Monday, December 31, 2012

A Chance To Expand


When I started BBE, there were not many blogging sites on the Internet.  Many more people have joined the blogoshpere since I started posting.  Our staff now includes seven bloggers covering a total of 28 different topics in as many blogs posted every week.  There are many areas of interest we do not cover.  We had decided early on that if we could not provide a quality blog on a topic, we would not put out a second rate post.  We do keep an eye on other sites posting on topics we do not address.  

One such blog site was operated by a company with offices in our city, Blogging Topics, Inc. (BTI).  I had been introduced to Bob, the CEO of BTI, at a blogger convention several years ago.  Finding that we had many mutual interests, we have stayed in touch over the years, getting together for lunch or dinner every few months and sharing stories of the blogging world.  Although his blog site could be considered competition in a general sense, our sites did not have blogs on the same topics.  In reality, there was no direct competition between our sites.

Bob had come to blogging later in life and was now in his late 60s.  In our last two lunch meetings, he had mentioned that the idea of retiring was becoming more and more attractive.  Although his staff and blog writers were very talented and enjoyed working for him, none of them had any interest in running the business.  Bob was faced with a very common problem for older business owners: how to cash in on the business he had created and nurtured to maturity.  Bob and his wife, Mary Pat, were the only shareholders of BTI, having funded the company themselves.

After some discussion with our Board of Directors, I set up a meeting with Bob.  When Alice, our President, and I met him at his offices, we suggested that BBE might have a solution to his problem:  BBE and BTI could enter into a merger, which means that BBE would buy the stock of BTI.  We told him there were several ways to do this.  One way would be for BBE to pay Bob and Mary Pat cash for their stock.  Another option would be a stock swap, i.e., pay for their stock in BTI with shares of BBE stock.  Bob said he and Mary Pat had spoken often about selling the company.  Both of them were in good health and looked forward to many years together in retirement.  He expressed concern over what might happen to his employees if he were to sell BTI.  He promised to get back to us in a few days.

A week later, Bob called and asked for a meeting to discuss how BBE might merge with his company.  We proposed that we get together at BBE's offices to explore various merger options.  We will join that meeting in the next blog.

Comments are always welcome.

Monday, December 24, 2012

Thoughts At Yet Another Year End


I posted my first blog on November 1, 2010, so this is my third year-end message to all of you.  I extend the best of the season to all of you and hope each of you enjoys this time of year in your own special way with family and friends.  I recently discovered that many readers have been sending comments to my posts, but I did not know it.

Apparently, the security settings established by my daughter when she created this site were very high.  Consequently, many of your comments did not make it to me.  Now I know how to find them, and, as I first promised, I will reply to them as I receive them from now on.  There were too many previously undiscovered comments for me to reply to each of them, and for that I apologize.

Your comments are posted on the blog you are reading at the time.  I will reply to the comments on the particular blog on which you left your comment.  So, if you want to see my reply to your message, you will have to return to that particular post to find it.  This blog site is a work in progress, and I continue to learn new things about offering it to you every day.

Again, my apologies for not replying to you earlier, but it won't happen in the future.

The best of the holiday season to each of you.  We will return to the regular blog next Monday, New Year's Eve.

Monday, December 17, 2012

Meeting The Banker


After conferring with the Directors of BBE, Alice met with Sam, the bank officer in charge of the company's accounts.  She explained the company's need for more servers, employees and space and asked him what sort of loan support the bank could provide. Sam offered the company a loan to buy the equipment.  However, he said it would not be an unsecured loan.  The bank would make the loan but would need the company to pledge the new servers being purchased and all of the other hard assets of the company (servers, computers and office furniture).  The interest rate for BBE's secured loan would be fixed for its term with regular monthly payments of principal and interest sufficient to completely amortize (repay) the loan in the loan's five year term. 

If BBE were to default on the loan, the bank would have first right to take the company's pledged assets, the collateral, sell them and apply the proceeds against the debt.  This is a secured loan, i.e., the bank would have first call on the assets of the company ahead of any general creditors of the company if BBE were to go bankrupt. General creditors of a business are usually vendors who sell items or provide services to the company on a regular basis, but do not collect their money immediately.  Such sellers extend short term credit, without charging interest, to the company and expect to be paid at the end of each month.  BBE's utility provider would be a general creditor.  Another example would be the alarm company which provides the security system for BBE's office space and, like the electric utility, is paid monthly.  General creditors do not have a prior claim on the assets of a business.  They share equally in any assets or cash remaining in a business' bankruptcy after any secured creditors have received proceeds from the sale of assets on which they have a security interest.  

Alice and Sam briefly discussed the company's need for more space.  Sam said that she should come back to discuss a mortgage loan if BBE decided to buy a building to house its expanding operations.  A mortgage loan is used to finance a real estate purchase. It is a secured loan with a longer maturity which is secured by a lien (evidenced by a document called a mortgage) on the land and building being financed.  The land and building are collateral, and, like any other pledged assets, a bank would have the right to foreclose a borrower's interest in the real estate and apply the proceeds against its loan ahead of any other creditors.  Since, at this time, BBE intended to lease another floor of the building presently housing its operations, they agreed that this was a topic for another day.

Alice then brought up another issue the company faced.  Cash flow was occasionally a problem.  The blog readers paid for their subscriptions at various times.  Some subscribers paid annually, some monthly and some weekly.  New blog readers sometimes paid daily with a credit card until they decided that they would subscribe to their favorite blog.  Consequently, cash flow was uneven, which, at times, resulted in difficulties meeting recurring  obligations.  Although the company received adequate revenues to pay its expenses over the year, the income stream was not steady.  Some months, the company received small amounts of subscription payments.  Other months, large amounts of money would flow in.  The company, however, had rent, utilities, payroll and other recurring expenses to pay each month.  On two occasions, the company had had just barely enough cash on hand to make those payments.

Sam said that cash flow was a common problem with small businesses.  The bank could make a specific type of loan to address BBE's cash flow problems, one very similar to a credit card loan.  Sam suggested a revolving loan, commonly called a "revolver".  The bank establishes a fixed amount of money BBE can borrow, but the company can take out the money if and when it is needed to meet its obligations and then pay the loan back when subscriptions were received.  BBE can then reborrow the money when it is needed again.  Interest is charged only on the amounts actually borrowed at a variable interest rate, which is based on the bank's prime rate.  A prime rate is the publicly announced lowest interest rate which the bank offers to eligible borrowers.  BBE's interest rate would be prime plus 1%.  If the bank's  prime rate, which can change daily, is 4% when BBE draws down money from the revolving loan, it would pay interest at 5% on that amount.  If BBE made a second draw on the revolver later when the prime rate was 3%, then its interest rate for that amount of money would be 4%.  A revolving loan is typically secured by a pledge of the borrower's accounts receivable.  Accounts receivable are the amounts which the BBE's customers owe but have not yet paid.  If a borrower defaults on a loan secured by receivables, the bank has the right to collect the receivables from the customers.  A revolving loan provides a company with the necessary funds to meet its obligations before customer payments have been received.  The loan "evens out" the company's cash flow over the year.  The bank generally makes the loan with a one year term for a first time borrower, such as BBE.  If the bank is satisfied with the company's performance under the loan, i.e., prompt repayment of borrowed funds when BBE receives its subscribers' payments, it will probably renew the revolver after the first year for a longer term.

Alice reported all of this to the Board, which immediately approved BBE's entering into the secured loan for the new equipment of $50,000 and the revolving loan of $25,000.  The loan documents were signed, and the company used the borrowed funds to expand its business yet again.  The revolver immediately improved its cash flow.  As with the first expansion, revenues did not increase immediately, but BBE was able to make its new loan payments and continue distributing dividends on both the preferred and common stock.

We will continue with BBE in the next blog.

Comments are always welcome.

Monday, December 10, 2012

Growth Leads To The Same Old Problem.


For several years after the VFI investment, BBE's business continued to grow.  In the early days, I had been the only blogger, initially posting a blog once a week.  Those weekly blogs had evolved into daily blogs on various topics.  Between my blogging duties and managing the business, I found myself unable to adequately meet all of the demands on my time.  I realized that I should cut back on my responsibilities and devote my time to what I did best, writing the material for the blogs.  I shared my thoughts with the Board of Directors.  They appointed Alice, a representative of VFI, the new President of BBE, and she took over day to day management of operations.

Over time, we had realized that there was a growing demand for blogs on some issues with which I had no familiarity.  Consequently, we had hired additional employees to write blogs.  BBE was now posting 4 different blogs every day.  This led to higher revenues and earnings, which brought us back to the same place we had been before:  once again, we needed to buy more servers, add more office space and expand our staff.  The VFI investment had been the right decision, but it had simply bought us time.  Ever more growth requires ever more equipment, employees and the space to house them all.

This time, however, the shareholders, including VFI, did not want BBE to issue (sell) any more shares, neither preferred nor common.  Alice, our President, and Mary Jo, our financial consultant, suggested that it was time for BBE to add debt to its capital structureHere is a link to a more detailed explanation of the term capital structure.  

Put simply, a company's capital structure has two components.  First is the equity capital contributed by the shareholders, whether common or preferred, plus the company's retained earnings.   A company's retained earnings are those earnings remaining at the end of each year after all expenses, loan payments, dividends and taxes are paid: its net profit.  Anything left over is "retained" by the company for future use. Here is a link to the calculation of retained earnings

The second component of a company's capital structure is its debt capital, i.e., money the company borrows from lenders.  There are various types of loans available to a business, each of which can be tailored for a specific need of the borrower.  The simplest type of loan is an unsecured loan.  This type of loan is made by a bank or other lending institution based solely on the financial strength of the borrowing company and the lender's belief that the company can and will repay the debt.  Such a loan is evidenced by a promissory note, a written document signed by the company which contains the borrower's promise to repay the loan and the terms of the loan, i.e., the amount borrowed (the principal), the interest rate charged, the repayment schedule (monthly, quarterly, semi-annual or annual repayments) and the maturity of the note, the date by which all principal and interest must be repaid in full.  An unsecured loan is generally a short term obligation which usually requires monthly payments of interest and, possibly, a portion of the principal.  Such a loan matures within a year or so, generally no longer than 3 years.  

A more familiar form of unsecured loan is the credit card, which can be used for daily expenses by companies and individuals.  Some of the amount borrowed on the credit card plus interest is repaid monthly.  The borrower/card holder has the option to repay the entire amount at any time.  The terms of the credit card loan (a form of promissory note) are contained in the borrower's application and the explanatory materials (a form of promissory note) received at the time the card is issued.  The terms of a credit card loan can be modified by the card issuer (the lender) upon prior notice.  Because the risk of nonpayment or default is high on credit cards, the interest rates charged are also high, 12% or more in most instances.

BBE now has an established business with revenues of $75,000 and a good financial history at this point.  It is already using credit cards for some of its routine expenses, but it would be a mistake to use a high interest credit card for a major purchase of the servers it needs.  Alice decides to approach the bank where BBE has its checking and payroll accounts for a loan.  Because of this relationship, the bank is already familiar with BBE's business.

We will pick up with her meeting with the banker in the next blog.

Comments are always welcome.

Monday, December 3, 2012

BBE Continues To Grow....Slowly


Having revisited Best Blogs Ever, Inc. (BBE) in the last few blogs, we return to the story.  The story of BBE is patterned after a narrative about a fictional business contained in How to Buy Stocks, a guide to successful investing, written by Louis Engel and first published in 1953 followed by revised editions every few years ever since.  New financial terms introduced in the story will be highlighted in bold when we meet them.  I realize that for many readers much of the information and terms may be old news, but some readers may not be familiar with many of the terms used in the financial world, so this story is for them and, hopefully, a refresher course for the more experienced of you.  We pick up the story after the investment in BBE by VFI.

The $70,000 invested in Best Blogs Ever, Inc. (BBE) by Venture Funds, Inc. (VFI) allowed BBE to set in motion its purchase of new servers, its office expansion and the hiring of additional employees.  However, all of this took time and effort to accomplish.  The delays experienced in taking delivery of the additional equipment, getting it installed in the newly built out floor of office space and training the new hires meant that the anticipated increase in revenues did not begin for many months after VFI's investment.  Despite these delays, the Board of Directors had to pay the required dividend of 2% on BBE's preferred shares, $1,200 on the first anniversary of their purchase by VFI.

The year's operations before the VFI investment had resulted in $5,000 of earnings with a distribution of $1,500 to the original shareholders.  Although BBE was able to maintain that level of earnings during the expansion, the money was needed to support the increased operational costs.  The preferred shares' dividend of $1,200 was paid as required, leaving $3,800 in earnings, which had to be plowed back into the business.  The Board of Directors felt that they could not prudently declare a cash dividend on the common shares.  In other words, the Directors would have to pass the dividend and keep the earnings in the company.  This is not the sort of news that shareholders want to receive.

After the Articles of Incorporation of BBE had been amended, the common stock split 10 for 1 and the VFI investment received, BBE had 41,000 authorized but unissued shares remaining.  After securing the consent of the shareholders, the Board declared a stock dividend on a 3 for 2 basis.  Each shareholder received 1/2 of a share of stock, at no cost, for each share he or she already owned.  It may take some time for financial benefits to be realized from a stock dividend, but if BBE continues to prosper, some benefit should be received down the road. 

In a way, a stock dividend is similar to a stock split because everyone ends up with more shares resulting in the same percentages of ownership.  However, those extra shares may result, ultimately, in extra dividends being paid to the shareholders since they now have additional shares on which additional dividends could be paid at a later date.  If prior to the stock dividend, a BBE shareholder had 1000 shares and was to receive a cash dividend of 5 cents a share, then he or she would receive $50.  After the 3 for 2 stock dividend, that same shareholder would have 1500 shares.  That same 5 cents a share dividend would net the individual $75, and the shareholder would not have spent any money for the extra shares and the larger cash dividends. In the case of a stock split, the dividend per share is reduced in inverse proportion to the stock split.  If there is a 3 for 2 stock split, the shareholder with 1,000 original shares also ends up with 1500 shares; however, the dividend per share is reduced from 5 cents per share to 3.3 cents per share, so the dividend remains $50. 

After several years, the hoped for benefits of the expansion were realized, and BBE now had annual revenues of $10,000, which allowed the Directors to pay the preferred share dividends ($1,200); provide a dividend of 50 cents a share on the common stock ($6,750), and keep the rest of the income in the company to support operations.  This was a good rate of dividend growth since the dividends paid at the time of the VFI investment had been 30 cents a share after the stock split.  Now the benefit of the stock dividend was enjoyed by the owners of the common stock.  VFI received its fixed dividend on its preferred shares, and it also participated in the benefits of BBE's increasing revenues and dividends through its common shares.

BBE now had 13,500 shares of issued common stock, i.e., the 9,000 shares owned by the original shareholders and by VFI, which were increased by 50% as a result of the stock dividend.  This left the company with 27,500 authorized but unissued shares of common stock.  This unissued stock will prove to be very useful when BBE is presented with an investment opportunity, which we will learn about in a future blog.

Comments are always welcome.