In the “Why equity funding?” section, we have studied the reasons for carrying out mergers, acquisitions, and equity funding. In this section we will see how to select the appropriate time for doing M&A activity as a business.
A business should not go for merger and acquisition activities if there is no synergy by acquiring the other business or by getting acquired by a big strategic business or by a financial investor in part or in full.
Also, a business should not go for equity funding if alternative debt fund is available with sanction of sufficient amount in given time frame. If debt fund is available from a bank, or from an NBFC or any other lending institution, first priority should be given to that option. Equity funding also should not be undertaken if the internal accruals of the business from the operations are more than sufficient. If there is no pressure on distribution of profits and there is priority for growth funding among the shareholders, it should be preferred that internal accruals are used for growth of the company.
There are primarily following reasons why equity funding should be the last resort of the company in all ordinary circumstances:
1. The loans from bank are cheaper and lenders are not interested in extraordinary profit made by the existing shareholders of the company. Hence, dear total cost is limited.
2. The banks do not interfere in the control of the company, management of the company, and operations of the company. (This may be at the cost of the benefit of the experience in finance domain if the same was availed from an equity investor).
3. The company can redeem the the loan amount, in time or before time, and the existing management can again make the company debt free. The company can release its property given as security and take back the personal & corporate guarantees.
The management of a company should note that if the operations of the company are going to be perfectly satisfactory till the end of the term of the loan and if future rejection of additional loan application for compulsory requirements by the bank is not going to adversely affect the operations, then bank loan should be preferred. If there is a probability of risk event, the bank will sell all the security and also the personal assets of the guarantors.
Apohan is in the business of equity funding, and we are candid enough not to mislead you by suggesting external equity funding even though the going is good.
Important aspects of M&A
Following are the times when equity funding (M&A) is to be considered seriously.
A company should be able to use all its existing manufacturing capacity. It should have all the required marketing setup. Its operations should be profitable. The capital structure should be optimal and there should be adequate return on the investment made by the shareholders. If the financial performance is deteriorating gradually the returns on investment made by the shareholders are below expectation, the company should first explore availability of cheap loans. If the loans are not available from the lending Institutions like banks, the option of equity funding should be explored. We have below listed the 25 gradual steps of the financial performance of a company which needs to be carefully monitored and merger and acquisition activity should be undertaken in a timely manner before shareholders’ wealth is destroyed.
Growth phase of a business is the best phase to raise capital through equity funding. The valuation of a growing business is very favourable in this phase for the existing shareholders. If the market is growing, and if there are many opportunities for expanding the business, an attempt should be made to fund the expansion from the internal accruals. If the internal accruals are insufficient, prudent businessman should not let go the opportunities if the management is capable of executing new growth initiatives. They should take equity funding and make most of the expansion. Management should not decide what to do based on their own ability to raise capital (with their own network of banks / investors), but based on their culpability to generate attractive returns buy successfully and confidently utilising the money.
It becomes very difficult to get funding when the financial performance of a company is not good or is bad. It becomes nearly impossible to get new loans from a bank if the company is already in a delay or default of a loan. This becomes a very tricky situation. A businessman is not a God. Some internal, small-time management decisions may have gone wrong. Sometimes the stakeholders suppliers or clients willfully or their circumstances also cause trouble to a company. It happens! Sometimes, even though the management is very capable, external circumstances, beyond the control of any stakeholders, of the business overpower the positive efforts of the management. For example, COVID-19! This, again, leads to the situation of financial distress. The problem of company is only momentary on many occasions; and if adequate capital funding is made available, the business can resume profitable normal operations again. On the other hand, if the company is liquidated, everyone is at loss. The promoters lose the capital that they had brought in the beginning. They lose whatever value added during the profitable period of the company. The employee suffer job loss. The bank also cannot recover its money is the liquidation value of a company is approximately nil. But still they don’t work in the right direction of turning around the business by helping the businessman. There is no distinction or difference made between wilful defaulters and genuine businessmen suffering from business circumstances. No enhanced credit is provided by the banks. The operating capacity of the company gradually starts falling down below the break-even point and it becomes an unrecuperable, irrecoverable situation. Now, the equity investors understand a business as a business. If they are approached in time, they can provide sufficient capital to turnaround the business.
Apohan’s biggest strength and the reason for its existence is to turn around the hundreds of Indian businesses from financial distress situation through equity funding.
Many a time, a company does not want to dilute its control in the management. In their opinion, the interference/participation in the operations of the existing business may not go down well with the traditional person-centric management. But at the same time its capacity, with existing resources, to expand is limited whereas the ability to expand is unlimited. In this time where control is to be retained and existing structure is to be kept intact, a business can undertake an unincorporated contractual joint ventures (JV) and similar activities which have an effect as good as that of mergers and acquisitions. They can also avail foreign capital apart from domestic capital.
Depending upon the management and control philosophy of a businessman, the management can prefer growth at the cost of control of the initial promoters. Typically, it is advisable that growing a company to its fullest potential by providing all the necessary capital is more prudent than remaining the sole controller of a very small company. At the different stages of the life cycle of a business, the risk profile of a company is different. Here, different types of investors are available to take that risk. An equity investment is available even when the proof of concept (POC) is not made orr even when the operations have not proved to be profitable in the market.
In many businesses, the original promoters, one or two of them, act as the face of company. The entire network of all the stakeholders is tied to them. There is no meaning of existence of that company without the involvement of these key people. These people do the business successfully with their ability for 2-3-4 decades. But when they turn 60, they become older and their philosophical orientation, physical abilities, life priorities change. Even if this does not happen, with the growing age, their mental and physical abilities weaken. Their ability to attend the increasingly complex business environment drops and hence a growing, profitable business till now starts becoming slowing and loss making gradually. A businessman, looking at his/her own life cycle stage, should outsource much of the management functions or prepare a succession plan for giving way to the new management by roping in new equity investors or training the internal senior manager or he/she should sellout the entire business in time. Also, an aged Businessman should prepare a death will to appropriately distribute the wealth among the heirs.
The following diagram shows the three types of business situations. The bargaining power of a business in each of these business situation is very different. The better the bargaining power, the more the value is realised by the existing shareholders. An attempt should be always made that instead of the selling the business as it is, it should be refurbished, revamped, made attractive first and then sold for a higher value.