Vernimmen Letter Number 76

8/13/2019 Vernimmen Letter Number 76

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N 76

September 2013

Next month :

NEWS: IASB's newprojects for leaseaccounting

TABLE: ROCE andROE in Europe

RESEARCH PAPER:

Debt financing andfinancial flexibility

Q&A: What is anintegrated report?

The Vernimmen.com newsletter

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* * *

NEWS: The financial policy of AGAP2, a start-up which has become a medium-sized

company

AGAP2 is a company set up in 2005 in Lisbon in the area of engineering and operational

consulting, specialising in energy and IT systems, with 62% of the company held by its founder-

managers and 38% by a business angel.

After seven years of activity, AGAP2 achieved 2012 sales of 83m for a headcount of

1,300 in 6 countries: Germany, Belgium, Spain, France, Portugal, Switzerland.

NEWS: The financial policy of AGAP2, a start-up which has become a

medium-sized company

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THIS MONTH'S GRAPH: Corporate income tax rates around the world 4-5

RESEARCH PAPER: The role of creditors in corporate governance 6-7

Q&A: What is a ratchet clause? 7-8
http://www.vernimmen.com/http://www.vernimmen.com/http://www.vernimmen.com/


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How was this company able to finance this pace of growth (+73% per year from 2006 to

2012, and "only +45% over the last 3 years)? There are four explanations.

1/ The characteristics of AGAP2s sector

The characteristics of a companys sector will naturally have a determining impact on its

financial policy, and in particular, on how capital intensive it is. AGAP2 operates in one of the

least capital intensive sectors there are - its ratio of sales to capital employed is around 9. In

order to make sales of 9, it has to invest 1, where, at the other extreme, Eutelsat in thesatellites sector has to invest 32.

In its sector, AGAP2 enjoys a very low level of tangible and intangible assets, and is

mainly concerned with working capital. This is made up, for the most part, of accounts

receivable, since inventories in this service activity are non-existent, and accounts payable,

mainly staff related (around 70% of costs correspond to personnel expense), which naturally

has a very short payment period, even if the social security organisations are paid a bit later.

So, while on the income statement, social security expense only accounts for around 27% of

total personnel cost, on the balance sheet, debts owed to social security organisations equal

debts owed to staff.

Finally, AGAP2s working capital requirement is rather limited, at around 5% of sales.

2/ Recourse to factoring

AGAP2s clients are the large industrial groups in the energy sector. Thanks to

factoring, AGAP2 is able to find financial resources easily and at a low cost, at least at a lower

cost than a standard bank loan, because the risk of its clients is less for a lender than its own.

Eight years ago, we published an article on factoring1, entitled Has factoring emerged from

the ghetto?. Already at that time, our conclusion was that it had and since then, the

1See the Vernimmen.com Newsletter n8 July 2005
http://www.vernimmen.com/html/letter/index.phphttp://www.vernimmen.com/html/letter/index.php


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The next logical step, as long as the excellent operating performances continue and that

AGAP2 is able to continue expanding geographically or to other sectors, would be an IPO. The

company still has to prove that it can also handle external growth, i.e., basically to successfully

integrate teams that previously worked for the competition, as well as it manages internal

growth. If it does, it will definitely find the financial resources it needs as there is not doubt

that investors will be very positive, based on its performances over time, and its shareholders

enjoy liquidity, ten years after their initial investment.

* * *

THIS MONTH'S TABLE: Corporate income tax rates around the world

The average corporation tax rate in OECD countries in 2012 was 25.31%, continuing the

downward trend it has been on since 1993 (38%)! But the average has been brought down by

countries from the former Soviet Block as the scope of the KPMG study has been extended to a

number of small countries with rather low corporation tax rates, intended to attract investors.

T

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i

s

y

e

a

r

,

Source: KPMG

Corporate income tax rates rate are going down in Sweden and in the UK.


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These rates are useful to compute corporate income taxes to be paid on pre-tax profits,

to compute free cash flows or cost of capital or produce business plans. But they cannot be

compared from one country to the other one to appreciate the tax burden borne by companies.

Indeed in some countries some local tax are not levied on the pre tax result but on added value,

turnover or the renting value of buildings. And they are in addition to those computed on the pre

tax result and shown in this table.

* * *

RESEARCH PAPER: The role of creditors in corporate governance

With Simon Gueguen Lecturer-researcher at the University of Paris Dauphine

What role do creditors play in corporate governance? According to the traditional view,their main role becomes obvious during situations of bankruptcy. In the absence of any default


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on payment, they remain passive investors. Three researchers from US universities recently

published a study4that goes against this idea. Creditors exercise power in the firm well before any

bankruptcy proceedings are introduced, and they encourage the creation of value.

From a sample of over 7,000 non-financial firms, listed in the USA between 1997 and

2008, Nini et alshow that creditors exercise influence over corporate governance as soon as there

is a breach of a clause in a debt contract (covenant5). Typically, this may be the failure to comply

with certain obligations (compliance with accounting principles, providing the lender with

information on a regular basis, taking out insurance, etc.), the carrying out of certain prohibited

activities (selling certain assets, excessive investments, dividend payments, etc.) or the failure to

comply with certain ratios (cash flows to assets, debt to EBITDA ratio, liquidity ratios, etc.). The

frequency of this type of event is a lot higher than payment default over 40% of firms in the

sample committed at least one breach of a covenant during the period studied.

Contractually, creditors enjoy the same rights as they do in the case of a payment

default - termination of the covenant and immediate repayment of the principal. In practice, they

prefer to renegotiate the terms of the covenants and to put pressure on managers. The amended

loan agreements are for lower amounts, run for shorter periods, have higher spreads, more

guarantees and more restrictive clauses. They can also exercise their power beyond the

covenants by giving advice to management or by requiring better reporting practices.

This empirical study shows that a firms financial policy changes substantially after the

breach of a clause. The total amount of assets is reduced by 2% compared with similar

companies. This reduction is the result of fewer investments and of asset sales. Payments to

shareholders (dividends and share buybacks) are reduced by 4% and the total amount of debt by

10%. We also see a sharp increase in changes in the management team. Specifically, the

likelihood of a dismissal or a forced resignation of a general manager increases by 60% during the

quarter following the breach of the covenant. It is, however, difficult to attribute the whole of

this impact to creditors alone.

Nini et alare also interested in the performance, both operational and stock market, of

the firm following the breach of a covenant. They show that operating cash flows, having been in

decline over the last five quarters prior to the breach, experience an increase of 5% (annualised)

over the next three quarters. Most of this increase is the result of a reduction in operating

expenses (rather than an increase in sales), reflecting an improvement in operating efficiency.

Similarly, shares in these firms show unusually high returns in the month following the breach,

here again around 5% annualised.

This last effect is interesting as it runs contrary to the idea that creditors and

shareholders necessarily have diverging interests at firms experiencing difficulties. Through their

4

G. NINI, D. C. SMITH and A. SUFI (2012), Creditor control rights, corporate governance, and firm value,Review of Financial Studies, vol. 25(6), p. 1713-17615For more on convenants, see chapter 35 of the Vernimmen
http://www.vernimmen.com/html/book-corporate-finance/Part_4_capital_structure_policies/Chapter_35_debt___equity_and_options_theory.htmlhttp://www.vernimmen.com/html/book-corporate-finance/Part_4_capital_structure_policies/Chapter_35_debt___equity_and_options_theory.html


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presence and their reinforced vigilance, creditors can make a useful contribution to the sound

corporate governance of a firm, for the benefit of all providers of funds.

* * *

Q&A: What is a ratchet clause?

The most frequent situation in the financing of start-ups is that investors subscribe their

shares at a higher price than those of the founders. When this happens, they insist on the

inclusion of a ratchet clause intended to protect them at the time of future fund-raisings, when

new shares are issued at a lower price than that which they paid. It may be surprising to see

venture capital investors seeking to avoid or to limit a loss, when such investors generally invest in

companies at their riskiest stage of development. This is just the counterpart of the

entrepreneurs appetite since the entrepreneur has insisted that the investors pay goodwill

before the relevance of the concept and the viability of the economic model have been

demonstrated.

It is difficult for an entrepreneur, who has got the investors to pay a price that includes

goodwill, to refuse to include such a clause, which will only come into force if the valuation that

the entrepreneur has put forward, turns out to be excessive. The investors would argue that the

entrepreneur has no faith in his/her valuation and his/her business plan.

The ratchet mechanism, when it is fully implemented (there may be conditions attached

that soften the application), triggers the issue by the company of additional new shares to the

investors, at a token price, so that they hold as many shares as they would have held as if they

had subscribed to the previous capital increase at the price of the capital increase underway. This

often results in the founders being highly diluted, which means that they will be a lot less

motivated. It is for this reason that a new investor may request that this clause be only partially

implemented by the investors in the previous round of fund-raising.

Lets take the example of a company that issues 1,000,000 shares at 1 to the founders

and 800,000 shares at 10 subscribed by the investors. 18 months later, it carries out a second

share issue in favour of an investment fund which agrees to invest 5m to hold a total of 36% of

the share capital.

The breakdown of the share capital at the outset is:

Founders: 56%,Investors: 44 %.

Without a ratchet clause, after the capital increase, we get:

Founders: 36 %,Investors: 26 %,


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Vernimmen Letter Number 76