to see management with the technical ability and character to run the business successfully and repay the loan. Lastly, the SBA lender will want collateral to support the loan, i.e. the assets of the business and possibly the assets of the principals of the business. ●

Insights Banking & Finance is brought to you by Bridge Bank.

Why you need to take a long-term view when managing your working capital

Companies that lack purpose in how they manage working capital can easily find themselves responding to one funding problem after another, says Justin Vogel, vice president and business line manager for Capital Finance at Bridge Bank.

“When you don’t have a plan, you manage your working capital on a reactive basis and don’t recognize until the last minute that you’re going to run short on cash,” Vogel says. “You have to find a quick solution to get cash rather than relying on a plan that is more cost-effective and ensures that you’re operating with liquidity at all times.”

Working capital is the lifeblood of your business. When it’s not managed proactively, it can severely limit your ability to grow your company.

Smart Business spoke with Vogel about best practices when it comes to managing your working capital.

What is a common mistake companies make in managing their money?
Some companies will routinely offer discount terms to their customers in an attempt to get paid more quickly.

However, if you annualize those discounts over a 12-month period, you’ll likely find that you end up paying out significantly more money in discounts to customers in your effort to get that cash more quickly. Often, the more affordable option is to get a bank line of credit and pay interest on that.

Typical discount terms are 2 percent if the customer pays within 10 days. If that customer is buying from you every other month, that adds up to 12 percent a year. The discount option may seem like a win-win for both you and your customers, but it usually does you more harm than good.

What can companies do when they don’t have a full-time CFO?
It can be a tough spot to be in when your business is growing, but hasn’t reached the point where you can afford to hire a full-time CFO. Many companies in this situation are not big enough that they need full-time service. One option to consider is hiring a part-time CFO.

Some companies rely on a bookkeeper or CPA, but the way the rules are written, CPAs need to be careful with the type of consultation they provide. A part-time CFO or consultant can check in with you on a regular basis and help you to make better and more informed decisions managing your working capital.

How much can a bank line of credit help a business?
A line of credit can help your business get cash before you get paid by your customers.

Some banks have two different lending tiers: A corporate group that handles more traditional banking needs and a capital finance group that focuses on asset-based lending. From a term, structure and pricing perspective, there is a significant gap between these two options.

The capital finance group is typically going to be more expensive and more structured from a collateral standpoint while the corporate finance group is going to be less in these areas, but more restrictive from a covenant perspective.

How can tax concerns restrict your profitability?
A company may decide to distribute profits to the ownership or management team in an effort to minimize taxes at the corporate level since they tend to be very expensive. But this step can have a negative effect on a company’s equity.

When profits are moved out of the business, they would otherwise flow through to the equity position of the company and onto the balance sheet. Over time, this can put a company that takes this action in the position of being overleveraged.

Most traditional bank financing options will require a debt to net worth ratio of 3-to-1. If the equity isn’t there, the debt component of that ratio can’t be very high at all before you start getting over that number. So you need to ask yourself: Is the tax savings worth the higher interest expense that you’ll have to pay on second tier debt options if you’re not building up that equity component on your balance sheet?

As you manage your working capital, you need to think about the long-term impact and cost-effectiveness of your decisions. The upfront investment you make to develop a comprehensive plan will be well worth it. ●

Insights Banking & Finance is brought to you by Bridge Bank.

How your bank can help you find the right funding strategy for your business

Debt financing can be an effective tool when growing your business, but leaders can be reluctant to pursue it, says Derek T. Almeida, vice president and business line manager for the Capital Finance lending group at Bridge Bank.

“Some businesses are run by their founders and they take pride in not having any debt on their balance sheet,” he says.
“Others don’t realize that they could qualify for debt because they feel they are too early stage or they have talked to people and been told they’re not traditionally bankable because they don’t have enough cash flow. However, there are multiple debt options available that might qualify your business sooner than you think.”

Equity is another option to grow your business, but Almeida says it’s not always the best path to take.

“It can become more expensive from a dilution perspective if you have to raise funds from friends, family or an institutional investor,” he says. “Sometimes you’re able to get bank debt. And even if you need to raise equity down the road, you might be able to push out that need and get a higher valuation so the dilution cost of bringing that capital in later is less.”

Smart Business spoke with Almeida about working with your bank to arrive at the best funding plan for your business.

How should past performance affect a company’s funding strategy?
When your company is on a strong growth trajectory and has tangible evidence to support continued success, you’ll obviously have more funding options on the table. But that doesn’t mean all hope of securing funding is lost if you’ve had a bad quarter, a bad year or even a bad couple of years.

You still need to talk to your bank, meet with potential funding sources including investors, and explore what’s available to help your business. Don’t make assumptions about what you believe banks can do because they can prove to be inaccurate.

When the overall economy is down, business leaders may assume that banks aren’t offering loans or financing to protect their own assets. The fact is, however, that banks can support a quality company with a strong growth plan in place.

And if they don’t believe it’s the right time to move forward with your plan, they can advise you and potentially help you avoid making a costly mistake.

Who should speak to the bank on behalf of your company?
When you provide your bank with more touchpoints and additional perspective about what your company is trying to do, you give it the tools to make a more informed decision as to what you need to achieve your goals.

Your financial team typically knows your company well from a fiscal perspective. If it’s a closely held business, the bank can meet with these leaders as well as the owner and come away with a good sense of where the company is at.

But not all companies operate that way. If it’s a company backed by venture capital or private equity, there may be leaders who aren’t as connected to the day-to-day operations and may be able to answer additional key questions a bank will want to know when you are trying to secure financing.

This dialogue can better familiarize the bank with your business model and either back up your projections or uncover potential flaws in your plan that you can now address collaboratively.

How can a bank help you raise equity?
Many banks can offer support to a company from the time it’s a startup to the period following an initial public offering and beyond. They work with companies that are looking to raise equity and have contacts with various private equity, venture capital and investment banking firms.

The bank can make an introduction to investors that it believes would be a good fit for your business or to an investment banker that can lead the process. A good bank looks beyond the deposit and credit relationship it has with your business and tries to build a partnership with your team to help you make connections and resolve your needs.

Banks can provide financing at multiple stages of a company’s life cycle and if they can’t do a deal for you, they can advise you to when they could and provide you with other options to consider. ●

Insights Banking & Finance is brought to you by Bridge Bank.

Be clear about your company’s needs before pursuing a new line of credit

One of the keys to securing an appropriate line of credit for your business is being clear about the problem you’re trying to solve, says Kelly Cook, senior vice president, Technology Banking Group at Bridge Bank.

“Are you trying to fill a cash flow gap between when you invoice for your product or service and when you actually get paid by the customer?” Cook says.

“Or are you trying to solve another problem in your business where you might be looking for additional cash to hire new salespeople or more operations team members. Those represent different types of cash needs that may require a term loan or even an equity investment.”

Clarity of purpose gives your bank or lender a solid starting point to help you find the right solution for your financing need. It also helps you avoid getting the wrong facility in place that could make it harder to obtain credit in the future.

“The more informed your bank or lender is with regard to the health of your business, your needs and your future plans, the better they can help you access additional borrowing capacity or financing to work out of a troubled situation,” Cook says.

Smart Business spoke with Cook about how to determine the appropriate line of credit for your business.

What are the best uses for a line of credit?

A typical line of credit is a working capital, revolving facility used to finance a short-term asset such as accounts receivable or inventory.

This differs from a longer term, more permanent type of financing like a term loan or equity that might be used to finance an asset with a longer life such as a new office or an increase in staffing. You want the type of financing to match the type of cash needed in the business.

What should you consider before pursuing a new line of credit?

First off, be sure that you clearly outline any existing debt or credit facilities for your prospective lender. Fully disclose any existing leverage, either through a bank loan, a finance company, or any other note or convertible note.

Your existing debt profile will have a strong influence on what a new lender can structure for your business. Depending on what you are trying to achieve, it may make sense to pay off the existing credit facility with a new one.

Where your business is in its life cycle is another factor which could affect the structure of your loan and the type of line of credit you can obtain. If your business is established and growing, you’re likely to get more favorable terms with a credit facility that provides flexibility as well as adequate borrowing availability.

If you don’t have a strong track record, it doesn’t mean financing is unavailable. It could just mean that you might start with a more restrictive structure or higher pricing for a period of time.

How important is a financial forecast in your ability to get a line of credit?

You and your senior leadership team should develop a forecast that represents your best estimate of how the business is going to perform going forward.

A lender is not only interested in where the company has been, it also wants to have a sense for what the future looks like.

Everyone understands that actual future performance will not exactly match the forecast, but the forecast should show performance that can support the line of credit being contemplated.

What is a line of credit collateral audit?

Lenders will often require a periodic collateral audit — a third-party checkup on how a loan’s collateral is performing and a profile of a business’s customer base.

For an accounts receivable line of credit, the audit will evaluate accounts receivable performance — validating that invoices are being issued against contracts or purchase orders, that they are being issued per contract terms and that payments are coming in per contract terms.

The audit will also measure customer profile information such as customer concentration. ●

Insights Banking & Finance is brought to you by Bridge Bank.

VC capital is available to entrepreneurs with a solid plan to take market share

Venture capital (VC) investment is at a 15-year high and offers no hint of slowing down, says Michael David, managing director for Equity Fund Resources at Bridge Bank.

The second quarter of 2015 saw VC investments totaling $17.5 billion, the most since the first quarter of 2000, which was the previous all-time high. Overall, $50 billion in VC funds were invested in 4,400 companies in 2014 and David expects that figure to be surpassed this year.

One catalyst for the sustainability of this strength in the VC sector is the relative weakness of other markets, David says.

“If you look at the bond market and over the past year, the stock market, they aren’t delivering the returns they once did,” David says. “There is higher risk in VC, but there is a ton of capital chasing good high-potential companies that should help sustain the momentum.”

Smart Business spoke with David about the VC market and what companies can do to stand out with potential investors.

What factors are driving VC investment?

Activity in this sector is strong across the board. Even more important is the tremendous amount of fundraising that is taking place. In the second quarter this year, $10 billion has been raised by VC funds. That’s the strongest fundraising quarter since the last record in 2007 and a 27 percent year-over-year increase.

New Enterprise Associates raised a $2.8 billion fund and IDP Investments LLC raised a $1.3 billion fund just in the second quarter. The Social + Capital Partnership raised $600 million. So far this year, 50 new funds have been raised, a figure which points to some sustainability for the future.

More companies are remaining private longer and not going public because there is so much capital available, both debt and equity capital. Additionally, nontraditional investors have entered the market, particularly for the late-stage, higher profile, ‘unicorn-type’ companies with billion-dollar plus valuations.

It’s a good time to raise capital, particularly for software and media-focused companies.

Which opportunities tend to attract VC investors?

The three big areas of investment right now are software, media and life sciences. Once companies get to the point of needing to raise institutional VC, they need to have a product, early revenue and customers. So you need to be in the right market and there needs to be evidence of sustainable growth.

The really early seed-stage deals are being done by some of the smaller funds, the angel investors. Once they hit critical mass with either a product or some buy-in from customers, that’s usually a tipping point for raising capital.

VC investors want companies that are going to grow fast and take market share or have the ability to create new market share. Everyone is looking for growth. Companies that are me-too companies, or just have mediocre growth are not going to attract a lot of capital.

What’s the key to making a positive impression when you meet with investors?

Present your growth story and a realistic plan for how quickly you can scale the business with a boost of outside capital. VC firms want to see within a five-year window how quickly you can grow the company and create value.

Strong management teams are really important as is a market niche that can be exploited.

These are smart people that dig into the intricacies of the market and the backgrounds of founders and management teams.

They want to see a team that has experience, has built a vision and is able to attract the people needed to build a sustainable company. If things go in the wrong direction or the market shifts, they want to know that the business has the ability to pivot.

What about balancing risk versus reward?

There is willingness to take risks in the early stages and as the business starts to get traction, VCs can continue to fund in multiple rounds to grow it.

But the passion of the entrepreneur and the vision, if it can be validated, is very powerful. If the right team is behind it, it can attract other people and show potential for the future. A clear, well thought out vision is key to the success of any lasting venture.

Insights Banking & Finance is brought to you by Bridge Bank.

Why your search for an investor has to be about more than just money

Success in the world of biotechnology and life sciences requires a level of patience that is foreign to most types of businesses and industries.

On average it takes 10 to 12 years and over $1 billion in capital to get a new drug from the laboratory to the market to be sold to consumers, says Rob Lake, senior vice president and head of Life Sciences at Bridge Bank.

With such great effort needed to get your product out the door, you want partners you’ll be comfortable working with for extended periods of time. When you face challenges, as most growing businesses do at some point, the relationship you have with your financial partner can go a long way toward determining your future.

“Some lenders tend to over steer,” Lake says. “So on top of whatever is already going on at your company, a relationship with an inexperienced lender can make it that much more difficult to manage your business.
“That can be very stressful for a management team and an investor group trying to position your company to work through the issues and get back on track.”

Smart Business spoke with Lake about the real value of selecting a lender or bank that truly understands the challenges your business faces.

What should you consider when looking to raise capital in the life science industry?

You need a lender who understands your business. A standard bank that does commercial and industrial lending is likely to underappreciate the peaks and valleys of a life sciences company, such as navigating through regulatory agencies or the uncertainties of clinical trials.

There is such a thing as ‘greener capital.’ A knowledgeable lender knows how to react to bad news, and how to chart the best course of action to keep things on track. It’s like piloting a small plane. If there is turbulence, you’re not going to want to over steer in one direction or the other to try to stabilize the aircraft.

You want to keep it as steady as you can and it will stabilize once you get through the bad weather. The same applies to working with a lender that clearly understands the issues life sciences companies face and will work through occasional challenges along the way to help the company achieve its goals.

What are some key things to know before you meet with a lender?
You need to think about what you would do if things with your business don’t go according to plan and compare it with the underwriting rationale of the lender. Lenders will typically underwrite to a downside case to explore that scenario.

What if you do not get approval on an expected date and it takes another year to get that approval? How would such a delay affect your company financially? How much more money would you need to raise? What will it take to get there? Do you have the resources to get there?

The base case is a little more optimistic scenario and the downside case is if the wheels completely fall off. The more likely case is a third option in which the wheels don’t totally fall off, but maybe you have a flat tire. How do you fix it and get through that scenario?

It’s helpful to hear the lender’s mentality as they go through the downside process.  There are lenders in the space that offer more favorable terms (i.e., more capital or lower cost); however, it could cost more money in the long run (fees and legal expenses) if they haven’t thought through what the downside looks like.

What are lenders looking for in a borrower profile?

Lenders like business models that are diverse and have novel intellectual property supported by an underlying ‘platform technology.’ Multiple shots on goal help the lender mitigate risk.

They also want to understand the value proposition and see that it makes sense from a commercial viability standpoint. Ultimately, does the product and or service you’re developing address an unmet need?  Improve patients’ lives or clinical outcomes?  Save the health care system money?

Validation is another important attribute lenders like to see. This could come from many sources including the quality and reputation of your investors, strategic partners, a positive reimbursement decision or revenue traction.

Insights Banking & Finance is brought to you by Bridge Bank.

A look at how FX hedging can help you mitigate foreign currency risk

Global currency markets have been experiencing larger than normal swings of late and with greater frequency, CFOs are citing foreign exchange volatility as a factor when companies miss their earnings targets. Increasingly, business leaders are looking to implement hedging programs to mitigate foreign exchange rate risk and create more certainty and stability within their organizations.

“For global businesses, the hedging of foreign denominated cash flows is vital to avoiding earnings swings,” says William R. Schumaker, vice president and foreign exchange advisor in International Banking at Bridge Bank. “Companies that maintain ineffective hedging programs, or those that do not hedge at all, unnecessarily expose themselves to financial risk.”

Foreign exchange (FX) hedging gives treasurers the ability to protect cash flow and profits by locking in certain rates of exchange. This is done for balance sheet items such as payables and receivables, as well as cash flow items such as forecasted sales and expenses.

Smart Business spoke with Schumaker about some of the key components of a successful hedging program.

Which tools can companies use as part of a hedging program?
Working closely with a trusted banking partner, an organization can easily gain access to the necessary and appropriate hedging tools available in the marketplace to mitigate their currency risk.

There are myriad FX hedging instruments which can be employed to lessen foreign exchange rate risk, from basic FX spot transactions to range binary options. But you don’t need a sledgehammer to kill a gnat; future foreign currency exposures can be effectively managed with a simple FX forward contract.

It is essentially the same as a standard spot trade, except that instead of the deal settling and funds being made available in two business days, settlement can be pushed forward to a predetermined future date of the customer’s choosing and with an exchange rate locked in.

This will protect company margins from unfavorable variations in the currency exchange rate from inception to settlement date. The price of the forward versus spot is adjusted marginally, accounting for the interest rate differential between the currencies involved given the duration.

With the nominal rate differentials between the U.S. and, for example, Europe, Canada or Great Britain, forward hedging costs in these currencies are relatively flat. A variation of the standard forward is the ‘window forward’ contract.

Offering more flexibility, the window forward allows the holder to choose a ‘window’ of time in which to execute a future foreign currency conversion. This tool can be particularly helpful when you have expected cash flows with nonspecific settlement dates.

What hedging strategies are used by global companies?
Many companies choose to execute all of their hedging for the entire year in one fell swoop prior to the beginning of their fiscal year. While this static hedging strategy provides companies the opportunity to set budget rates for the year, it is also limiting.

The practice of establishing cash flow hedges at the start of the year lacks flexibility as opportunities to react to FX forecast changes and favorable market entry points are largely lost.

A better method is often the layering of hedges. This dynamic approach realizes the correlation between time and risk; with longer dated exposures carrying a greater degree of uncertainty with respect to exchange rates.

As an example, one might consider hedging shorter term commitments, perhaps out to six months, at 100 percent while commitments from six months to one year may have a hedge ratio of 75 percent and exposures beyond a year could be treated with yet a lower hedge ratio.

As time progresses, hedges can be adjusted to fit their appropriate ratio for the new time period. No matter how you implement it, this ‘rolling’ hedge structure should see more stable hedge results and provide a smoothing effect on forward hedge rates over time versus a single hedging event.

These are but a few key hedging concepts. The areas of netting, derivative accounting and effectiveness testing are important topics which demand attention. Nevertheless, it’s certainly worthwhile to consider developing a hedging program to protect against adverse FX movements. ●

Insights Banking & Finance is brought to you by Bridge Bank

Experience is key when developing your strategy to create an ESOP

The complexity of transitioning to an Employee Stock Ownership Plan (ESOP) can be intimidating, says Elisabeth C. Schutz, senior vice president and director for the ESOP Group at Bridge Bank.

“Many attorneys and CPAs don’t want to spend the time and energy it takes to learn about them,” Schutz says. “That’s one reason why you don’t see more ESOP companies in the U.S. today.”

An ESOP is a qualified retirement plan. It’s regulated by the IRS and the Department of Labor and came into being with the passage of the Employee Retirement Income Security Act in the 1970s. The regulation is meant to ensure that the plan is used for the benefit of employees.

The process can be challenging, but when done the right way, it can provide significant financial benefits for a selling shareholder, the sponsoring company of the ESOP and its employees.

“Studies have been conducted comparing two companies that are of similar size and in similar industries,” Schutz says. “One company with an ESOP and one without. The studies have found that the company with the ESOP is more profitable by about 2 percent at a net income level. In the right situation, it’s a powerful tool.”

Smart Business spoke with Schutz about some of the important details to consider when exploring an ESOP.

What are some benefits to forming an ESOP?

The following are advantages to companies that choose to form an ESOP:
■  Flexibility – The seller can sell either a minority interest or up to 100 percent of the stock to the ESOP. Plus, the seller controls the deal.
■  Cash Flow Enhancement – The ESOP sponsor company can repay acquisition debt with pre-tax dollars.
■  Corporate Finance Tool – An ESOP is the only type of qualified employee benefit plan that can borrow money, provided the ESOP uses the money to buy employer stock.
■  Profitability – ESOP companies are typically more profitable than similar companies that do not have an ESOP.
■  Employee Ownership – Employees of ESOP companies vest ownership in the stock of the company over time. The sponsoring company makes the contribution to the ESOP on behalf of the employees – the employee does not make any contribution.
■  C corporation tax benefit – Sellers of C-corp stock may defer, sometimes permanently, capital gains tax on the sale by reinvesting the proceeds from the sale into “Qualified Replacement Securities.”
■  S Corporation tax benefit – A 100 percent ESOP-owned S-corp pays no federal income tax.

What does a company need to know when looking to set up an ESOP?

You need a lawyer with experience implementing ESOPs.

It is customary to have separate counsel represent the ESOP and the company. You also need a qualified valuation adviser with ESOP experience who is independent, having no relationship with the company or the other advisers involved in the transaction.

Due to the administrative complexity inherent in ESOPs, a qualified third-party administration firm will be engaged to track participant accounts and assist with compliance issues. Depending on the company and the situation, you may hire an investment banker, a financial adviser and an institutional trustee to assist with setting up and implementing the ESOP.

Aside from the technical aspects of running the plan, companies often find it a very good idea to hire ownership culture consultants to help communicate what the plan is about and create employee participation structures.

How do you find the right adviser?

You’ll find some excellent ESOP advisers and some that are not as good.

Consider reputation in the industry and experience with ESOP transactions. If you have an adviser that isn’t familiar with some of the subtleties that come into play, that can create problems. So you want someone who knows the ins and outs of crafting an ESOP to make it a smooth transition for your business. ●

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