Accounting and Finance for Your Small Business Second Edition_8

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Accounting and Finance for Your Small Business Second Edition_8 Financing CHAPTER 5 • Preferred stock may have sinking fund provisions for the repur- chase of the stock. • Debt holders have a superior claim to assets in case of liquida- tion and have first claim to earnings. However, preferred stock- holders’ claims are superior to common stockholders’. Taxes affect the amount of earnings needed to meet debt service and preferred stock dividends. However, because they receive dif- ferent tax treatment, they affect earnings differently. Suppose that both debt and preferred stock command a return of 12 percent and the applicable corporate tax rate is 46 percent. To pay the 12 percent interest rate on debt, the firm has to earn 12 percent before taxes. Interest on debt is paid in before-tax dollars. To pay the 12 percent dividend for preferred stock, the firm has to earn 12 percent in after-tax dollars. For a 12 percent earnings after taxes, 22.2 percent—12 percent/ (1 − .46)—is required in before-tax dollars. Because dividends are paid in after-tax dollars, the firm has to earn more to pay a dividend of comparable worth to an investor than it has to earn for interest. The tax rate the company pays will have a great deal to do with the amount of dividend paid for two reasons: 1. The lower the company’s real tax rate, the more disposable cash it will have to reinvest and pay dividends. 2. The lower the company’s tax rate, the more flexibility it can have in designing dividend policies to be attractive to investors and enhance the goodwill and value of the firm. Private Placement of Stock A company may find itself with an excessive proportion of debt in relation to its equity, or there is no way to obtain additional debt, forcing the owner to go in search of equity. A private company accomplishes this through a private stock placement, where shares are sold to a limited number of individuals or business entities. It may be possible for company management to sell shares on an informal basis to friends and family, but this is at best a limited 157 Operating the Business SECTION II source of equity. When more equity is needed, you must search outside your circle of acquaintances. A formal private placement of stock may require the services of an investment banker with far-reaching connections. A reputable investment banker will require an in-depth review of the company to ensure that it is an acceptable investment vehicle for potential investors. Next the banker will construct an offering memoran- dum, which describes the type and terms of stock to be offered, its price, the company, and how the company plans to use the funds. The offering memorandum will then be sent to a group of prospec- tive investors, followed by investment meetings where the man- agement team makes presentations to investors. If all goes well, the investment banker then coordinates a closing where the investors pay the company for the proffered stock. Sounds easy? It is not. Finding the right investment banker who works well with the company is difficult, as is the writing of an offering memorandum, and presentations require long prepara- tion and role-playing. And do not forget the investment banker’s fee. This can vary substantially, but expect some variation on the Lehman Formula, which is 5 percent of the first $1 million raised, 4 percent of the second $1 million, 3 percent of the third $1 mil- lion, 2 percent of the fourth $1 million, and 1 percent of all funds raised above that amount. For example, the fee for an investment banker who raises $5 million on behalf of the company will be $150,000. In addition, a banker may request a large number of warrants on the purchase of company stock in order to take advantage of any potential increase in the company’s value at a later date. Swapping Stock for Expenses Often equity is obtained to pay off short-term expenses. This is a two-step process of obtaining the equity from one party and using the resulting cash to pay off suppliers. You sometimes can short-cut this process by issuing stock directly to suppliers in exchange for their services. Although this can be an effective way to ...