What is the enterprise value of my business?
Many entrepreneurs ignorant of the importance of the value of the enterprise. Being aware of it is important while undertaking strategic decisions like sale or investment transaction.
We met with a new client who is into the business of HR services with over Rs 100 crore turnover. The performance has been consistent and not affected by the Covid pandemic. Moreover, the company has reasonably well-established governance and internal control practice.
He is looking for an exit strategy through sale. The reason for the sale of the business is apparent. He wants to exit as he is growing old and children have no inclination to carry forward the legacy—a commonly sighted situation in the MSME segment in India in recent years.
We observed that the process to sell the company is very inappropriate. There is no preparation of any documents, no organised thought process, or professional advice on the sale. They tried to seek potential buyers through their friends and relatives. They got a potential buyer through their network and almost agreed on a price. We felt that it was much below its worth.
MSMEs generally do not give enough attention to improving the enterprise valuation before any action like sale, investment etc., instead, they accept whatever the value arrived during the transaction process.
Having devoted one’s entire life to developing the enterprise, assessing how valuable one’s business is should be paramount. Secondly, the valuation of the enterprise need not be linked to the immediate sale. There are many reasons for undertaking valuation.
Reasons to Value Your Business
· To sell your business
· To attract investors
· Buying out the other owners
· Offering employees equity
· To better understand business’s growth
The list can go on as small business owners’ personal and professional lives revolve around their business and potential. While many of the reasons above involve changes in the company or its ownership, personal events such as marital discord, illness of a critical person, the sudden demise of the enterprise, age factor etc., may also influence the valuation.
How to Prepare for a Business Valuation
If you’re conducting a business valuation for informal purposes, you may want to do it independently. However, hiring a professional valuer like a certified valuer registered with the Insolvency and Bankruptcy Board of India(IBBI), Merchant bankers, Chartered Accountants, or Financial Advisors could be a good idea if you need the analysis for more serious matters.
In either case, there are a few steps you can take to prepare for the valuation:
Get Your Financial Documents in Order
Every valuation is going to be based, at least in part, on your business’s finances. Even the market-based valuation method requires your business’s financial information to find suitable comparable to justify the value you will seek.
At a minimum, you’ll want the previous three years financial statements, including the balance sheet, income statement, and cash flow statement. Then, combine these statements to ensure everything is up to date.
Other finance-related documents, such as sales reports and industry forecasts, can also be important, particularly for DCF and market-based valuations.
Organise Other Essential Documents
Depending on your reason for the business evaluation, you may also want copies of your business licenses, permits, deeds, and certifications available, along with any ongoing contracts with insurers, creditors, vendors, and clients.
If you’re looking for business loans, you’ll likely need to share these along with your financials. You can also pull out your bureau report (Ex CIBIL) and present it to show your credentials.
List Additional Intangible Assets
It would help list the business’s tangible assets (such as cash, property, and equipment) on your balance sheet. Some intangible assets may be listed there, such as copyrights or patents. But think about other intangible assets that may be providing value.
An extensive email list, customers loyalty scheme, good rankings in search engine results, engaged social media profiles, and positive online reviews can all help you attract and retain customers. These types of assets could help improve your business’s valuation even if they don’t have a value on its balance sheet.
Identify sustainable competitive advantages.
If sustained for years and decades, every business must have something playing a crucial role in its success. So be aware of such strengths that support your business to be there.
There are also ways to demonstrate the business’s value to potential buyers that don’t rely on the numbers. For example, if you can show how processes and systems are in place that will keep the business running after you leave, buyers may be more willing to agree to a higher valuation.
Or, perhaps you can highlight how your employees are happy and take ownership of their work. Low turnover can save the business money, and responsible employees can make transitioning to new management easier.
Improving Your Business Valuation
Your business’s valuation will depend on how much money it makes, and increasing revenue and cutting costs are the core essentials to improving your valuation. This apart enterprise value is influenced by aspects such as the business prospectus, internal control, governance, business process, HR practice, etc.
The enterprise valuation can be improved by working on various elements listed above. However, it will happen over a while, not instantly.
You may hire a professional to advise you on improving the valuation. Hiring a professional valuer might be an excellent step, as they can give you the current valuation and help you identify your business’s strengths and weaknesses. They may even be able to offer suggestions for improvement based on what they’ve seen work for other companies.
Do a Practice of Regularly Valuing Your Business
Learning how to estimate the value of a company can be important for MSMEs for many reasons. Even if you’re not planning on selling your business or seeking investment, regularly performing a quick business valuation can help you track your progress over time. In addition, taking a deeper dive into the valuation may help you uncover growth opportunities.
Regular exercise of undertaking valuation is a healthy practice. It is a strategic initiative and can benefit the company in many ways. Giving attention to factors that contribute to higher valuation will put the firms on a pedestal and help the firms secure investment at shorter notice if the need arises.
An Idea to Business model: Analyse the commercial viability
Business Ideas may be unique. Unless they are analysed and validated for commercial viability, they are not worth pursuing
Recently we had an interaction with an entrepreneur who was planning to launch a new business. He had done a great deal of research and identified the opportunity.
His market research was amazing and certainly, there was ample opportunity for success as it specifically addressed a point of pain prevailing among the consumers of that product.
He presented a nice pitch that looked very attractive. The purpose of the presentation was to raise equity for the initiative. But what was missing was the financial model to link the opportunity to his business idea. In other words, the business case did not give any indication of the commercial viability of the project it intends to initiate and seek investment.
Having discovered an opportunity is not enough to start a business. Entrepreneurs must find a viable path to make it commercially successful. Sometimes we are tempted by the success stories we hear and read through print and online channels. We tend not to look at the intricacies of the business we’re trying to do.
We have encountered cases where entrepreneurs present estimates of different heads of costs & revenue without evaluating the situation on the ground just to prove their point. It is desirable that we research the aspects of costs, revenues and investments to come up with a viable business model.
Everything requires measurement:
Ideas may be vague and unclear. Numbers are objective. How many customers at what price points produce the profit? How much profit do we need to sustain growth? How much business can be referral-based from satisfied customers to reduce outside marketing spend? What is the initial outlay?
Once those numbers are known, you can be very clear about what you need to do and what you need to pass every day to be successful. You can manage what you know and measure the results you need.
Management thinker Peter Drucker is often quoted as saying that “you can’t manage what you can’t measure.”
Drucker means that you can’t know whether or not you are successful unless success is defined and tracked. With a clear success indicator, you can quantify progress and adjust your process to deliver the desired outcome. Without clear objectives, you are constantly in a state of speculation.
It is apt to recollect another great statistician’s comment. ”In God we trust. All others must bring data.” This quote, made by W. Edwards Deming, refers mainly to the importance of data measurement and analysis when doing business.
By clearly defining what results constitute a win in the venture, we sit on, we are able to make objective, data-driven decisions that will give better visibility to the path forward and instil confidence for investors, lenders, other stakeholders like employees and even for entrepreneurs themselves.
Clarifying expectations, defining success, and measuring, analyzing, and adjusting are the right steps to creating winning processes. Implement these habits and your business will improve. This process is data-driven.
Data makes the model very transparent. Transparency means that there’s no hiding behind jazzy taglines, buzzwords, and marketing jargon. Instead of focusing on making ourselves look good, we have to focus on being good.
Give attention to details:
Financial planning should consider the maximum number of variables that may affect viability. Approximations or guess works may satisfy us and may save time to bring the proposal forward; it is likely to result in overlooking vital factors that can significantly alter the outcome.
I would like to talk about an incident that occurred when I was the head of the bank branch. A long-time client came up with a proposal for the production of a consumable item. He was new to the trade. Naturally, we were concerned about the risks. In the course of the proceedings, we asked him about the commercial viability of the project. We were amazed at the level of preparedness of the business plan. He put out a sheet that explains the cost of each input, not less than 31 in the production of each unit. The main input was mild steel, which consumes roughly 80% of the cost of production. However, he did not choose to approximate the remaining inputs. They were all part of the detailed analysis, which obviously gives confidence for examining investment.
Numerous start-ups have blossomed not because they boasted a revolutionary business idea, but because they managed to find an efficient solution to a problem. More importantly, while coming up with such a solution, they invariably check if it can make commercial sense to venture in.
The assumptions underlying the financial model should be realistic and reflect market conditions. A robust financial model is the ultimate source of comfort.
An ill-conceived strategy to sell the company: Prone to legal and other risks
While many entrepreneurs plan to leave the business for a variety of reasons, the strategic approach is essential to make it a successful sale.
Recently, I received an entrepreneur who had trouble coming out of her failed exit plan. The business had been running successfully for many years. However, the COVID-19 pandemic and the consequent lockdowns had a severe impact on the business of the company. The company experienced supply chain disruptions on the one hand and the delayed restarting of orders from some of the customers on the other hand.
In view of advancing age and lack of successor within the family, she decided to quit the business and started exploring someone who can take charge of the business and run it.
She identified a businessman looking for diversification to take over the company. The terms were negotiated. He did his due diligence and assessed the company’s potential. After mutual discussion, it was agreed to enter into a partnership in which he would own 95% and hers would be 5%. Upon signing of the deed of partnership, the manufacturing facility was immediately transferred to new premises (belonged to new owner).
Bonhomie did not last long. Cracks started to appear in the association as they went into business. There were gaps. For instance, execution of personal guarantee of the new partner to bank loan was deferred rather bank permission was not obtained for new partnership arrangement. Consent of the bank to shift the assets were not obtained. With respect to compensation for the current owner, there was no explicit agreement rather it was left to mutual unwritten understanding. There was no formal business transfer agreement. The partnership deed was more forward-looking as if for a new entity than addressing the transitional challenges and issues. Likewise, few other issues began to bother them and in turn lead to friction.
The entire transaction was organised in a very unprofessional way and without a solid legal basis. Above all, the new partner was new to the industry and did not show much interest in learning the intricacies of the business of the company. This lead to a situation of mistrust and one began to blame the other. The partnership came to an end. The seller lost a great deal to relocate the company to new premises and again bringing it back. On top of that, the company suffered a business loss for six months because of the bickering. In the end, she felt associated with the wrong person.
Selling to the Wrong Person:
Accepting the first offer may not be an appropriate choice. This may not necessarily be your best offer. Selling your company at a high price with little or no money upfront with an extended contract can lead you to lose it all. This is what opened in the case discussed above.
Business sales often go bad after the new owner takes over. The new owner may be inexperienced in business, have a closed mind or be a bad leader. The list goes on and on.
When this occurs, the new owner eventually closes its doors and lets the previous owner hold an empty bag.
The steps one needs to take while putting business for sale.
It is fact that many small businesses do not find successors in their families when the children pursue their own interests. There are other reasons such as poor health, premature death of a key individual, partner differences, etc.
In any event, an orderly sale requires certain essential measures, a methodical approach and respect for existing legal and procedural aspects. Following are few steps we suggest:
1. Timeframe for Sale and preparedness
Keep a time frame of one or two years to conclude the sale. This timeframe must be utilized to update financial records, ensure legal compliance, document the processes, etc., to make the business fit to BUY. This will make the transition friction-free and will not cause disruption.
2. Business Valuation
Next, determine your business’s value, to make sure you don’t set a price too high or too low. Identify key strengths & opportunities. Consult a professional for an assessment with a detailed explanation of the value of the company. The document will provide credibility at the requested price and may serve as a gauge for your offer price.
3. Avail service from an advisor
An experienced advisor can bring expertise to manage the sale and also free up your time. They can add value by leveraging their business network to speed up selling.
4. Preparing Documents
Prepare a detailed Information Memorandum including financial records, legal compliance, detailed list of assets, contact list of customers and suppliers, disclosure of potential disputes, etc.
5. Finding a Buyer
Use the trade networks, online platforms, professional advisors to identify the potential buyers. Sometimes your own associates may assist you in finding the buyer.
Once you have prospective buyers, qualify them before letting to start due diligence in terms of financial standing and more importantly suitability of the person to keep the business running.
The sale of the company must not lead to legal hurdles either to the seller or to the buyer. Because it can destroy the business you have nurtured for many years. It is highly recommended to take the assistance of professionals to create the documentation and deliberate every aspect before signing.
For many MSMEs, the sale is a compelling transition strategy. In addition, selling is the means of realizing the value of the business built assiduously over the years.
Assess your options and choose the best choice in the long term interest of the business you nurtured. Ask yourself, is he the best person to buy and run my company? Or, can they quickly connect with the customer base and learn how to market effectively? When the business sale goes as planned, it creates a tremendous opportunity for new business owners and the success continues.
It is saddening to see a business fail after years of success due to the lack of a professional approach to sell the business.
Poorly structured sale of a business may also incur unnecessary additional costs, including commercial, legal, financial and tax issues.
Distressed businesses require a review of their financial strategy, not money upfront
Many businesses in distress lookout for new money to revive the business. The fact is that if the source of distress is something other than money, more money will not solve the problem of distress.
Recently, I had a chance to review with a restaurant business that is slipping into distress at an alarming rate. Once they were regarded as a landmark brand in the neighbourhood and the footfalls were very high. Having been here for decades, the restaurant has become a household name and a brand associated with the city. From here they moved to a new classy place of their own, far from the commercial place. At the new location, the company did not reach the level it wanted. The footfalls were lower than previously seen in the business at the previous place. The new site has been developed through high-cost borrowing. Cash flow is not sufficient to repay the debt.
Sensing the urgency to revive the sagging fortune, the promoters have been desperately looking for fresh money for clearing the existing bank facility which is in distress and secondly to fund the working capital which they believe would help them to turn around. In spite of the best efforts, the banks were unwilling to commit. Later, they started to seek funds in the informal market, which is quite expensive and the market is filled with many unscrupulous elements.
New location required new strategy:
Upon studying their situation and financials we found that the money would not solve the problem. Investing more money into the current business model will only increase their distress instead of bringing them back to normal.
The fault was with their business strategy. Earlier they did well because it was closer to the commercial hub. Now, having moved away from the commercial hub, expecting a repetition of the same client with the same way of consuming was incorrect. The business model of catering to the fast-moving population in the commercial centre is not feasible in the new premises. The focus should have been on a different theme of catering to a market of leisure visitors with more time at their disposal and seek to entertain families and social gatherings as well as business clients. It wouldn’t have been too difficult given their strong brand connection with the city.
The business at the new location fails because promoters are not able to refine their business model. Now, investing more money won’t relive the fortune unless they tweak the menu and amenities.
A situation like this where the financial constraints seem to be stronger, but cannot be overcome simply by increasing funding. We need to pause and look at the financial strategy to identify the shortcomings.
Review Financial Strategy – A pointer to identify deficiencies.
A review of the financial strategy enables you to assess your financial needs and the resources required to support and meet your objectives and to fulfil your organisation’s overarching objective, as well as plan for continued growth to enable business success and sustainability.
It focuses on aligning financial management with an organisation’s corporate and business objectives.
This is an exhaustive examination of the financial aspects of the company. A thorough analysis of the financial situation will make it possible to understand the difficulties of the system impartially. It allows the promoters to understand where the flaw lies.
If the reason distress is anything to do with the products, marketing, etc. The review of the financial strategy is an intermediary step and will effectively flag the key concerns.
In our analysis, we identified three key issues: lower than expected sales, lower than expected EBITDA, and higher cost of borrowing. Finally, we found that the company suffered as a result of the wrong strategy. In fact, there was no new customer acquisition plan for their new venture. The new value proposition is not conveyed or any marketing to attract the crowd to dine in the leisure environment. As a result, the company began to suffer losses and on the other hand, the owner continued to focus on mobilizing more money hoping that someday the company will recover.
Second, no consideration was given to its other strengths. Having succeeded for decades, an enterprise naturally carries some lasting competitive advantages. The promoter must be conscious of these strengths. In this case, the store served the market with spicy numkeens and bakery items that could have been monetized by branding and widening marketing channels. It is also very profitable and able to support the company to support without falling into distress. This could have happened with little to no additional funding.
The struggling company should do an in-depth analysis of the financial strategy rather than simply explore new financing options. This review would identify critical issues that need to be resolved to overcome distress. Let us not forget that if money is not a source of distress, more money will not solve the problem of distress. The analysis of the financial situation will lead to a potential examination of business practices, processes, cultural products, etc. Therefore, the course correction can be completed before the situation worsens.
Credit rating – An invaluable tool to build a sustainable organisation
Many MSMEs treat credit rating as a ritual to satisfy the bank. In reality, it has the potential to enable building stronger and sustainable entities.
We recently came across a case in which an MSME enterprise’s credit rating was below investment grade. As a result, the bank’s loan exposure to the firm was priced slightly higher. The entrepreneur was clearly upset, and he blamed the credit rating system, which he believes is more of a burden than a virtue. He was chastising his bank for ignoring his long-term relationship.
We took up the case and analysed the inputs given to the rating agency, and we made our own assessment of the firm’s financial and business standing. We found that his grievances are not entirely out of place. The firm standing is much better than many others in that industry.
The obvious question is why the firm did not get the credit rating it deserves
The notable reason for the lower credit rating, we observed, was the poor level of accounting practice. The principles of corporate accounting are not adhered to despite having a large turnover. It is further compounded by the low level of engagement with the representatives from rating agencies while they were doing their work.
The company religiously handed over documents that were needed by the rating agency. There was no attempt from the company side to interact and provide deeper insight into the operational, managerial, financial, and industrial factors which are benign to the company and how the future would look like for the company.
This disinterested approach is emanated from the perception that the rating just a ritual to satisfy the bank that extended the loans.
Its true value was not appreciated by the company promoters. Simply they were not aware that interaction with rating agencies during the process would enable them to have better insight into their own business which the representatives of rating agencies normally discuss. Secondly, they were not aware of the multiple benefits the credit rating exercise will bring.
The benefits of Credit Rating:
- Diversify the funding base and lower the interest cost: A good rating can help you gain faster and cheaper credit for your venture. The firm’s rating visible to the general public online may prompt structured debt providers to approach directly with better structures at competitive rates. A good rating can trigger an appetite for investors to join hands.
- Expanded business opportunities: The independent risk evaluation of SMEs by an unbiased third party lends credibility to them and opens doors for them while dealing with MNCs and corporates. They can submit credit ratings for tenders and make you more credible to get bigger orders. It is a fact that better ratings have helped the SMEs retain customers and suppliers, and negotiate better terms with them.
- Risk Mitigation and self-improvement: Credit rating is a third-party assignment and the work needs to adhere to certain regulations. They normally do their job in an unbiased way. Further having been in this exercise, they do advise on improving the internal controls, better adherence to accounting standards, and suggest ways to improve the governance. It emphasises the strengths and weaknesses act as triggers for self-correction. Regular renewal of ratings not only helps improve a firm’s performance but also internal control.
- Better-rated entities will enjoy a higher reputation: Another advantage is a higher reputation. It has the potential to embellish the reputation in the market. Disclosure of the rating of the firm by credit rating agencies is mandatory and being published in the press briefing and rating agencies website. This is easily amenable to the general public to view. Having been rated well means positive vibes will spread about the company. A firm that received a better rating has an obvious chance of receiving good review and enhanced confidence for those who would like to engage in the business with it.
Sustainable Organisation and rating:
Every entrepreneur aspires to make his organisation lasting longer. They strive hard, sacrifice a lot of privileges, passionately pursue their mission, and put at risk everything they possess.
However, no organisation can claim stability in the face of a fast-changing business environment and disruptions imposed by multiple factors.
The rating can help the organizations in two ways:
- It will help to eliminate the risks by exposing bad practices in the annual rating exercise.
- The organisation’s which aspire for better rating will obviously improve its governance, compliance and control mechanism and thereby build encumbrance.
Credit rating is a statutory obligation for those who have availed a significant amount of debt from the bank. In reality, it is a potential tool to elevate the standing in the minds of customers, suppliers, potential employees, potential investors & debt providers, and other stakeholders including larger society.
Every organisation- small or big, having a bank loan or not- should take credit rating like a serious exercise and strive to secure a superior rating. Those who are rated lower must strive to improve the rating by working in the weak areas.
Author: Anil Kumar Shetty, Founder SME Advisors
Debt Restructuring – Capitalise relaxed regulations
Debt restructuring is important to overcome the distress especially during the pandemic. However one should exercise caution while seeking initial moratorium and revising repayment schedule
Recently we came across a case wherein the borrower sought debt restructuring under RBI guidelines on the resolution of stressed debt due to the COVID 19 pandemic. The loan was recast at the appropriate time and the bank was very responsive to that. However, upon perusal of the detailed term and conditions, it was awful to note that the moratorium taken was at just three months though the RBI guidelines have given flexibility for two years. The unit remains stressed because the business revival did not happen rather deteriorated due to the second wave of Covid 19
RBI regulations on Restructuring of the debt:
RBI is magnanimous in framing the regulations to accommodate the needs of the enterprises to seek course correction to the revival of the business. Businesses are vulnerable to internal failures and external shocks. It is very pronounced in the MSME segment as the margin of error is obviously thin the segment.
In recent time the Covid 19 pandemic and immediate policy responses to contain the spread brought in a sudden surge of disruptions and none of the businesses- big or small -escaped the stress barring a few select sectors such as healthcare.
It is heartening to note that RBI responded well by creating a window of opportunity and setting simplified parameters to restructure the loans. This will enable the enterprises to relook at the business and also seek debt restructuring to weather the storm.
Quick resolution is necessary to protect the value of the enterprise:
No business can wish away the stressed situations in the life cycle. It is endemic. The sources of stress may vary at different points in time. The persisting stressed situation may affect the organisation built assiduously over the years. Enterprise value which is the reflection of not only tangible assets but also network and reputation, intellectual assets etc may see deterioration unless we take timely corrective measures to reduce the stress.
To revive the business from the stressed situation, resolution plan for borrowing from the institutional source is paramount. It is because, if they launch the recovery proceedings against the enterprise, this will lead to rapid deterioration of public profile as well as confidence of stakeholders.
Bank debt restructuring alone is enough?
No. It is a primary requirement but not alone. Many enterprises normally take a sigh of relief once the bank loan is restructured. Stressed business requires many more steps to return to normalcy. For whatever reason/s it may have been under stress, its return to normalcy is multifunctional exercise. To name a few:
- Appropriate organisational wide behaviour change towards improving the efficiency
- Review of the road travelled to identify the gaps in the internal processes
- Risk analysis and mitigation practice to minimise the negative surprises in the future
- Undertaking strategic review to revisit the purpose, products, and markets
- Review the manpower, skill-base and augment the gaps
- Leverage the opportunities extended by the tax authorities and other regulators
Why initial moratorium and proper redrawing of repayment of bank loan matters?
Because any Stressed business needs time to heal and lookup.
It is an obvious question for all of us how long we need to seek a moratorium to start repayment and how the repayment structure should be. It is prudent to seek maximum leverage from all the stakeholder including the bank.
Way forward to turnaround…….
We need to draw a turnaround strategy. The qualitative aspects and quantitative aspects required to be analysed while drawing it.
Qualitative aspects cover the economy, state of affairs in the industrial segment and review of our internal workings that lead to crisis. This should lead us to take a pragmatic view of our situation and prepare ourselves for mapping our turnaround strategy.
The strategy must be reflected in the quantitative model. All our future action plans must be translated into financial plan we prepare for revival. The debt repayment structure should be well aligned to cash flow from the revival process.
The plan must be prepared for ourselves and this should act as the guide map for reviving our business. Many a time the entrepreneurs submit the plan to the bank/s without involving themselves in preparing it. That is not correct. The ownership and burden to implement the revival plan vest with the entrepreneur himself.
Covid 19 is an uncertain event and we are unsure how it will play out in to the future. In the globalised trade environment, it is not enough if one country comes out of the grip of Covid 19. Thus it is adding to uncertainty to many industrial sectors as many of them depend either on the supply of inputs or marketing of products and services with the rest of the world. Also domestically the Covid 19 still prevailing and not sure of the gravity of its impact our business.
During the crisis time, restructuring of the bank loan is an important stepping stone to stabilise the businesses facing rough weather. It is important that the business revival is backed by a proper plan to convince all the stakeholders including the bank. Also, ensure that the firm gets maximum leverage in terms of rescheduling of debt moratorium and new repayment structure synchronising with the cash flow forecasting.
Adherence to the Regulations by Lenders – Enforcement is needed
The pandemic is still raging and many entrepreneurs are living under the shadow of uncertainty with regard to restructuring.
We have been assisting the couple to deal with financial distress emanated from COVID 19 pandemic and consequent lockdown in the early last year. The flourishing restaurant business nosedived to a complete standstill. Thanks to their spirited reworking of the strategy and increasing online orders, the business remains afloat. Though the profitability is still a far cry, there is a glimmer of hope and optimism that the days ahead will be better. They have few loans from NBFCs and banks as well. We all know that when the going is good, the enterprises tend to borrow a business loan that comes without any collateral security and it is quick in delivery of the loans. Unfortunately, the Covid 19 made things go very bad. NBFC which had been recovering the regular instalments till the pandemic did not show any remorse at the situation rather insisted on payment though there is not enough cash flow. The borrower made repeated requests for restructuring the loan and a softer repayment schedule for the balance outstanding which they ignore.
What is astonishing is- the approach of the NBFC to ignore RBI’s guidelines on One Time Restructuring (OTR). The subject party is eligible to seek OTR as per RBI norms. Despite repeated requests to consider under the RBI Scheme of OTR, they ignored the request.
The question is- what is the sanctity of the regulations which is not adhered to by the NBFC
In the midst of the COVID 19 pandemic and post lockdown, the Reserve Bank of India came out with series of regulatory guidelines to banks and Non-Banking Finance Companies(NBFCs) to extend relief to customers to overcome the financial distress and smoothen the process of recovery of loans in an orderly fashion. Also, Govt of India came out with many guidelines to help the MSMEs to overcome the stress.
RBI issued two comprehensive guidelines on August 6 2020. They are: Resolution Framework for COVID-19-related Stress (for personal loans and corporate exposures) and Micro, Small and Medium Enterprises (MSME) sector – Restructuring of Advances.
The circulars were very clear and unambiguous in their intent. It has given enough flexibility to enable banks and NBFCs to restructure loans with liberal terms and addressed the key concern by waiving the condition to downgrade the loan to non-performing status.
In the first reading, it sounded as if it is a panacea for avoiding conflicts between banks and borrowers. There was a great sigh of relief among MSMEs that there will not any harassment for recovery rather the process to recover from the COVID 10 pandemic will be smoothened.
Many MSMEs have given a request for restructuring in view of the delay in the onset of business recovery.
This particular couple also made a request way back in September 2020 to restructure the loan to NBFC. However, it was very agonizing to see that the lender neither took serious note of the request nor shown any inclination to implement RBI guidelines. They were absolutely cold to the proposal. In fact, there was no one to discuss the proposal.
It is not an isolated case rather than a system-wide practice. Despite the standard conditions set by RBI for identifying the eligible entities to undertake a restructuring, the banks and NBFCs are not enthusiastically taking up and do not see any obligation to act under the regulations. Their action is very patchy.
The obvious question is- what is the sanctity of the regulations issued by the RBI. Who will have to oversee the implementation?
The regulations are announced as a response to demand from industry bodies and citizens. If it is ignored by the lenders and if they focus on recovery, it will not serve any purpose.
Bank/NBFC is a party for the transaction. It is prudent to leave it to their wisdom to decide on the restructuring proposal? Is there any department or a statutory body which is having the supervisory responsibility to enforce the regulation promulgated by RBI? Indeed it is needed.
Regulations and policies are meant to remove personal prejudices, individual discretions and notably, it will facilitate the contract between two parties conflict-free. Having regulations on OTR is indeed positive for the MSMEs to overcome the covid induced stress. However, its significance is lost when there is no appetite among the lenders to implement.
An agency from Govt/Regulators will have to look at the efficacy of implementation of schemes. This is needed to eliminate the uncertainty and enable effective implementation. It requires setting up a mechanism to help the borrowers to notify their desire to seek restructuring in an independent platform and such request should be referred to Bank /NBFC headquarters for further action.
Setting up such a mechanism with the online channel is quite easy and requires minimal investment. The benefit will be multifold. Having provided the platform, the process will become more transparent and the banks & NBFCs will be compelled to take an objective view of the proposal. It will take away the uncertainty. Brining more stressed business assets into productive use will result in a more economic capacity to grow.
Restructuring is beneficial to all the stakeholders:
Restructuring of loan is one important step in the broader agenda of the revival of stressed business. Unfortunately, there is an element of restlessness among the bankers and NBFCs to undertake this. Rather many are willing to call the customers for One time Settlement of the loan; a sort of inducement. It is not correct. A business of an individual member of the society constitutes an economic asset of the whole country.
Secondly, it is in the interest of banks and NBFCs to hold a dialogue with stressed customers and create a viable path for turnaround. After all pestering, the borrower in the hour of the crisis engulfing the whole society will only lead to self-inflicted injury to these institutions than bringing meaningful recovery.
The fact is in the long run the restructuring is indeed beneficial to the banks and NBFCs though they have to endure short term mismatches in the asset-liability management.
COVID19 Pandemic is causing havoc in the economy. Small business owners are bearing with brunt. The OTR scheme is very much important for stabilising their business and finance. RBI and Govt should make its implementation very effective and facilitate fixing the stressed relationship with lenders so that they will move to revive their business. That will facilitate faster economic recovery.
A weak resolution environment is negative to promote entrepreneurship
COVID 19 exposes the vulnerability of MSMEs in the face of uncertain events. This shows a need for a robust resolution mechanism to deal with creditors and find a viable path forward.
I met with a group of partners of a restaurant business who had been doing extremely good till the COVID 19 pandemic started. The format was very unique in the industry and has the potential to be replicated elsewhere. In fact, the promoters had drawn an ambitious plan to expand the footprint through the franchisee route to take it is to different parts of the city as well as pan India. Pandemic and consequent sudden lockdown had made the calculations go haywire.
The business just slipped out of control. They could not salvage the business. The creditors and suppliers demand was too much to bear with. The bank loan which was well within the normal level till the lockdown suddenly became too much to digest as there was no income flow. The leased property, wherein they invested more than Rs 1 crore to create a unique theme, had to be demolished as the rent payment becomes burdensome. With the removal of the store from the place which was part of their brand, there was no chance to return to the normal business. The condition deteriorated to the level beyond their imagination in the wildest of dream and all happened in just a matter of a few months.
Now the partners are helplessly watching the unfolding of recovery actions from the multiple lenders who have extended business loan at a high rate of interest with a short maturity.
The absence of policy support to deal with uncertain times is the central issue
The pandemic was unanticipated rather an uncertain event. Equally the lockdown was sudden and there was no time to think of alternative options. None of these was under their control.
Today we are in a situation wherein there is no regulatory or legal framework to enable entrepreneurs troubled by uncertain events to carve out a viable path to return to normalcy. The uncertain events affect all in equal measure. However, what is missing is a legal framework that will distribute the pain without letting anyone in the contract to be benefitted or remain unaffected whereas another the party will remain in an advantageous position at the previous level or better. For instances when the lender is a party to the contract, the borrower undergoing the uncertain event will remain indebted to the fullest extent because there is no statutory binding for the bank to sacrifice a fraction of the loan to make the business viable or allow to service the debt with a haircut and a longer schedule.
This unequal position in fact deteriorates the situation further as it will bring in too much uncertainty in the minds of entrepreneurs who will have to deal with the enlarged ego of the other party. This will divert the focus away from resurrecting the troubled business and end in the destruction of the enterprise. Destruction of an economic enterprise brings agony to not only the entrepreneurs & his family but also but the larger society as it will also suffer loss in many ways.
This unequal position is not a stand-alone event affecting a few. It is visible very widely. The entrepreneur will have to answer the same question from many others such as suppliers, unsecured creditors, tax authorities etc. They in turn will have to face a similar situation with others. In all, it is a challenge for the whole society.
Thus there is a need for a standing mechanism to support those victims of uncertain events. The mechanism should be able to help them to withstand the immediate pressure on cash flow and stabilise the business. Once the business returns to normalcy they should be compelled to make the payment to obligors be it bank, creditors suppliers alike.
In the face of uncertainty, the most important support an entrepreneur require is to stand firmly against the wind flow and thus preventing the run on the business. This will create breathing space and allow the firm to review its business and find a viable path forward.
In the process, it may require the creditors have to make a sacrifice in the immediate future with or without a clawback option to recover the loss in the medium to long term depending upon the circumstances and viability.
Resolution support in India:
There were few attempts to create a window of opportunity for distressed firms to review and rework a path forward. The very comprehensive support mechanism was enshrined in the 2015 circular of the Govt of India (Framework for Revival and Rehabilitation of MSMEs). It indeed addressed the concerns. Unfortunately, it suffered from the lack of enforceability of the guidelines. Rather it remained a wishful policy framework and its adoption is purely voluntary.
However, enactment of the Bankruptcy Code in 2016 had raised hope for many. Though Insolvency and Bankruptcy Code (IBC) has the power and scope for stressed business firms to seek relief as in many advanced countries, it is not fully implemented covering all types of the constitution rather limited to LLC(Limited Liability Companies) and LLPs(Limited Liability Partnerships). For the rest, though the law provides for, Govt has not notified yet.
It is time for Govt makes IBC law accessible to all forms of businesses uniformly. There were apprehensions that bankruptcy tribunals will be overwhelmed with litigations. It is not the correct position. Because having an option in the hand will facilitate dialogue among the creditors with the firms and will help to find a viable solution voluntarily. If you look at the history of litigations in Bankruptcy Tribunals(NCLTs), the voluntary understanding that arrived among the stakeholders forms a significant proportion of resolutions than otherwise.
MSME Prepack- A welcome step
There are discussions in various fora that the Govt will bring in a Prepackaged resolution solution under IBC to simplify the process and expedite the resolution for the benefit of MSMEs. The process under the pre-pack insolvency envisages formulation of a resolution plan before the initiation of a formal court process. It is a welcome step and it should be made available to all forms of the business including proprietorship firms and partnership firms along with LLCs and LLPs.
Resolution support de-risks the operating environment and hence promotes entrepreneurship:
A populous country like India needs to encourage entrepreneurship to create employment opportunity and improve the competitiveness of the economy. However the journey of entrepreneurship is filled with experiments, adventurism, and itself is a learning curve for many. It is unlikely to be smooth and cannot be predicted to proceed as planned.
Having a support mechanism for those who may suffer along the path of the entrepreneurship journey to revisit the journey will create a great enabling environment for many to take entrepreneurship. In the long run, the country will win.
A law like IBC is much needed for businesses at this point in time than ever in the history of organized business because the uncertainty in the operating environment is at an elevated level. The entrepreneurs require a sense of assurance through the legal framework to seek a solution if the business proposition fails to yield the desired result. This way the resolution support can promote entrepreneurship.
Proper classification of entries in the annual accounts- An essential task for SMEs
Accurate classification of entries in the book of account is a basic requirement for proper representation of financial standing before lenders and other stakeholders.
Recently we were approached by one construction company having many projects in its fold for advice on the difficulty in securing the bank loan despite having a good amount of own investment and healthy growth over a few years and he was willing to extend good collateral security to the comfort of the bank.
He said that the bank is not in favour because the financial ratio is not favourable. As per the initial assessment the current ratio, key ratio to decide on the working capital limit was below one. Something the banks consider not acceptable.
We started analysing the financial records of the year 2019-20. We found that the reason for the low current ratio was the wrong classification of the unsecured loan. To our dismay, we found that the unsecured loan was clubbed with sundry creditors. On the hand the firm has acquired fixed assets to that extent.. Of course in the first reading, anybody will get an impression the firm has diverted the short term creditors’ money to acquire long term assets.
Apparently the bank had drawn a conclusion that the party does not have financial discipline and has diverted the short term money for long term use.
Party indeed invested the money into the business in the form of an unsecured loan and he has no plan to get back that loan in the near future. Rather this amount was invested keeping in view the requirement of long term funding needs for the growth of the business.
Here the wrong conclusion on the part of the bank originated in the wrong classification of the loan from the promoters into the short term liability that too clubbed with sundry creditors.
Annual Accounts –an important document to represent our business:
Maintaining books of the account is the process of recording and maintaining financial transactions and information relating to a business, on a day-to-day basis. It ensures that records of the individual transactions are correct, comprehensive and updated with accuracy.
Some of the entrepreneurs treat book keeping as a low priority one and hardly look at it for its veracity and integrity. Further, they treat annual auditing of accounts is just a ritual for compliance and tax assessment. They do not see any significant relevance to their business plan. Still worse many boldly state that the books of accounts do not reflect the true picture of the business.
In fact, some SMEs failed in financial management due to weak or no accounting records. On the contrary, financial management is very crucial to the success of a small business. Many repent this when they hit the distress.
These opinions and perceptions won’t help the entrepreneurs. The books of accounts are important for many reasons. Annual accounts are only documents that address the concerns of stakeholders – bank, suppliers, buyers, potential investors, tax authorities etc.
Why SMEs should maintain proper books of account
To prepare Financial Statement: Balance sheet, profit and loss account, cash flow statement are the key elements for reporting to investors/ financiers/bankers on crucial information about the financial status of the enterprises, and books of account are a precursor for it.
To fulfil tax obligations: Paying tax is an obligation by law; beitincome tax, customs and other taxes and duties. To know the correct amount of obligation and to resolve any disputes, one needs adequate and accurate books of account
Legal requirement: There is a certain stipulation in the IT Act to file the returns and this requires to be backed by the books and account. Further Companies Act 2013 also requires every company to maintain their books of account.
Better financial management: At present, better financial management provides a better picture of the health of a company. To make forecasting of financial requirement, acquiring necessary capital and to analyse investment decisions, you should have adequate records of business transactions. Also, the review of the operating performance in relation to time periods or peer comparison can be effective only with proper accounting practice.
Long term sustainability: A thoroughly studied and prepared annual accounts throw many facts and expose the inefficiencies in managing the finances. Thus it will eliminate scope for the surprise appearance of liabilities and financial stress.
Interacting with Accountant especially Auditor is important task:
Proper preparation of our books of accounts is our primary responsibility and getting it thoroughly audited by a Chartered Accountant is an equally important job.
No accountant is interested to make a wrong representation of entries. However, for want of clarity or lack of evidence in the books about the nature of the transaction or by oversight, they may also err in the grouping of the data.
Further, the Auditor having gone through your books of accounts during the course of the audit may have observed deficiencies. Such observations are vital to improving our internal control and risk mitigation. Thus entrepreneurs should interact closely with their Auditor during the annual audit process. Their wisdom drawn from multiple engagements will help you to improve internal control. Also, it will eliminate the scope for errors.
Accurate classification of the entries in the books of account is in the interest of the entrepreneurs. A growing business requires support from multiple sources including banks. Hence accurate representation of the annual accounts is important for winning the confidence of finance providers such as bankers and investors.
CGSSD Scheme: New lease of life for stressed MSMEs in India
The new scheme is a well-conceived framework to enable stressed potentially viable MSMEs to secure a new lease of life and a much needed bridge to facilitate constructive engagement with the bank.
Recently an entrepreneur sought our assistance to revive his business units, one in South and the other one in North. Both are in the same activity and are incorporated in the year 2016. Both together consumed the investment in excess of Rs 30 crores with little than 50% of the bank loan. The business was new to the family although they are in the higher reach of the value chain of the industry for more than four decades.
Both businesses faced quite the same problem. They failed to gather a robust team. The capacity utilisation was lower than the minimum viable level. . The key risks were not in control. Since the family members were at the helm of affairs, there was lax internal control and governance. No one took the burden of running the business professionally.
Despite the most modern production facility and promoted by the family of successful entrepreneurs, the business failed to reach the expected revenue targets and started incurring huge losses resulting in the account becoming NPA in the books of the bank. Having no option left with, Banks in both the places initiated recovery action under SARFAESI Act.
The family repeatedly sought assistance from the banks to restructure the loan and revive the business by infusing additional capital. However, banks were very adamant insisting for the recovery of the loan.
Latest Development: Revival is underway
Thanks to the Govt’s initiative of helping the stressed MSMEs through a new scheme “Credit Guarantee for subordinated Debt (CGSSD)”, the businesses of both these units are seeing a revival.
Under the new scheme, the loan restructuring is underway at the individual bank level. A new business strategy is put in place. The operation is restarted in both the units. The capacity utilisation is steadily rising.
The new guidelines from the Govt of India made the difference:
Recently Govt brought out a new scheme to facilitate the revival of stressed but potential MSMEs. The purpose is to provide guarantee coverage for the CGSSD and provide Sub-ordinated Debt support in respect of the restructuring of MSMEs. 90% guarantee coverage would come from scheme/ Trust and the remaining 10% from the concerned promoter(s). The objective of the scheme is to provide personal loan through banks to the promoters of stressed MSMEs for infusion as equity / quasi-equity in the business eligible for restructuring.
The salient features are:
- The borrower should be the promoter of MSME unit
- The Account should be SMA 2 or NPA as on 30.4.2020
- The accounts classified as NPA after 1.4.2018 are eligible
- The loan amount will be 15% of Promoters stake in the business to the maximum of Rs 75 lakhs
- The loan will be extended to promoters.
- The loan will have guarantee cover from CGTMSE
The scheme is a game-changer:
The scheme is a source of great relief in the above instance. The promoters were sincerely looking for a way out from the messy banking relationship to revive the business. The scheme extended a framework to work with the bank and find a viable path to return to profit. Today the units are in a position to extend jobs to many unskilled and semi-skilled employees in the region. Precious public money will come back to the bank in a phased manner without going through stressful, expensive and value destructive recovery actions.
A mechanism for handholding during the stressful scenario is needed for MSMEs.
Entrepreneurship requires to be encouraged for India to become a global powerhouse and assisting entrepreneurs in the stressed scenario should be part of the policy support they need. We explain here below some of the reasons:
- Dealing with an uncertain environment is endemic to entrepreneurship: Despite the best planning, many firms may challenge to survival due to factors not in their control. Many time changes in the policy or local regulation do impact the business of the small businesses very badly.
- Internal factors and learning curve: There are chances that many a time entrepreneurs fail to get the grip on certain vital functions that may be the key success factor for the business. Every venture has its own learning curve and they need to be supported if there is any delayed onset of the business for want of understanding if its nitty-gritty.
- Bad financial planning: Many a time the decision to launch new busies is more an emotional decision than followed up with a clear financial strategy. We have seen many entities struggling to put the financial maths in place despite the best of technology, manpower, and having huge opportunities to become successful.
- Absence of professional advisors and mentors: Many first-generation entrepreneurs go through a long-struggling learning curve in the absence of access to independent and credible advisors and mentors. As a result, the process of finding the right formula for success gets longer.
Entrepreneurs do make mistakes especially in the early stage of new business. There should be an avenue for course correction. Such businesses deserve a chance to correct the course and redraw their path to success.
In the above cases the CGSSD scheme played a major role to bring in difference. In the similar instances elsewhere entrepreneurs need to be given chance for course correction. An opportunity to review and strategize their business will be of great to protect the value of enterprise they have passionately built.
Also the CGSSD scheme can create a good platform to make the engagement between the bank and entrepreneurs more constructive even when there is distress and facilitate them to find a viable path jointly to turn around the stressed business. In any case It will not take away the discretion of the bank to enforce the recovery if the attempt does not help to revive.
Further improvement required:
CGSSD scheme is a welcome step to help the stressed MSMEs. The support mechanism for stressed MSMEs may be further improved to broaden its horizon. Some of them are:
a) Make it available all across the banks and NBFCs: The borrowing of any MSME is wider than one source. This should be mandatory of all of them join in the process. Unfortunately, lenders other than Govt owned banks are not supporting the MSMEs in this regard. It should be available on a non-discriminatory basis. Govt may bring in required legal and/or regulatory actions in this regard.
b) Remove the age of NPA clause: As per the norms of the guidelines, accounts classified as NPA from April 1, 2018, onwards are eligible. This may be relaxed to cover any potentially viable unit irrespective of the date of becoming NPA.
CGSSD scheme is a welcome step to help the stressed MSMEs to find new lease of life. Also, it is a much better option for the banks instead of seeking recovery action immediately after becoming NPA.