Monday, February 25, 2013

Office Space Gets Tight (2)


With the help of Matt, the head of the Blogtropolis Development Agency, we are able to secure two older buildings which the City owns and intends to demolish.  This will provide us with the necessary land on which to build our new one story office building.  We propose to finance the land purchase from the City at a reduced cost and the building construction with a $2,040,000 Industrial Revenue Bond (IRB) to be issued by the City.  We want the bonds to bear interest at a fixed rate of 4% per annum and have a term of twenty-five years.  We would like to pay interest only for the first five years of the term of the IRB and then payments of the principal and interest amortized over the remaining twenty years.  Although simple in concept, the details of the transaction are complicated.  We need $2,000,000 for our project.  The extra $40,000 is for the costs of issuing the bonds, legal fees, trustee fees and other closing costs.  Matt thinks we can find investors willing to buy IRB bonds on these terms.

The IRB is a municipal bond issued by the City of Blogtropolis.  The first decision to be made is whether the IRB will be issued in a public offering or a private placement.  If the IRB will be issued to the public, the costs of issuance increase sharply.  If we can find a small number of "accredited investors" as defined in the securities laws to buy the IRB bonds, the costs will be much lower.  Here is a link to the definition of an "accredited investor" under the Securities & Exchange Commission rules.  Matt supplies us with a list of banks and insurance companies which have purchased Blogtropolis IRB issues in the past.  Matt explains to us that the City will play no role in setting the terms of the IRB issue.  We must contact the potential investors to negotiate the terms of the IRB to be issued by the City for the benefit of BBE.  Simply put, the investors loan money to BBE using Blogtropolis as a conduit to provide tax exempt status for the interest they will earn on their investment in the IRB.

Alice, our President, and Mary Jo, our Chief Financial Officer (CFO), meet with representatives of a number of banks and insurance companies to see if there is any interest in purchasing the Blogtropolis IRB to finance our project.  After many meetings, they locate three insurance companies and two banks interested in buying the bonds.  Because BBE is a small privately held company, it has no credit rating from any of the rating agencies.  Rating agencies, such as Moody's, study companies and their securities and issue ratings on their financial strength and credit worthiness.  Since they have no credit information on BBE to justify an unsecured loan, they insist that the bonds be secured by a mortgage on the land and building.  The property will serve as collateral for the bonds.  We agree that for the first five years, BBE will pay interest only on the bonds on a quarterly basis.  We will make quarterly principal and interest payments in order to retire the bonds (pay them completely) during the following twenty years of the twenty-five year life of the bonds.  Each of the investors will put in $408,000.  They will share equally in the payments and the mortgage collateral.  All of details relating to the purchase of the bonds by our investors from the City will be provided in a rather lengthy document called an Indenture.  Five bonds will be issued under this IRB, each in a denomination of $408,000, one for each investor.

After further negotiations, we reach agreement with the investors on the final terms for the bonds.  Other than an increase in the interest rate and the granting of a mortgage on the property, we get most of our financial terms.  The IRB will bear interest at a fixed rate of 5.5% per annum and have a term of twenty-five years.  BBE will pay quarterly payments of interest only for the first five years.  Thereafter, the company will make payments of accrued interest and a principal payment of $25,500 every quarter.  The annual principal payments of $102,000 will completely pay off the $2,040,000 by the maturity of the IRB, twenty-five years hence.  All of these terms will be included in the promissory note representing the loan from Blogtropolis to BBE and also in the bonds issued by the City to the investors.  Additional terms will be contained in the mortgage, the document which grants a lien to the lender on the property.  In the event of a default in payment by BBE, the mortgage can be foreclosed and sold by the lender to recoup the loan made to BBE.  BBE will be legally liable for any deficiency if the sale of the property is not enough to pay off the loan balance.

In bond issues of this type, one of the most important parties is the bond trustee.   A bond trustee is a third party, usually a corporate trust company, designated to act on behalf of the bond holders.  The City issues its bonds in order to raise the money to loan to BBE.  The bonds are held by the bond trustee until sold.  At the closing, the investors pay their money to the bond trustee, who then delivers the bonds to them.  The money is then lent to BBE on the basis of the loan documents between the City and BBE.  Those loan documents will be assigned to the bond trustee so that the bond trustee steps into the shoes of the City as BBE's lender.  All payments are made by BBE to the bond trustee who, in turn, makes the quarterly payments to the bond holders.  If there is a default, the bond trustee would take all necessary collection action, including a foreclosure of the mortgage on BBE's property.  The duties of the bond trustee are contained in a document called a Trust Indenture.  The terms of the Trust Indenture also include the assignment of all of the loan documents between the City and BBE to the bond trustee.  Because we are constructing a building, the bond trustee will hold the bond proceeds and pay them to BBE as the construction progresses.

We finally get to the closing on the Blogtropolis Industrial Revenue Bond (Best Blogs Ever, Inc. Project-2013).  The conference table at the lawyer's office is covered with stacks of documents, each to be signed by all of the parties.  Once we have closed and the bond trustee has the $2,040,000 on deposit, we buy the land from the City and start construction.  The construction project is completed on time and on budget.  All of BBE's employees are now working on the same floor in the same building.  Operations are much smoother now.

We will return to the story of BBE in the next blog.

Comments are always welcome.

Monday, February 18, 2013

Office Space Gets Tight (1)


As in the past, I am going to again ignore reality in telling the story of Best Blogs Ever, Inc. (BBE).  The legislation and tax rules governing a form of financing called Industrial Revenue Bonds restrict their use to certain industries.  BBE might not qualify under those complex rules, but for purposes of this blog, we will assume it could obtain this type of loan.  We now return to the story.

Following completion of the merger with Blog Topics, Inc., the business of Best Blogs Ever, Inc. (BBE) started to take off.  We went through two more equipment expansions funded by bank loans and have hired additional blog writers and administrative staff.  We also acquired another blogging company in a cash for stock merger.  We paid for that merger by buying the stock of the company from its shareholders with a combination of cash we had accumulated over the years and a bank loan.  We now have a logistical nightmare with employees in three different offices.  We still occupy our original offices, which have expanded such that we now occupy the entire building.  The BTI bloggers still work in their offices, and we have the newest employees still working in the offices of the company we just purchased.  BBE needs enough office space to house all of our employees, servers and equipment in one location.

We now face the question that many successful small businesses must answer, i.e., whether to continue to rent or to buy or build a building.  Mary Jo, formerly our financial consultant and now our Chief Financial Officer, presents us with her analysis of the situation.  She recommends that we look into buying a facility.  Aside from the possibility for appreciation in value, a building also gives us the option to design the space to meet all of our needs now and in the future.  If necessary, we can add space onto a building BBE, thereby avoiding the disruption of yet another move to a larger location in the future.  We hire an office design firm to lay out new space for us, and we retain the services of a real estate agent to find buildings in our area.

We have suffered with our offices being located on several floors of the building over the last few years.  Using the stairs and the elevator to go between departments on different floors has proven to be a large inconvenience and a major waste of time.  We know that wherever we go, the office must be on one level.  Our space designers present us with a floor plan that groups the various departments in close proximity to each other and provides plenty of space for expansion.  Unfortunately, our real estate agent can not find a building to match the design.  BBE will have to build its new offices, but there is not much vacant land in Blogtropolis, where we are located.  We expand our search into neighboring communities.  Our employees begin to grumble about long commutes if we move out of of the City.

Municipalities do not want businesses like ours to move away.  This adversely affects a city's tax base and reduces its population if companies and their employees leave.  Mary Jo has had several conversations with the Blogtropolis Development Agency about our situation.  This Agency is responsible for bringing in new businesses and their employees.  They also help existing businesses to grow in order to keep them there.  They have offered to help BBE find new facilities in the City, which could solve our space problems and keep our people happy.  Based on the design for the new space and the lack of suitable buildings, we will need to construct a building in Blogtropolis if we are going to stay.  The estimated cost of such a project is $2,000,000.  If we borrow money from a bank to acquire the land and build our new offices, the interest rate would be 8% and the longest loan term would be eight years.  At the maturity of the loan, we would have to refinance it at whatever the bank's interest rate might then be.  BBE can not afford to pay off that amount of money in only eight years.  We would much prefer to have a lower interest rate and a loan term of at least 20 years.  Matt, the head of the Blogtropolis Development Agency, offers to help with a loan in the form of an Industrial Revenue Bond (IRB), which is a form of government financing provided by the City to businesses located in Blogtropolis.  IRBs are also called industrial development revenue bonds and private activity bonds.  A bond is a debt security which is purchased by investors for the interest payments made on the bond.  The amount of the bond is repaid in installments during the term of the loan or at maturity.

The basic idea of an IRB is that the city will issue the bond, which pays tax exempt interest.  In other words, the holder of the IRB does not have to declare the interest as income.  Since the interest is tax exempt, the bond's interest rate can be lower than the rate on a taxable bond and still provide the bondholder with the same net yield.  Assume that a bond of $1,000 pays taxable interest at the rate of 10% ($100 per year).  If the holder of the bond is in a 20% tax bracket, that means that $20 of the $100 of interest received is paid in taxes, for a net of $80 for the bond holder.  If the same $1,000 bond is tax exempt, the interest rate could be set at 8%, and the bond holder receives the $80 tax free.  In either case, the bond holder ends up with the same amount, $80.  The higher the tax bracket the bond holder is in, the greater the tax savings.  The city takes the IRB proceeds received from the sale of the bond and loans that money to the company at the same low interest rate and on the same repayment terms as the IRB.  Such bonds can also have longer maturities than bank loans.  The money repaid by BBE is remitted to the bond holders.

It sounds like an IRB may be the way to go for BBE.  We will continue exploring this idea in the next blog.

Comments are always welcome.

Monday, February 11, 2013

The Final Merger Meeting (2)


We return to the meeting on the merger of Best Blogs Ever, Inc. (BBE) and Blog Topics, Inc. (BTI).  We have agreed that $180,000 of the $650,000 to be paid for the company to Bob and Mary Pat will be in the form of tax deductible compensation and covenant not to compete payments.  The remaining amount, $470,000, will be paid by the issuance of a second series of preferred stock.

We now must reach agreement on the dividend to be paid on those shares.  Dennis, the attorney for Bob and Mary Pat, suggests a dividend of 10%, which means that they would receive $47,000 per year on their 470 shares of $1,000 par value preferred stock.  Our attorney, Carl, says that dividend rate is too high, given the current rates being paid on publicly traded preferred shares in the market.  He suggests that a more reasonable rate would be 4% or an annual payment of $18,000.  Our financial consultant, Mary Jo, offers a compromise.  She suggests that BBE issue a second series of preferred stock with a dividend of 5% with an added feature.  The preferred shares would be participating.  A participating preferred share receives not only its declared dividend, but also an additional dividend based in some way on the dividend declared on the common shares of a company.  For instance, participating preferred shares may receive an extra dividend when the dividends paid on the common shares exceed a certain amount.  In the last full year of operations, BBE had earnings of $4.82 per share.  We had declared a dividend of $1.25 on each common share.  A 5% dividend on the preferred shares to be issued to Bob and Mary Pat would result in an annual payment of $23,500 or $50 per share to be paid on the 470 shares of $1,000 par value preferred shares.  We agree that if the dividend on the common shares of BBE ever exceeds $50 per share, their preferred shares would receive a participating dividend equal to any dividend paid on the common shares over the $50 per share benchmark.  Given the present dividend, that would seem unlikely, but at least Bob and Mary Pat have the possibility of receiving more money.

With the issuance of the second series participating preferred shares with a 5% dividend to Bob and Mary Pat, BBE is taking on a significant financial obligation.  It must pay $23,500 per year to them regardless of the annual earnings it may have in the future.  If business declines and earnings drop, they are still entitled to their dividend.  We ask for one other feature for the shares.  If the preferred shares are participating, they should also be callable.  This means that BBE can redeem their preferred shares at par value.  This might happen if BBE could borrow money to pay off their shares at an interest rate lower than the 5% dividend rate, resulting in a lower annual payment.  Bob and Mary Pat agree to this and we are almost done.

In our first meeting, they had insisted that their blog writers receive some consideration as part of the merger.  We had discussed the idea of issuing a number of common shares of BBE to the writers, but we insisted on maintaining the existing share control of the company.  To accomplish this, we offer to issue a second class of common shares with all of the rights of the regular common shares but one.  The second class of common shares would have lower voting rights than the first class of shares.  Each second class share would have a vote equal to one-twentieth (1/20) of the voting rights of each first class share.  In other words, 20 shares of the second class would be needed to equal one vote of a first class share.  Each of the six blog writers will receive 400 shares of the new issue upon completion of the merger and an additional 800 shares if they continue to post their blogs for BBE for one year after the merger.  This provides them with an inducement to continue to write their blogs for BBE after the merger.  Will and Catherine, the senior blog writers representing the other writers, agree with this.  They will have a smaller vote in the company (a total of 360 votes on the 7,200 issued shares), but they will receive their full pro rata share of any regularly declared dividends with all the other common shares, regardless of class.  Henceforth, the original class of BBE common shares will be A shares, and the second class will be B shares.

Although not typical, there are several publicly traded companies with dual classes of shares, such as Berkshire Hathaway, Warren Buffett's company, Ford and Google.  In each case, the voting power of one class of shares is a fraction of the voting power of the other class.

Having reached agreement on all of the issues, we tell the lawyers to draw up the necessary papers to complete the merger.  The merger is completed, and BBE is now a much larger company.  As everyone had hoped, things go well and BBE continues to grow.

We will continue to follow BBE in the next blog.

Comments are always welcome.

Monday, February 4, 2013

The Final Merger Meeting (1)


We meet at the offices of Blog Topics, Inc. (BTI) to hopefully reach an agreement on a merger of Best Blogs Ever, Inc. (BBE) and BTI.  Bob and Mary Pat, the owners of BTI have their attorney, Dennis, with them and their senior blog writers, Will and Catherine.  BBE is represented by our President, Alice, our attorney, Carl, Mary Jo, our financial consultant and me.  The general outline of the merger has been agreed upon as a swap of the common shares of BTI for an issue of preferred stock of BBE.  We have also discussed the issuance of some common shares to the BTI staff in order to ensure their continuing to work for BBE after the merger.

The first order of business is to arrive at a value for BTI as a business, which translates directly into the value of the BTI shares to be swapped by Bob and Mary Pat.  Following the earlier advice of our attorney, we ask them what they want for the company.  Mary Pat indicates that they think BTI is worth $700,000.  Since BTI had GAAP earnings of $40,000 for its last year of operations, this translates into $200 of earnings per share.  Using a price/earnings ratio (P/E) of 17.5, the value of each of the 200 outstanding shares of BTI would be $3,500.  With the same methodology, Mary Jo, our financial consultant, had earlier arrived at a value of $600,000 for BTI, using a P/E of 15.  After more negotiations back and forth, we agree on a P/E of 16.25 for the BTI shares.  Using that multiple on the earnings of $200 per share, the value of each share is $3,250 for a total of $650,000 for the 200 shares owned by Bob and Mary Pat in BTI.

Now the question is how to pay the $650,000.  We had reached preliminary agreement on the idea that BBE would issue a series of preferred shares to be exchanged for the common shares.  When VFI had made its $60,000 investment in BBE's newly issued cumulative, convertible preferred shares, we had established a par value of each share of $100 and issued 600 of the shares.  Earlier, there had been discussion about a par value of $500 per share, but everyone agrees that is too low given the price of $650,000.  We agree that BBE will issue preferred shares with a par value of $1,000.  Because BBE has already issued one series of preferred shares, the ones owned by Bob and Mary Pat will be the second series, with a different par value and dividend rate.  Their shares will be subordinate to VFI's shares.  This means that VFI's shares are prior to the second series and would be paid first if we were to liquidate the company and pay out all of the share holders.  VFI would be paid for its senior preferred shares first, then Bob and Mary Pat would be paid for their second series of preferred shares, and finally the owners of the common shares would receive the balance.  All of these equity shares would be junior to any debt owed by the company, which always gets paid first..

The problem, from our perspective, is that any dividends paid on the new preferred shares to be issued to Bob and Mary Pat will not be tax deductible.  We know how much we will be paying for BTI, $650,000, but how that amount is to be paid to Bob and Mary Pat remains open for discussion.  It would be good if some of that purchase price could be deducted by BBE on its tax return.  Carl, our attorney, suggests that Bob and Mary Pat might continue to work for us after the merger is completed.  They want to retire and enjoy themselves, but would be willing to devote a limited amount of time to the business.  They had drawn combined salaries of $60,000 in the previous year.  Any salaries paid to them would be deductible.  They agree to work for BBE on a part time basis as consultants to help in the transition of BTI's blogging business into ours for two years after the merger is completed.  They would make themselves available on a limited basis (no more than 10 hours per week) to help us run the combined operations for this two year period.  In return for this help, BBE would continue paying each of them their previous salaries of $30,000.  We do not expect to need their help for the entire two years, but this is a way to convert some of the purchase price for BTI into a tax deductible $120,000 paid over that two year period.  In addition, we will pay them a combined $60,000 for one more year after their consulting period is over for a covenant not to compete agreement.  Under a covenant not to compete agreement, they agree to neither work with another blogging company nor start up another blogging business and, in either case, compete with BBE.  The payments for the non-compete agreement will also be tax deductible.  With these payments, the amount to be paid in BBE preferred shares is reduced to $470,000.

Bob and Mary Pat appear to be getting less of a purchase price for their company, but on a cash flow basis, they are getting paid some of the money sooner than if they received only preferred shares.

We will rejoin the meeting in the next blog.

Comments are always welcome.