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.
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.
Sustainable competitive advantages and Financial discipline in SMEs
COVOD19 pandemic triggered disruptions have shown how important it is to build good financial discipline alongside building sustainable competitive advantages.
Recently we met an entrepreneur who has been into a service industry. He came with a request to advise him to tide over the crisis which is threatening his survival in the business. He has been into this industry for a long time and steadily built his business over the last 10 years. The business started from scratch reached a level of a couple of crores per month. Even before the COVID 19 pandemic business had been quite weak for some time due to poor financial management mainly diversion of funds outside the business. That had indeed damaged the banking relationship.
Having been in the business over 10 years he has built a strong sustainable competitive advantage and that is giving him enough room to stay in the business in spite of the lack of financial discipline.
The COVID 19 crisis followed by overnight lockdown orders changed the scenario. When the lockdown was announced he was already on the edge; like many other small business owners who are often financially fragile, with little cash on hand or resources to buffer even a minor financial shock. Many MSMEs have ongoing expenses and little or no revenue and face the prospect that they may not sustain for long or never reopened.
Though Govt had announced many schemes to help MSMEs to overcome the challenge, he could not avail any of them due to his low credit profile. On the other hand, the creditors’ demand just became unbearable.
The sustainable competitive advantages built assiduously over the years under the threat of vanishing as he is not in a position to revive the business to the previous level even though the normalcy is slowly returning to the industry.
Building SCA is no mean task. It is hard work, require sheer dedication & passion. It happens over a period of time.
Sustainable Competitive Advantage(SCA):
Sustainable Competitive advantage stems from the many discrete activities a firm performs in designing, producing, marketing, delivering and supporting its product. Each of these activities can contribute to a firm’s relative cost position and create a basis for differentiation.’
Sustainable competitive advantage is the key to business success. It is the force that enables a business to have greater focus, more sales, better profit margins, and higher customer and staff retention than competitors.
At its most basic level, there are three key types of sustainable competitive advantage.
- Cost advantage: the business competes on price.
- Value advantage: the business provides a differentiated offering that is perceived to be of superior value.
- Focus advantage: the business focuses on a specific market niche, with a tailored offering designed specifically for that segment of the market.
Most MSMEs don’t have the market share and buying power to effectively compete on price and are not big enough to be all things to all customers in a market.
Therefore, to successfully compete, small businesses need to develop a sustainable competitive advantage that is based on providing superior value to a specific niche.
Is SCA enough? Will it guarantee enduring success?
The question can be answered through our own experience or looking at some entities which are passing through financial distress. It is quite obvious among the financially stressed organisation to see the depletion of ‘organisational capabilities’ encompassing both physical resources (raw materials, plant and equipment) and human resources (financial, managerial, technical knowledge and skills) which are critical to the ability of firms to nurture Sustainable Competitive Advantage.
We can infer that Sustainable competitive Advantage alone will not bring success in the business. Having all the ingredients, if there is no financial discipline, the firm will likely to fall into distress sooner or later.
The major areas of financial management that require perennial attention to enduring the success of any organizations are :
Cash flow management– Mainly ensuring that long term asset acquisitions/diversifications are funded by surplus (more than required for existing business’s requirement) or funded by long term sources.
Asset management: Efficient management of current assets (cash, receivables, inventory) and current liabilities (payables, accruals) turnovers and the enhanced management of its working capital and cash conversion cycle.
Financing Decisions and Capital Structure- The firm needs to have a well-defined capital structure. The optimum capital structure is expected to enhance ROCE and ROE, without enhancing the financial risk.
Profitability Ratios: Profitability ratios also indicate inefficient areas that require corrective actions by management; they measure profit relationships with sales, total assets, and net worth.
Tax Optimization: Manage the level of tax expenses undertaken in conducting business and to reduce expected taxes.
In the instant case described above, having robust SCA but poor financial discipline exposed him to face a severe level of risk of failure of the business. It was evident that when things were going good, adhering to financial discipline was the last priority.
The recent incident of Covid lockdown exposed many entrepreneurs to the risk of failure. However, those who have built sustainable competitive advantage coupled with better financial discipline are able to navigate the challenge better.
Possession of Sustainable Competitive Advantage is a necessary condition for success for an MSME. This condition is, however, not alone sufficient. Firms require financial management capability to realize the potential present in that strategic asset. This will help the firms to navigate any challenges, mitigate risks and overcome the impact of uncertainties like COVID 19.
Diversification: A significant transition risk for MSMEs
Many entrepreneurs opt for diversification to mitigate the risks from existing business. However, success depends upon how well it is handled from the beginning.
Recently I had interacted with an entrepreneur who is setting up a new business in an altogether new vertical. His existing business is doing very well. There is enough buoyancy in the order flow and he could almost overcome the challenge from COIVD 19 lockdown. However, having seen the volatility in the business he started exploring the ways and means to mitigate the risk to himself by diversifying into another area which is not sharing the same type and level of risks the present business is witnessing.
During the interaction, I could found his approach was very detrimental to his own interest and there are very chances of harming himself if he takes that route. I would like to summarise in the following points:
- He asked his senior executive to hire a person to prepare DPR (Detailed Project Report). He, in turn, hired a consultant having long years of experience and got the DPR done.
- The entrepreneur did not involve himself during the course of the preparation of the report and the author was asked to submit the final report
- The assumptions were outdated and not reflect the present situation in the industry.
- Strangely the DPR is not exactly aligned to the objectives set by the promoters
- DPR is prepared with an aim to secure the bank loan; not a document to help the entrepreneurs to understand the nuances of new business.
- It does not explicitly say whether it is worth pursing; how is the reward structure for investors.
- No risk analysis from the perspective of the entrepreneur and mitigations they suppose to look at.
- Packed with download from search engines, the DPR does not discuss the technical feasibility to the point of relevance.
Transition Risk for MSMEs
The change is an integral part of the entrepreneur‘s journey. In the normal course within the existing business, these changes are brought in the incremental way to align with new trends, introducing new products as per the customer requirements or compliance the new regulations etc.. It rarely requires external help except for some highly specialised interventions. In any case, the context and expected outcome are well within the comprehension of the entrepreneur. Thus there is little chance of failure due to the changes going to be implemented.
However, it is not the case with entering into a new venture where we have no knowledge or have any expertise. Transition risk is a significant risk for MSMEs. We have studied many MSMEs which have failed during their transitional phase of diversification. We observed the common traits as below:
Hands-on involvement, a hallmark of their success in the first venture is notably missing in the subsequent ventures. It is a fact that the visibility of the leader and the day-to-day involvement of the entrepreneur in the operations is a potential advantage in the implementation of a new venture. We did not see that level of involvement in the proposed ventures among them. It can be attributed to their unwillingness to come out of their comfort zone( of running core venture).
Not enough deliberations, just pursuing ideas; sometimes just fancy ideas- Many a time the strategy of diversification is driven by the irrational perception of the potential of the opportunity presented than validated by the facts and figures. No attempts were made to understand key success factors of the opportunity and how we are placed to capitalise that. The depth of deliberations is very shallow. Low level of preparedness including identifying key risks is quite evident.
No proper financial planning. In some of the projects, surprisingly they have initiated the construction without financial closure leading to midway stoppage of the work. No milestone, or no visibility of date to launch the commercial operations. In almost all cases the financial distress in the new venture just seeped to exiting one resulting in the loss of momentum in the well-run company.
Lack of HR strategy: It is a fact that when a company sets on the ambition of high growth or diversification, what is important is clear and unambiguous HR strategy that creates a sense of assurance and promote willingness among the employees to work passionately for the betterment of the organisation.
Absence of Internal audit: Having vested the responsibilities in the hands of the professionals is not enough. In an employee-driven business environment, there is a need for rigid checks and balances to oversee the performance and mitigate the risks.
Diversification is needed…
Many sectors show some sort of cyclicality of varying degrees. Any business faces a higher risk of a downturn and diminishing revenues when it caters to one product or market. During economic uncertainties, small and medium enterprises are more vulnerable than their larger counterparts to this risk.
Diversification is beneficial for an entrepreneur to secure long-term financial stability. It is prudent to diversify into different products, industries, and markets. This not only helps one to boost revenue but minimize risks associated with business uncertainties.
However, what is important is the degree to which the promoter involves himself in shaping the new entity matter the most to see its success.
We believe that the following measures help to reap the benefit of diversification:
- 360 degrees view of our preparedness and meticulous analysis of the opportunity.
- Entrepreneurs need to study the business plan thoroughly before consenting to it
- Seek independent advisors to help to shape the venture however make a background check to validate their credentials. Give attention to conflict of interest, if any.
- The attention span required will remain as much as in the startup stage of the first venture.
- People make difference: It doesn’t matter how great your products or services if you don’t have great people, and if they are not being led by great leaders then you’re not going to be realising your company or organisation’s full potential. It is possible to groom people for excellence provided if we have a clear HR strategy.
- If you choose to operate through management team it is also necessary to have independent audit (internal & management) of the business on an ongoing basis to get a third party view about the state of affairs in the new entity. The ongoing audit will bring the checks and balances that there will not be surprises and shocks.
The diversification strategy is good to beat the downturn in the existing core business and secure financial stability. However, its success depends upon entrepreneurs approach and policies.
Leverage & Uncertainty- Double Whammy for MSMEs
The MSMEs which are leveraged will find going will be very challenging in the present circumstances. This should enhance the appreciation for prudent financial management.
Recently I had a call from one entrepreneur who has been into a movie screening business. The unit is leased to an operator for a monthly fixed rental payment. The same is discounted with a bank to get into another business. Unfortunately, that new business suffered a huge loss as they were new into it and they did not make a proper financial strategy before entering.
Despite the loss in the new venture, the debt servicing remains intact due to regular rental income from the tenant. However, the global pandemic of COVID 19 has changed all the calculations. The movie screening is stopped and so is the cash inflow.
The industry is not sure how long the situation will persist. The entrepreneur and his family are very tensely watching the evolving scenario.
COVID 19- Not a risk rather an uncertain event
Many are cribbing that they are not prepared for intense liquidity stress due to the economic impact of COVID 19 and resultant difficulty in debt servicing. The fact is that COVID 19 is not a risk to anticipate. The risk is one which can appear and reappear on the horizon and a positive probability can be assigned to it. Such that we may take some preventive measures, avoid its happening and /or at least we can mitigate its impact. In case of uncertainty based events, nothing can be predicted- neither its arrival nor its impact.
Today the whole world is experiencing an uncertain event and its longevity is unpredictable. So is its impact on the individual business.
Leverage is a prudent strategy in the period of high economic growth. But timing high growth is a challenge:
The leveraged business model is good so long as the economy keeps an upward trend in growth because the cost of debt is lower than equity. The challenge is to predict how long it will last. It is difficult to predict. Growth prediction is becoming a challenge due to the globalised trade regime and newer disruptions from evolving regulations, technological advancement and changing business process driven by the internet.
If the economy hits a downward spiral or industry in which you are operating is slowing down, the debt will be a serious challenge. Once trapped into a vicious debt trap, many entrepreneurs borrow more to meet the repayment obligations. As they borrow more and more, the cost of borrowing will go up and eventually the credit record will suffer. More borrowing coupled with slowing business is sure toxic combination for any business to survive.
In India, we have been witnessing a steady decline in the growth in the last two to three years. That has affected the business of many well-run entities. We have witnessed the collapse of many large companies and being sold under bankruptcy code in the last two years. The common denominator was a high debt load.
COVID 19 has aggravated this. Many long-standing businesses are facing a serious crisis of survival in the wake of pandemic and coupled with borrowing. The borrowing now appears excessive due to lowering sales and they are facing a double whammy situation.
Policy Response to COVID 19: Govt/RBI initiatives and their impact
Many debt-laden firms are staring at the imminent collapse. Govt & RBI came to their support by offering fresh loan under ECLGS, Moratorium and MSME Debt restructuring Scheme.
Fresh loan under ECLGS has helped many to postpone their immediate repayable to four-years spread. Moratorium gave temporary respite from cashflow burden for stalled businesses. Whereas the restructuring extended a window of opportunity to take a fresh look at the business scenario and revise the debt servicing.
The measures are lead to rearranging the payables with reference to timing; whereas interest burden pertaining to moratorium remains and business sentiment remains weak. Otherwise, a normal level of leverage in the orderly economic scenario is now crystallizing to distress due to lower than expected cash flow. Burden from the period of the moratorium will have a compounding effect. A realistic solution could be allowing reduction or sacrifice of the interest burden. In the absence of such a step, the viability of many businesses will remain doubtful.
MSMEs are more vulnerable and affect the personal life of an entrepreneur
The long term prediction of the prospects with excessive reliance on debt is becoming a risky proposition for businesses –big or small. The impact will be more severe for small businesses because they normally mortgage their assets like living home to secure credit for the business. Any impact on the business will directly affect their family life. This is not the case with large corporates.
Many of the entrepreneurs do not think about derisking their business model while seeking more growth. They continue to pursue the growth through loans from banks and NBFCs and thus retaining 100% risk for themselves. All their assets and cash flow(business as well as personal) are intensely leveraged to meet the financing needs.
COVID should be an eye-opener. It is the high time for MSMEs to explore ways and means of de-risking the business model and take it as a precursor for pursing the growth ambition. At least explore ways of minimising the risks to the family through smart structuring.
A leveraged business model is a good option in a high growth period. However, it can be toxic if there is a decline in the business that may arise due to internal and external factors. Creating excessive leverage on the cash flow anticipating the same economic scenario into the future for years is quite a dangerous phenomenon. No business can be stable in the long term in the new trade regime.
The learning from the present crisis is- Restrain from unbridled borrowing to fund the business plans. Rather derisking oneself while pursuing the growth should be the preferred option.