How to set up a business|for busness people
Apr
29
Dr. Dennis Vink asked:
Introduction
The asset-backed market has grown to become one of the largest capital markets in the world in terms of size and volume. Since 1998, companies have increasingly often used whole–business securitization to refinance whole lines of businesses that frequently form a substantial portion of the assets of the parent company. In one year’s time, both the Dunkin Brands transaction (May 2006) and the Domino’s Pizza deal (April 2007) pushed about $3.5 billion of asset-backed papers onto the market. Transactions in this asset class have primarily focused on the intellectual property arena, including fast food, licensing, music, and film and drug royalties. More recently, a broader area of transactions – including London Heathrow, Gatwick and other airports – has been securitized with the help of newly created whole-business or operating-assets techniques.
Because securitization – in principle – has many advantages, many (Dutch) firms seek my advice in their attempts to answer the question whether or not they would act sensibly if they refinanced all or part of their business activities through this type of securitization. If I then ask them why they should consider this type of financing, I often receive answers related to increasing (irrelevant) accounting ratios, attracting more money, and most of all doing all this at a lower price. This may be true to a certain extent, but of course there is no such thing as a ‘free ride’ or a ‘free lunch’ in the financial market. In short, it is assumed that some sort of advantage must be gained somewhere by means of securitization compared with the more traditional alternatives that are available, such as financing through a common (bank) loan or a loan backed by a collateral (secured loan).
The decision to use whole-business securitization involves an explicit choice regarding the financial structure concerned as well as managerial involvement and control. This article aims to introduce the reader to the structural features of whole-business securitization by discussing 10 important lessons. First, the general concept of asset-backed securitization will be discussed. Next, the reader will be introduced to the terminology framework for whole-business securitization. Finally, an answer will be presented to the question how whole-business securitization distinguishes itself from more traditional areas of corporate finance.
Asset-backed securitization
Lesson 1: The definition of asset-backed securitization refers to the issuance of tradable debt papers, which are guaranteed based on a well-defined collection of assets.
Unfortunately, the term ‘asset-backed securitization’ is used differently by many, since usage is not entirely consistent. Asset-backed securitization first appeared in bank funding. Hess and Smith (1988), for example, explained asset-backed securitization in the context of financial intermediaries to manage interest rate exposure. The authors defined asset-backed securitization as a financial intermediation process, which re-bundles individual principal and interest payments of existing loans to create new securities. More recently, the term ‘asset-backed securitization’ has come to be used to refer to so-called ‘structured finance’, the general process by which illiquid assets are pooled, repackaged and sold to third-party investors. So, asset-backed securitization can best be defined as the process in which assets are refinanced in the market by issuing securities sold to capital investors by a bankruptcy-remote special purpose vehicle. This definition comprises the fundamentals of asset securitization.
Lesson 2: The objective is that only the investors in the SPV will have a claim against the securitized assets in the event of the seller’s bankruptcy: not the seller or the seller’s creditors.
Legal concepts in the area of securitization often differ, and thus have specific accounting and tax rules, including tax consequences for both sellers and investors. Common-law countries (such as Australia, the United Kingdom and the United States) for example, follow different legal rules in comparison with civil countries (most other countries). Despite fundamental differences in the legal environment, the primary objective of the SPV is to facilitate the securitization of the assets and to ensure that the SPV is established for bankruptcy purposes as a legal entity separate from the seller. In other words, the objective is that only the investors in the SPV will have a claim against the securitized assets in the event of the seller’s bankruptcy: not the seller or the seller’s creditors. Because the pool of assets is insulated from the operating risk of the seller, the SPV in itself may achieve better financing terms than the seller would have received on the basis of his own merits. This is the key driver for reducing financing costs by securitization in comparison with alternative forms of financing.
Whole-Business Securitization
Lesson 3: The element of future exploitation of the asset is a key distinction between standard securitization and whole-business securitization.
Whole-business securitization uses securitization techniques for refinancing a whole business or operating assets. You may wonder what exactly is meant by ‘whole business’, and where precisely the difference lies compared with the more usual types of collateral used in securitization transactions: credit cards or mortgages, for example. In order to make you understand whole-business securitization, its definition will be presented first. Next, the difference will briefly be explained between whole-business securitization and the more common forms of securitization as we know them today: for example the use of mortgages and credit cards.
Whole-business securitization can be defined as a form of asset-backed financing in which operating assets are financed in the bond market via a bankruptcy-remote vehicle (hereafter: SPV) and in which the operating company keeps complete control over the assets securitized. In case of default, control is handed over to the security trustee for the benefit of the note holders for the remaining term of financing.
One of the great challenges lies in defining the difference between operating asset securitization and the more common forms witnessed in securitization transactions. Consider for instance a mortgage pool. If the mortgages have been securitized, the seller (sponsor) has no further obligations towards the consumer. The mortgage has been closed and stipulations concerning future payments – to be made by the consumer – have been laid down in a contract. Simply stated, the financial institution then collects payments from the consumer for the balance of the life of the loan. In effect, the traditional classes of securitization assets are self-liquidating. By contrast, in the example in which claims on the basis of operating assets are securitized, the sponsor has an obligation to exploit the underlying assets. To offer an illustration: when a football club securitizes its revenues from the sale of tickets, the sponsor must continue to render services that allow football fans to buy their tickets at the box office. Thus, the securitization process requires permanent managerial involvement on the part of the original owner in order to generate revenues. The element of future exploitation of the asset is a key distinction between standard securitization and operating-asset securitization.
Lesson 4: The receiver has authorization to seize control over the assets of the securitized business at the loss of any other creditor.
In a standard ‘whole-business securitization’ transaction, a financial institution grants the sponsor a loan secured by a pledge on a specific set of assets. This secured loan is then transferred to a bankruptcy-remote special purpose vehicle which issues the notes. The security attached to the loan is also transferred to the SPV. Thus, ownership and control of the assets remain with the sponsor, and bondholders are only granted charge over those assets. Control is required because the owner of the assets should exploit the assets for the full term of financing. Also, the sponsor intends to repay the loan out of the cash flows generated from its business. The issuance of a secured loan in a ‘whole-business securitization’ transaction is illustrated in Figure 2.
In case of default of the sponsor, the SPV receives complete control over the securitized assets by appointing a receiver for the full term of financing. The receiver has authorization to seize control over the assets of the securitized business at the loss of any other creditor. Also, the receiver eliminates the risk of external activities of management decisions reducing the return to bondholders. This is called bankruptcy remoteness. The SPV increases the likelihood of the business being able to continue as a going concern rather than being forced to have a ‘fire sale” of the individual assets. This preserves the value of the assets securitized, which is of great importance to the investors. Whole-business securitization therefore efficiently uses the privileges of bankruptcy law offering bondholders extensive security in case of default.
A clear case of effective receivership in default is that presented by Welcome Break, the U.K.-based motorway service area operator and the first whole-business securitization operation in its segment. When Welcome Break was no longer able to meet its obligations following its weaker-than-expected operating performance in 2002, the owner was in danger – if the economy continued to slide – of landing in a situation in which the company would not be able to meet its debt obligations. The owner then made an offer to the bondholders: Class A’s were to be repaid at par (£309 million par value), and Class B’s at 55% (£67 million par value). This was rejected by the bondholders. Subsequently, after Welcome Break failed to make full payment on its loan, it was put into receivership. Deloitte was appointed administrative receiver. A few days later, the owner finally agreed to pay all classes of bondholders back at par by selling nine service stations.
Lesson 5: It is hard – but not impossible – to separate the assets legally while the sponsor still retains operating control and services these assets.
Control over the cash flows of the securitized business is established either through a sale of the assets, or through an adequate legal structure that ensures continuation of cash flows in the event of the insolvency of the borrower. This feature makes it difficult in some countries to structure a business securitization deal. In fact, it has been proven to be hard to separate the assets legally while the sponsor still retains operating control and services these assets. Under U.K. law, this difficulty has almost been eliminated by the 1986 Insolvency Act, which permits the holder of a charge over substantially all of the assets of a corporate to control the insolvency proceeds of that corporate through an administrative receiver.
Unfortunately, in the Netherlands no whole-business deals have so far been finalized that could act as an example. One of the reasons for this is presented by the role played – and the responsibilities held – by the receiver in a bankruptcy case. If it involves a bankruptcy situation, the receiver has extra powers. He may, for instance, in certain situations nullify specific obligatory juristic acts: for example if both the debtor and the third party involved knew that a bankruptcy petition had already been filed, or if the case involved collusion between the creditor and the debtor to the detriment of the other creditors. Does this then imply that such things could not occur in the Netherlands? On the contrary: France, Belgium and Germany have encountered similar problems. In these countries, a series of large transactions has recently been witnessed in which the role of the receiver and securing the pledge in default cases have been adequately and appropriately dealt with.
Lesson 6: The holder of an asset-backed bond is not affected by the non-performance of the sponsor’s other assets; an ordinary secured bondholder is.
The result of bankruptcy remoteness is that the SPV generally issues securities that are rated higher (and in many cases significantly higher) in comparison with other alternatives, such as the issuance of ordinary secured debt by the company. This is the result of the risk mitigation generated by isolating the assets from the bankruptcy and other risks of the parent company through the whole-business securitization structure. Hence, the holder of an asset-backed bond is in a position similar to that held by the holder of an ordinary secured bond with regard to the sponsor, because repayment of the bonds takes place from a defined pool of assets. The difference is that the holder of an asset-backed bond is not affected by the non-performance of the sponsor’s other assets, whereas the ordinary bondholder is.
Credit rating improvement
Lesson 7: The credit rating of a security is based on the company’s unsecured rating, but is notched up or down depending on its seniority of claim.
The rating of a company is known as its senior implied rating, or unsecured credit rating (comparable with a credit rating without any collateral). This rating reflects the corporate-wide default risk and the estimation of the firm-wide possibility to pay its obligations aggregate. This rating focuses on the company in general in its industry context, such as the strength of its management, consolidated balance sheet positions, competitive position, market prospects, and how these may change. Rating agency Moody’s, for example, generally notches (numerical rating category) securities based on the average historical loss severity rates – given their priority of claim in default of the company. Table 1 is a classification scheme consisting of 21 rating scales for three rating agencies: Moody’s, Standard & Poor’s and Fitch. A word of caution is needed here, as it is important to remember that the rating scales are inverse scales, so that spread increases as rating decreases.
Each security’s rating is based on the company’s unsecured rating, but is notched up or down depending on its seniority of claim. As expressed in Table 2, secured bonds (high seniority) historically demonstrate a 30% lower loss severity upon default than the unsecured corporate bond, resulting in a favorable (higher) credit rating (and lower spreads). Senior subordinated bonds have experienced a 40% higher loss severity, subordinated bonds 52% higher, and junior subordinated bonds (with the lowest possible seniority) show a 62% higher loss severity, all indicating a lower credit rating (and higher spreads) in comparison with the unsecured corporate bond.
Lesson 8: Standard debt is rated a maximum one or two notches above the corporate rating, whereas whole-business securitization debt-like features could realize one to six notches above the corporate rating.
Moody’s approach to rating whole-business securitization transactions is based on the same expected loss methodology it applies to evaluating the credit risk of any structured security: cumulative expected loss equals the product of default probability and loss severity, summed over all possible scenarios. To date, credit rating agencies have assigned ratings in whole-business securitizations between two and six notches above the unsecured corporate rating of the sponsor. The key driver of an increase in credit rating for whole-business securitization versus ordinary debt is the fact that the value of the assets in a securitization transaction is much better preserved, thanks to bankruptcy remoteness, in comparison with the value of the assets in an ordinary debt contract.
This will be illustrated by the following example. The unsecured credit rating of a corporate is Baa3 (value 10 in Table 1). If this company issues $75 million of debt secured by a $100 million of Baa3-rated of the company’s operating assets, the debt would be rated Baa1 (collateral as security qualifies for two notches of credit). But the credit rating agencies would rate a $50 million issuance secured by the same $100 million of assets Baal as well, despite it having a substantially lower leverage. Thus, if the $100 million of assets degrades to $60 million, investors in a $75 million issuance lose $15 million. However, had the issuance been $50 million, the investors would have received all the required principal and interest fully guaranteed. Giving the same rating – Baal – to both issuances ($75 million versus $50 million) would not seem logical given the fact that the $50 million could withstand much more asset deterioration than the $75 million issuance. In a whole-business securitization transaction, it is in fact possible to grant the $50 million issuance a more favorable rating, for example an A1-rating. This is in contrast with a standard debt contract, in which a more favorable rating is not likely to be granted. This can be explained by the fact that bankruptcy remoteness eliminates certain relevant business risks from the sponsor’s other activities: risks that cannot be completely covered in a standard debt contract.
Lesson 9: A whole-business securitization structure tends to carry a lower average cost of debt and it usually issues debt with a longer maturity, which reduces pressure on the corporate issuer to place refinancing.
Structural features in whole-business securitization are designed to decrease the moral hazard of the borrower, and to decrease potential investment conflicts between borrower and bondholder. In other words, these features mitigate the risk that the strength of the business will be impaired through mismanagement. According to Moody’s Investor Service (2002), it may be possible to achieve a rating substantially above the corporate’s unsecured rating by issuing senior classes that have significantly lower leverage than the corporate bonds of the sponsor. Standard & Poor’s (2001) states that the business securitization structure tends to carry an average lower cost of debt in comparison with ordinary debt, thanks to higher credit ratings, and it usually issues debt with a longer maturity, which reduces pressure on the corporate issuer to place refinancing.
Lesson 10: Certain kinds of business are unlikely to benefit from a business securitization transaction.
According to Standard & Poor’s (2001), borrowers whose business risk corresponds to a rating below “BB” are unlikely to benefit from whole-business securitization. This is so because their future cash flows are, by definition of the rating, so uncertain that in the opinion of the rating agency they cannot justify stretching the maturity of the debt and are not likely to support a substantial decrease in credit risk. Furthermore, certain kinds of business are not likely to benefit from a business securitization transaction. These include businesses that are capital intensive, are reliant on unique management skills, or are evolving rapidly. All of the business securitization transactions executed were business activities of which the cash flows could be accurately estimated thanks to long-term contracts and a well-documented history of stable cash flows through which the business and financial risks were considered low, or could be significantly mitigated by structural features. Also, all these companies have a well-defined source of income: rent income, for example, or contracted beer sales, catering sales on specific locations, mobile phone revenues, restaurant loyalties, clothing licenses, music royalties or gate ticket sales for popular entertainment attractions.
Conclusions
Whole-business securitization is form of financing in the early stages of development. It enables a business to set up a structure in which business and financial risks can be managed and in which the level of credit risk for the investor can subsequently be limited. Without a doubt, this represents the largest innovation in comparison with familiar standard debt contracts such as common (bank) loans with or without collaterals.
Applying such structures, however, is not without risks: witness the problems encountered in the Welcome Break transaction. A combination of too little return on investment and too high leverage damaged the sponsor to such an extent that it was ultimately forced to make repayments to the investors by winding up the business. Still, many enterprises have so far been eager to use the whole-business securitization technique in order to enjoy the advantages offered by cheaper financing in combination with longer terms.
The structure discussed here will undoubtedly evolve over time and adapt to changing market conditions. Many Dutch firms could definitely benefit from repaying their perhaps needlessly complex, but certainly expensive bank loans taken out with various lenders and from replacing them by a transparent and straightforward securitization transaction structure – witness the highly innovative and successful transactions that have so far taken place in neighboring countries. Think about airports, for example, or hospitals, motorway restaurants, entertainment parks, movie theatres or royalties paid to famous Dutch artists. And how about revenues generated by the many major football clubs operating in our country?
Research into the possibilities of setting up securitization structures, into the opportunities that will be generated and into calculating the profits to be gained by individual businesses will have to demonstrate whether this techniqes is worth applying.
References
Hess, A.C. and C.W. Smith, 1988, Elements of mortgage securitization, Journal of Real Estate Finance and Economics 1, 331-346.
Mitchell, D., 2007, Franchise feeds whole-business securitization, Asset Securitization Report (July 2).
Moody’s Investors Service, 2001, Non-bankruptcy-remote issuers in asset securitization, International Structured Finance Special Report (March 22).
Moody’s Investors Service, 2002, Moody’s approach to rating operating company securitizations, International Structured Finance Special Report (February 2).
Standard & Poor’s, 2001, Principles for analyzing structured finance/corporate hybrid transactions, Rating Commentaries (July 02).
Virgil
Introduction
The asset-backed market has grown to become one of the largest capital markets in the world in terms of size and volume. Since 1998, companies have increasingly often used whole–business securitization to refinance whole lines of businesses that frequently form a substantial portion of the assets of the parent company. In one year’s time, both the Dunkin Brands transaction (May 2006) and the Domino’s Pizza deal (April 2007) pushed about $3.5 billion of asset-backed papers onto the market. Transactions in this asset class have primarily focused on the intellectual property arena, including fast food, licensing, music, and film and drug royalties. More recently, a broader area of transactions – including London Heathrow, Gatwick and other airports – has been securitized with the help of newly created whole-business or operating-assets techniques.
Because securitization – in principle – has many advantages, many (Dutch) firms seek my advice in their attempts to answer the question whether or not they would act sensibly if they refinanced all or part of their business activities through this type of securitization. If I then ask them why they should consider this type of financing, I often receive answers related to increasing (irrelevant) accounting ratios, attracting more money, and most of all doing all this at a lower price. This may be true to a certain extent, but of course there is no such thing as a ‘free ride’ or a ‘free lunch’ in the financial market. In short, it is assumed that some sort of advantage must be gained somewhere by means of securitization compared with the more traditional alternatives that are available, such as financing through a common (bank) loan or a loan backed by a collateral (secured loan).
The decision to use whole-business securitization involves an explicit choice regarding the financial structure concerned as well as managerial involvement and control. This article aims to introduce the reader to the structural features of whole-business securitization by discussing 10 important lessons. First, the general concept of asset-backed securitization will be discussed. Next, the reader will be introduced to the terminology framework for whole-business securitization. Finally, an answer will be presented to the question how whole-business securitization distinguishes itself from more traditional areas of corporate finance.
Asset-backed securitization
Lesson 1: The definition of asset-backed securitization refers to the issuance of tradable debt papers, which are guaranteed based on a well-defined collection of assets.
Unfortunately, the term ‘asset-backed securitization’ is used differently by many, since usage is not entirely consistent. Asset-backed securitization first appeared in bank funding. Hess and Smith (1988), for example, explained asset-backed securitization in the context of financial intermediaries to manage interest rate exposure. The authors defined asset-backed securitization as a financial intermediation process, which re-bundles individual principal and interest payments of existing loans to create new securities. More recently, the term ‘asset-backed securitization’ has come to be used to refer to so-called ‘structured finance’, the general process by which illiquid assets are pooled, repackaged and sold to third-party investors. So, asset-backed securitization can best be defined as the process in which assets are refinanced in the market by issuing securities sold to capital investors by a bankruptcy-remote special purpose vehicle. This definition comprises the fundamentals of asset securitization.
Lesson 2: The objective is that only the investors in the SPV will have a claim against the securitized assets in the event of the seller’s bankruptcy: not the seller or the seller’s creditors.
Legal concepts in the area of securitization often differ, and thus have specific accounting and tax rules, including tax consequences for both sellers and investors. Common-law countries (such as Australia, the United Kingdom and the United States) for example, follow different legal rules in comparison with civil countries (most other countries). Despite fundamental differences in the legal environment, the primary objective of the SPV is to facilitate the securitization of the assets and to ensure that the SPV is established for bankruptcy purposes as a legal entity separate from the seller. In other words, the objective is that only the investors in the SPV will have a claim against the securitized assets in the event of the seller’s bankruptcy: not the seller or the seller’s creditors. Because the pool of assets is insulated from the operating risk of the seller, the SPV in itself may achieve better financing terms than the seller would have received on the basis of his own merits. This is the key driver for reducing financing costs by securitization in comparison with alternative forms of financing.
Whole-Business Securitization
Lesson 3: The element of future exploitation of the asset is a key distinction between standard securitization and whole-business securitization.
Whole-business securitization uses securitization techniques for refinancing a whole business or operating assets. You may wonder what exactly is meant by ‘whole business’, and where precisely the difference lies compared with the more usual types of collateral used in securitization transactions: credit cards or mortgages, for example. In order to make you understand whole-business securitization, its definition will be presented first. Next, the difference will briefly be explained between whole-business securitization and the more common forms of securitization as we know them today: for example the use of mortgages and credit cards.
Whole-business securitization can be defined as a form of asset-backed financing in which operating assets are financed in the bond market via a bankruptcy-remote vehicle (hereafter: SPV) and in which the operating company keeps complete control over the assets securitized. In case of default, control is handed over to the security trustee for the benefit of the note holders for the remaining term of financing.
One of the great challenges lies in defining the difference between operating asset securitization and the more common forms witnessed in securitization transactions. Consider for instance a mortgage pool. If the mortgages have been securitized, the seller (sponsor) has no further obligations towards the consumer. The mortgage has been closed and stipulations concerning future payments – to be made by the consumer – have been laid down in a contract. Simply stated, the financial institution then collects payments from the consumer for the balance of the life of the loan. In effect, the traditional classes of securitization assets are self-liquidating. By contrast, in the example in which claims on the basis of operating assets are securitized, the sponsor has an obligation to exploit the underlying assets. To offer an illustration: when a football club securitizes its revenues from the sale of tickets, the sponsor must continue to render services that allow football fans to buy their tickets at the box office. Thus, the securitization process requires permanent managerial involvement on the part of the original owner in order to generate revenues. The element of future exploitation of the asset is a key distinction between standard securitization and operating-asset securitization.
Lesson 4: The receiver has authorization to seize control over the assets of the securitized business at the loss of any other creditor.
In a standard ‘whole-business securitization’ transaction, a financial institution grants the sponsor a loan secured by a pledge on a specific set of assets. This secured loan is then transferred to a bankruptcy-remote special purpose vehicle which issues the notes. The security attached to the loan is also transferred to the SPV. Thus, ownership and control of the assets remain with the sponsor, and bondholders are only granted charge over those assets. Control is required because the owner of the assets should exploit the assets for the full term of financing. Also, the sponsor intends to repay the loan out of the cash flows generated from its business. The issuance of a secured loan in a ‘whole-business securitization’ transaction is illustrated in Figure 2.
In case of default of the sponsor, the SPV receives complete control over the securitized assets by appointing a receiver for the full term of financing. The receiver has authorization to seize control over the assets of the securitized business at the loss of any other creditor. Also, the receiver eliminates the risk of external activities of management decisions reducing the return to bondholders. This is called bankruptcy remoteness. The SPV increases the likelihood of the business being able to continue as a going concern rather than being forced to have a ‘fire sale” of the individual assets. This preserves the value of the assets securitized, which is of great importance to the investors. Whole-business securitization therefore efficiently uses the privileges of bankruptcy law offering bondholders extensive security in case of default.
A clear case of effective receivership in default is that presented by Welcome Break, the U.K.-based motorway service area operator and the first whole-business securitization operation in its segment. When Welcome Break was no longer able to meet its obligations following its weaker-than-expected operating performance in 2002, the owner was in danger – if the economy continued to slide – of landing in a situation in which the company would not be able to meet its debt obligations. The owner then made an offer to the bondholders: Class A’s were to be repaid at par (£309 million par value), and Class B’s at 55% (£67 million par value). This was rejected by the bondholders. Subsequently, after Welcome Break failed to make full payment on its loan, it was put into receivership. Deloitte was appointed administrative receiver. A few days later, the owner finally agreed to pay all classes of bondholders back at par by selling nine service stations.
Lesson 5: It is hard – but not impossible – to separate the assets legally while the sponsor still retains operating control and services these assets.
Control over the cash flows of the securitized business is established either through a sale of the assets, or through an adequate legal structure that ensures continuation of cash flows in the event of the insolvency of the borrower. This feature makes it difficult in some countries to structure a business securitization deal. In fact, it has been proven to be hard to separate the assets legally while the sponsor still retains operating control and services these assets. Under U.K. law, this difficulty has almost been eliminated by the 1986 Insolvency Act, which permits the holder of a charge over substantially all of the assets of a corporate to control the insolvency proceeds of that corporate through an administrative receiver.
Unfortunately, in the Netherlands no whole-business deals have so far been finalized that could act as an example. One of the reasons for this is presented by the role played – and the responsibilities held – by the receiver in a bankruptcy case. If it involves a bankruptcy situation, the receiver has extra powers. He may, for instance, in certain situations nullify specific obligatory juristic acts: for example if both the debtor and the third party involved knew that a bankruptcy petition had already been filed, or if the case involved collusion between the creditor and the debtor to the detriment of the other creditors. Does this then imply that such things could not occur in the Netherlands? On the contrary: France, Belgium and Germany have encountered similar problems. In these countries, a series of large transactions has recently been witnessed in which the role of the receiver and securing the pledge in default cases have been adequately and appropriately dealt with.
Lesson 6: The holder of an asset-backed bond is not affected by the non-performance of the sponsor’s other assets; an ordinary secured bondholder is.
The result of bankruptcy remoteness is that the SPV generally issues securities that are rated higher (and in many cases significantly higher) in comparison with other alternatives, such as the issuance of ordinary secured debt by the company. This is the result of the risk mitigation generated by isolating the assets from the bankruptcy and other risks of the parent company through the whole-business securitization structure. Hence, the holder of an asset-backed bond is in a position similar to that held by the holder of an ordinary secured bond with regard to the sponsor, because repayment of the bonds takes place from a defined pool of assets. The difference is that the holder of an asset-backed bond is not affected by the non-performance of the sponsor’s other assets, whereas the ordinary bondholder is.
Credit rating improvement
Lesson 7: The credit rating of a security is based on the company’s unsecured rating, but is notched up or down depending on its seniority of claim.
The rating of a company is known as its senior implied rating, or unsecured credit rating (comparable with a credit rating without any collateral). This rating reflects the corporate-wide default risk and the estimation of the firm-wide possibility to pay its obligations aggregate. This rating focuses on the company in general in its industry context, such as the strength of its management, consolidated balance sheet positions, competitive position, market prospects, and how these may change. Rating agency Moody’s, for example, generally notches (numerical rating category) securities based on the average historical loss severity rates – given their priority of claim in default of the company. Table 1 is a classification scheme consisting of 21 rating scales for three rating agencies: Moody’s, Standard & Poor’s and Fitch. A word of caution is needed here, as it is important to remember that the rating scales are inverse scales, so that spread increases as rating decreases.
Each security’s rating is based on the company’s unsecured rating, but is notched up or down depending on its seniority of claim. As expressed in Table 2, secured bonds (high seniority) historically demonstrate a 30% lower loss severity upon default than the unsecured corporate bond, resulting in a favorable (higher) credit rating (and lower spreads). Senior subordinated bonds have experienced a 40% higher loss severity, subordinated bonds 52% higher, and junior subordinated bonds (with the lowest possible seniority) show a 62% higher loss severity, all indicating a lower credit rating (and higher spreads) in comparison with the unsecured corporate bond.
Lesson 8: Standard debt is rated a maximum one or two notches above the corporate rating, whereas whole-business securitization debt-like features could realize one to six notches above the corporate rating.
Moody’s approach to rating whole-business securitization transactions is based on the same expected loss methodology it applies to evaluating the credit risk of any structured security: cumulative expected loss equals the product of default probability and loss severity, summed over all possible scenarios. To date, credit rating agencies have assigned ratings in whole-business securitizations between two and six notches above the unsecured corporate rating of the sponsor. The key driver of an increase in credit rating for whole-business securitization versus ordinary debt is the fact that the value of the assets in a securitization transaction is much better preserved, thanks to bankruptcy remoteness, in comparison with the value of the assets in an ordinary debt contract.
This will be illustrated by the following example. The unsecured credit rating of a corporate is Baa3 (value 10 in Table 1). If this company issues $75 million of debt secured by a $100 million of Baa3-rated of the company’s operating assets, the debt would be rated Baa1 (collateral as security qualifies for two notches of credit). But the credit rating agencies would rate a $50 million issuance secured by the same $100 million of assets Baal as well, despite it having a substantially lower leverage. Thus, if the $100 million of assets degrades to $60 million, investors in a $75 million issuance lose $15 million. However, had the issuance been $50 million, the investors would have received all the required principal and interest fully guaranteed. Giving the same rating – Baal – to both issuances ($75 million versus $50 million) would not seem logical given the fact that the $50 million could withstand much more asset deterioration than the $75 million issuance. In a whole-business securitization transaction, it is in fact possible to grant the $50 million issuance a more favorable rating, for example an A1-rating. This is in contrast with a standard debt contract, in which a more favorable rating is not likely to be granted. This can be explained by the fact that bankruptcy remoteness eliminates certain relevant business risks from the sponsor’s other activities: risks that cannot be completely covered in a standard debt contract.
Lesson 9: A whole-business securitization structure tends to carry a lower average cost of debt and it usually issues debt with a longer maturity, which reduces pressure on the corporate issuer to place refinancing.
Structural features in whole-business securitization are designed to decrease the moral hazard of the borrower, and to decrease potential investment conflicts between borrower and bondholder. In other words, these features mitigate the risk that the strength of the business will be impaired through mismanagement. According to Moody’s Investor Service (2002), it may be possible to achieve a rating substantially above the corporate’s unsecured rating by issuing senior classes that have significantly lower leverage than the corporate bonds of the sponsor. Standard & Poor’s (2001) states that the business securitization structure tends to carry an average lower cost of debt in comparison with ordinary debt, thanks to higher credit ratings, and it usually issues debt with a longer maturity, which reduces pressure on the corporate issuer to place refinancing.
Lesson 10: Certain kinds of business are unlikely to benefit from a business securitization transaction.
According to Standard & Poor’s (2001), borrowers whose business risk corresponds to a rating below “BB” are unlikely to benefit from whole-business securitization. This is so because their future cash flows are, by definition of the rating, so uncertain that in the opinion of the rating agency they cannot justify stretching the maturity of the debt and are not likely to support a substantial decrease in credit risk. Furthermore, certain kinds of business are not likely to benefit from a business securitization transaction. These include businesses that are capital intensive, are reliant on unique management skills, or are evolving rapidly. All of the business securitization transactions executed were business activities of which the cash flows could be accurately estimated thanks to long-term contracts and a well-documented history of stable cash flows through which the business and financial risks were considered low, or could be significantly mitigated by structural features. Also, all these companies have a well-defined source of income: rent income, for example, or contracted beer sales, catering sales on specific locations, mobile phone revenues, restaurant loyalties, clothing licenses, music royalties or gate ticket sales for popular entertainment attractions.
Conclusions
Whole-business securitization is form of financing in the early stages of development. It enables a business to set up a structure in which business and financial risks can be managed and in which the level of credit risk for the investor can subsequently be limited. Without a doubt, this represents the largest innovation in comparison with familiar standard debt contracts such as common (bank) loans with or without collaterals.
Applying such structures, however, is not without risks: witness the problems encountered in the Welcome Break transaction. A combination of too little return on investment and too high leverage damaged the sponsor to such an extent that it was ultimately forced to make repayments to the investors by winding up the business. Still, many enterprises have so far been eager to use the whole-business securitization technique in order to enjoy the advantages offered by cheaper financing in combination with longer terms.
The structure discussed here will undoubtedly evolve over time and adapt to changing market conditions. Many Dutch firms could definitely benefit from repaying their perhaps needlessly complex, but certainly expensive bank loans taken out with various lenders and from replacing them by a transparent and straightforward securitization transaction structure – witness the highly innovative and successful transactions that have so far taken place in neighboring countries. Think about airports, for example, or hospitals, motorway restaurants, entertainment parks, movie theatres or royalties paid to famous Dutch artists. And how about revenues generated by the many major football clubs operating in our country?
Research into the possibilities of setting up securitization structures, into the opportunities that will be generated and into calculating the profits to be gained by individual businesses will have to demonstrate whether this techniqes is worth applying.
References
Hess, A.C. and C.W. Smith, 1988, Elements of mortgage securitization, Journal of Real Estate Finance and Economics 1, 331-346.
Mitchell, D., 2007, Franchise feeds whole-business securitization, Asset Securitization Report (July 2).
Moody’s Investors Service, 2001, Non-bankruptcy-remote issuers in asset securitization, International Structured Finance Special Report (March 22).
Moody’s Investors Service, 2002, Moody’s approach to rating operating company securitizations, International Structured Finance Special Report (February 2).
Standard & Poor’s, 2001, Principles for analyzing structured finance/corporate hybrid transactions, Rating Commentaries (July 02).
Virgil
Comments Off
Apr
25
recalcitrant99 asked:
Hi.
Hi.
Is a business statistics course considered equivalent as a
regular statistics course in college?
In other words, if a student wants to earn a bachelor’s degree
in business and the school that he is enrolled in requires him
to take a business statistics course, would he meet that requirement
if he took a regular math statistics course and not a business
statistics course? Have a nice day.
Lester
Apr
22
Filed Under (Make Money) by
Eric M asked:
I’ve been writing off my home based business for the last few years. If I stop using that portion of my home solely for my business, how do I indicate that on my taxes?
I’ve been writing off my home based business for the last few years. If I stop using that portion of my home solely for my business, how do I indicate that on my taxes?
Additionally, does anyone know of any resources that indicate what the implications are of stopping a home based business write-off?
I see lots of information on how/what to write-off for a home based business, but can’t seem to find anything on what to do when that ends.
Lisa
Apr
15
Filed Under (Make Money) by
We Buy Your Business asked:
We Buy Your Business
For some, planning a business exit can be a predictable, methodical process. We know the competition; we understand market demands, know when we want to sell and might even know the actual date. But for far too many business owners, the business exit comes as a harsh reality and often unplanned event.
Protecting your business and assets against the dreaded six D’s of an unplanned business exit can give whole new meaning to the term “Disaster Management”. While every business may experience unexpected pitfalls, careful planning to ensure risk exposure is minimized can assist in keeping you in the driver’s seat when it comes to managing your company. Familiarize yourself with the six D’s of an unplanned business exit: debt, death, disability, divorce, departure and disaster. Know the enemy and look to address all six D’s in your operating and buy / sell agreements.
The Six D’s of an Unplanned Business Exit
Debt:No one goes into business and plans on it not succeeding, but 40,000 businesses fail every month in the United States. When debt exceeds revenue, it is critical to exit timely in order to minimize loses. Understanding limitations and protecting critical assets are key to successful divesture.
Death:Many businesses are solely dependant on their owner’s abilities, relationships, and passion to drive success, and when there is a death of an owner or partner of a business, it can have significant impact to a business almost immediately. While no one wants to consider their own demise, the strength and longevity of a business relies on being able to plan for such a critical loss even if it means downsizing or reorganization. The survival of a business in relation to key individuals needs to be evaluated and exit strategies planned accordingly.
Disability:Unbelievably, death is not as likely to end the business as a disability. A disability to a business partner can put a significant drain on cash flow, daily workloads, and excess down time, all of which can be devastating. Insurance and financial planning towards alleviating such an impact needs to be carefully evaluated especially when dealing with small business start ups where funding and resources are limited.
Divorce:No one wants to plan for a business or personal divorce, yet while Pre-nuptial agreements may be gaining in popularity many people never look to manage such impact to their businesses. What happens when the partners cannot get along? Or worse, you inherit another partner due to a personal divorce settlement? Exiting the business might be the only alternative you are provided.
Departure:It does not sound as bad as death, but it can wreak the same results. A partner, key employees, or other resources decide to go to the competition, retire, burn out, or win the lotto. When they leave, how does this impact your business going forward?
Disaster:If the five D’s above where not enough to impact your business, there are no limit to the other disasters that may occur that were never planned on: robbery, sickness, employee theft, employee turnover, natural devastating events, etc. In today’s post Katrina, 911 world the impact of the chaos theory is enough to keep even the best business minds awake at night. Plan for the worst; strive for the best and know when to get out if need be.
For the typical business owner, each one of the six D’s has special demands on the family, income, taxes, and control of assets. An agreement, commonly called buy/sell agreements, can be used to plan for the impact associated with the dreaded six D’s. A successful sustaining business exists as a separate entity from personal concerns and risk can be reduced by developing mutually fair and equitable agreements prior to these events occurring.
Business is an evolution and travels a diverse path. While some may look on an unplanned exit as a failure others may see an opportunity for growth and freedom.
www.WeBuyYourBusiness.com
Whitney
We Buy Your Business
For some, planning a business exit can be a predictable, methodical process. We know the competition; we understand market demands, know when we want to sell and might even know the actual date. But for far too many business owners, the business exit comes as a harsh reality and often unplanned event.
Protecting your business and assets against the dreaded six D’s of an unplanned business exit can give whole new meaning to the term “Disaster Management”. While every business may experience unexpected pitfalls, careful planning to ensure risk exposure is minimized can assist in keeping you in the driver’s seat when it comes to managing your company. Familiarize yourself with the six D’s of an unplanned business exit: debt, death, disability, divorce, departure and disaster. Know the enemy and look to address all six D’s in your operating and buy / sell agreements.
The Six D’s of an Unplanned Business Exit
Debt:No one goes into business and plans on it not succeeding, but 40,000 businesses fail every month in the United States. When debt exceeds revenue, it is critical to exit timely in order to minimize loses. Understanding limitations and protecting critical assets are key to successful divesture.
Death:Many businesses are solely dependant on their owner’s abilities, relationships, and passion to drive success, and when there is a death of an owner or partner of a business, it can have significant impact to a business almost immediately. While no one wants to consider their own demise, the strength and longevity of a business relies on being able to plan for such a critical loss even if it means downsizing or reorganization. The survival of a business in relation to key individuals needs to be evaluated and exit strategies planned accordingly.
Disability:Unbelievably, death is not as likely to end the business as a disability. A disability to a business partner can put a significant drain on cash flow, daily workloads, and excess down time, all of which can be devastating. Insurance and financial planning towards alleviating such an impact needs to be carefully evaluated especially when dealing with small business start ups where funding and resources are limited.
Divorce:No one wants to plan for a business or personal divorce, yet while Pre-nuptial agreements may be gaining in popularity many people never look to manage such impact to their businesses. What happens when the partners cannot get along? Or worse, you inherit another partner due to a personal divorce settlement? Exiting the business might be the only alternative you are provided.
Departure:It does not sound as bad as death, but it can wreak the same results. A partner, key employees, or other resources decide to go to the competition, retire, burn out, or win the lotto. When they leave, how does this impact your business going forward?
Disaster:If the five D’s above where not enough to impact your business, there are no limit to the other disasters that may occur that were never planned on: robbery, sickness, employee theft, employee turnover, natural devastating events, etc. In today’s post Katrina, 911 world the impact of the chaos theory is enough to keep even the best business minds awake at night. Plan for the worst; strive for the best and know when to get out if need be.
For the typical business owner, each one of the six D’s has special demands on the family, income, taxes, and control of assets. An agreement, commonly called buy/sell agreements, can be used to plan for the impact associated with the dreaded six D’s. A successful sustaining business exists as a separate entity from personal concerns and risk can be reduced by developing mutually fair and equitable agreements prior to these events occurring.
Business is an evolution and travels a diverse path. While some may look on an unplanned exit as a failure others may see an opportunity for growth and freedom.
www.WeBuyYourBusiness.com
Whitney
Comments Off
Apr
08
Filed Under (Make Money) by
Jeff Williams asked:
Soon you will find yourself deeply involved in reaching your marketplace, analyzing customer needs and imagining attention-getting promotional ideas. But first there are a number of basic organizational steps you should complete.
There are just enough stories in newspapers and magazines about successful new business that were started on a “shoestring” to make you believe you do it also. In fact, several monthly magazines are devoted to presenting low-cost home business ideas that are “guaranteed winners”.
In our experience, very few viable new businesses ran be started with less than $1000.00. A recent survey by Home Office Computing magazine revealed that the average reader spent around $5,000 to start his business. It should be apparent that shoestring businesses run out of cash fast – often just when the sales start to come in.
Assessing Your Financial Readiness
The first step in examining your financial preparedness is to sit down with your family and analyze where the money goes each month. Start with the major expenses first, such as mortgage or rent, car payments, utilities, insurance, food and school expenses. These categories probably represent over 60% of your total family spending each month.
Next add in important but postponeable expenses, such as new clothing or furniture, a vacation or going to the movies or out to eat. By the time you are done you will probably have 15 to 20 key expenses in the family budget. Put the total by category on one piece of paper and add them for a grand total. Make sure every family member understands where the money has been going each month.
Lastly, see what you can cut out of the budget. But beware, quitting a job (or losing one) and then starting a business will put your family under tremendous mental stress. Don’t expect them to endure too much further pain in order to cut the family budget.
Most of us would be lucky to cut 5% out of the budget. Once you have some agreement on a monthly budget, it is time to review what sources of income the family has. The most common are: spouse’s salary and bonus, investment interest and dividends and rental income if you own property. Ask yourself a tough question: How reliable are these streams of income? Has your spouse’s employer announced layoffs? Is the return on your investments likely to go up or down over the next twelve months?
Subtracting all the family income other than your income (you’ll he quitting remember) from the monthly expenses results in what I call the “business burden”. This is the dollar amount that vour economic activity must eventually create if the family budget is to continue at its agreed-upon level. Every month that your sales are not enough to cover this burden you must borrow – from yourself, your credit cards, your home equity loan or from your relatives. This gets old fast.
The second area of personal finance you must carefully evaluate is your debt. Who do you owe? How much? What percentage of debt could be paid off in on more than one year? Remember, you won’t be working a regular job. Be realistic; if you credit card debt is $400 per month minimum payment, you will have a very hard time paying your business phone bill and buying gas for your car.
Examine also what you own that you might turn into cash or use as collateral for a loan. The house is the most commonly used personal collateral, but remember what you are risking when you use a home equity loan.
Estimating Startup Costs
Startup costs are one-time expenses for equipment, furniture, computers, rent deposits, stationery; telephone hookup, insurance premiums, office supplies, and initial advertising. Be cautious here, it is very easy to spend a couple of thousand dollars before you realize it. Before you buy anything ask yourself: Can I get it used? Do I already have something that will work? Can I trade something for it? If you are starting with a home office you of course save on rent deposits and moving expenses.
If you will be opening a retail store, it is critical that you research what inventory you will need, who supplies it and what is the lowest price you can get. You may also be facing a serious investment in renovation construction, fixtures and carpeting and painting. The average startup costs for a retail store, including inventory, run around $75,000.
If you plan to make a product for sale you will need to buy raw materials. Do the same kind of investigation as the retail business owner does. Calculate the minimum material investment to produce the desired sales for the first few months. In addition, examine what additional tools, equipment or vehicles our business may require. A typical manufacturing startup can cost over $100,000.
Exploring Business Expenses
For most small businesses, the owners personal compensation is far and away the largest operating expense for the business. This is your contribution toward the “business burden”. But there are potentially many other business expenses you will face. Among the most common are: Rent, utilities, telephone and telefax charges, supplies, computer software and repair, insurance, bookkeeping fees, auto expenses, dues and subscriptions, travel and entertainment and sales promotion expenses. Some new business need an employee right from the beginning, so you would have to add in wages and withholding taxes.
You find out what expenses your business will have to pay by talking with owners of similar businesses, through magazine and newspaper articles and from trade associations, just to mention a few. Also apply some common sense: ask yourself what expenses seem normal for my type of business? I suggest that you add 20% to your estimate of monthly business expenses.
To discover what magnitude of starting capital your business will need, take your “business burden” and multiply by three. Add in the one-time startup costs. Multiply the monthly business expenses by three and add to the other two groups of costs. The total is known as “initial capitalization” — the money you had better have access to before you open the door of your new business, Don’t kid yourself; new businesses are very hungry — for money. Try to starve them and they perish!
Picking A Business Name
Up to this point, you have probably only spoken about your new business to your family and yourself. But now it is time to prepare to talk to the outside world. The first step in communicating all the wonderful things your business can provide is to create an identity for it by carefully selecting a business name and address.
I have long believed that there is no such thing as the perfect name for a new business. After all your customers are largely buying you in the beginning. But a cleverly selected business name goes a long way toward making your new company more memorable. Here are some tips for selecting a business name:
Keep it Short – no more than four words
Make sure It can be easily pronounced
Use either your own name or one that says what your business does
Look in the Yellow Pages to avoid a name that is confusingly similar to an existing business
Make sure that is looks as good on a business card as it does on a piece of letterhead. A way to do this is to use a graphic artist to sketch the name business card size.
Be aware that some businesses not only legally register their business names but also trademark them. Trademarking is a legal technique made available by states and the federal government to give you the right to a particular name if you can prove you publicly used it before anyone else, To receive national protection you must file for a trademark through the U.S. Trademark Office (part of the Commence Department). This is much more expensive and time consuming. See an attorney before taking this step.
Selecting a Business Address
You now need a business address to go along with your legal business name. While you have been researching your startup costs you should have thought about where you will locate your business office. Will it be in your den? In a local office building? A retail store? Or in an industrial building?
The simplest and least expensive way is to use your home address as your business address also. But before you decide to do this remember the following tips about selecting an address.
Analyze who you want to sell. Would they think you are less professional if they see a residential address on your business card?
Are there potential zoning problems if your city or town finds out about your home business?
Will your suppliers or customers be corning regularly to your house? is there enough parking space so as to not annoy your neighbors?
Can you easily receive UPS, Federal Express, etc. at your home?
If you don’t locate at home, what are your other options? There are three basic alternatives:
#1 Post office box. I don’t like them because they are used by scam artists, Also, you can’t get to your box 24 hours per day and customer service at the Post Office is less than great.
#2: Private mail box store: A little more expensive than P.O. boxes but offer many more business services such as shipping of all kinds, telefax, photocopying, passport photos, office supplies, to mention a few. The largest number of stores are the Mail Boxes Etc. outlets springing up all over. Costs start at $12-$16 per month for a mailbox.
#3: Shared service office suites: Many traditional office buildings are setting up areas with small offices which share services, such as the receptionist, mail room, telefax, photocopy and a conference room. Rents start at $400 per month, but some buildings offer an abbreviated version, known as identity programs where you keep your office at home, but rent their address for your mail, have their receptionist answer your business phone line and meet with clients in their conference room. Costs start at $75 per month.
Picking A Legal Form of Organization
When you open a business, your life becomes more formalized because you are now subject to more laws and regulations. One of the first legal requirements you will face is deciding how to organize the business from a legal point of view. There are three major ways to do this:
#1: Sole Proprietorship — Single owner or husband and wife. All business profit goes on your personal tax return. You are personally liable for all business debts and legal disputes. Very little regulation by the government. Over 70% of all small businesses are proprietorships, often because it is the easiest, fastest and cheapest way to legally organize.
#2: Partnership — Two or more owners joining together to invest in and to run a small business. Similar legally to a proprietorship in that each partner is personally liable for business debts and disputes. In addition, each partner is bound by the business actions of the other partners, even if they don’t know about them. In our experience it is hard to hold together a partnership because it is rare that two (or more) people share the same values, grow at the same rate or see risk the same way. We strongly urge that you review a written partnership agreement (sold at office supply stores) before you talk seriously about joining together.
#3: Corporation – A lot of new entrepreneurs think that they need to be a corporation. But in reality, few new businesses need to be incorporated. The first step is to realize that your life becomes more regulated if you incorporate. We also estimate that it will cost you $700-$1000 more per year in accounting and legal bills to be a corporation. However, there are many potential tax savings for corporations. The second step is to decide with whom you will organize the corporation (incorporators). The third step is to decide if you want to operate as “plain vanilla” corporation (“C” corporation) or as a “S” corporation (requires approval of the IRS). For the next steps see “How to Register” which follows.
No matter what legal form your new business takes, some branch of government (or several) wants to know about it, But note: before you attempt to legally register, you must have selected a business name and address.
How to Register Your Company
Proprietorships and Partnerships Most proprietorships and partnerships use a business name other than the name on the owner’s birth certificate. This business name is known legally as a fictitious name, assumed name or as a DBA (Doing Business As). The county in which you live requires you to register this assumed name. The procedure usually goes as follows:
Call your County Clerk’s Office and request an Assumed Name Registration form and ask the fee.
Fill in all forms with the legal name of the business, its official address, your real name arid your home address. One of the forms may have to be notarized, so see the accompanying instructions.
Usually you send back one form, the longer one, and keep the shorter form. Include a check made our to the County Clerk for the registration fee.
Take the shorter form to any newspaper in your county (call first to get their rate for an assumed name ad) and place an ad for three consecutive weeks. The newspaper will give you proof that the ad ran.
Send proof of ad placement back to your County Clerk, right away.
In three to four weeks you wilt receive a registration certificate.
Corporations Registering a corporation is more involved than the assumed name registration. Here is the procedure commonly found. It may vary in your state:
Call your Secretary of State and ask for Corporate Name Registration.
Have two or three name choices written down by the phone. Ask if the first name is available. If not, go to the next, and the next. Hopefully one of the three is available.
While you have them on the phone, request two copies of the registration paperwork known as the Articles of Incorporation (or similar name).
Use an attorney or one of the Small Business Development Centers for help in filling out the Articles of incorporation. They are pretty easy, but the section on issuing stock can be a little tricky. Check the form for how to calculate the incorporation fee.
Send two copies of the Articles with a certified check or money order for the incorporation fee made out to the Secretary of State at the address in the instructions.
In a few weeks you will receive the official notice of incorporation. After this time whenever you use your business name it must be ended by one of four suffixes: “Inc.”, “Corp.”, “LTD”, or “Co.”. Place the certificate in a safe place. You will need it for a number of purposes but most importantly you must show it in order to open a corporate checking account.
Soon you will find yourself deeply involved in reaching your marketplace, analyzing customer needs and imagining attention-getting promotional ideas. But first there are a number of basic organizational steps you should complete.
There are just enough stories in newspapers and magazines about successful new business that were started on a “shoestring” to make you believe you do it also. In fact, several monthly magazines are devoted to presenting low-cost home business ideas that are “guaranteed winners”.
In our experience, very few viable new businesses ran be started with less than $1000.00. A recent survey by Home Office Computing magazine revealed that the average reader spent around $5,000 to start his business. It should be apparent that shoestring businesses run out of cash fast – often just when the sales start to come in.
Assessing Your Financial Readiness
The first step in examining your financial preparedness is to sit down with your family and analyze where the money goes each month. Start with the major expenses first, such as mortgage or rent, car payments, utilities, insurance, food and school expenses. These categories probably represent over 60% of your total family spending each month.
Next add in important but postponeable expenses, such as new clothing or furniture, a vacation or going to the movies or out to eat. By the time you are done you will probably have 15 to 20 key expenses in the family budget. Put the total by category on one piece of paper and add them for a grand total. Make sure every family member understands where the money has been going each month.
Lastly, see what you can cut out of the budget. But beware, quitting a job (or losing one) and then starting a business will put your family under tremendous mental stress. Don’t expect them to endure too much further pain in order to cut the family budget.
Most of us would be lucky to cut 5% out of the budget. Once you have some agreement on a monthly budget, it is time to review what sources of income the family has. The most common are: spouse’s salary and bonus, investment interest and dividends and rental income if you own property. Ask yourself a tough question: How reliable are these streams of income? Has your spouse’s employer announced layoffs? Is the return on your investments likely to go up or down over the next twelve months?
Subtracting all the family income other than your income (you’ll he quitting remember) from the monthly expenses results in what I call the “business burden”. This is the dollar amount that vour economic activity must eventually create if the family budget is to continue at its agreed-upon level. Every month that your sales are not enough to cover this burden you must borrow – from yourself, your credit cards, your home equity loan or from your relatives. This gets old fast.
The second area of personal finance you must carefully evaluate is your debt. Who do you owe? How much? What percentage of debt could be paid off in on more than one year? Remember, you won’t be working a regular job. Be realistic; if you credit card debt is $400 per month minimum payment, you will have a very hard time paying your business phone bill and buying gas for your car.
Examine also what you own that you might turn into cash or use as collateral for a loan. The house is the most commonly used personal collateral, but remember what you are risking when you use a home equity loan.
Estimating Startup Costs
Startup costs are one-time expenses for equipment, furniture, computers, rent deposits, stationery; telephone hookup, insurance premiums, office supplies, and initial advertising. Be cautious here, it is very easy to spend a couple of thousand dollars before you realize it. Before you buy anything ask yourself: Can I get it used? Do I already have something that will work? Can I trade something for it? If you are starting with a home office you of course save on rent deposits and moving expenses.
If you will be opening a retail store, it is critical that you research what inventory you will need, who supplies it and what is the lowest price you can get. You may also be facing a serious investment in renovation construction, fixtures and carpeting and painting. The average startup costs for a retail store, including inventory, run around $75,000.
If you plan to make a product for sale you will need to buy raw materials. Do the same kind of investigation as the retail business owner does. Calculate the minimum material investment to produce the desired sales for the first few months. In addition, examine what additional tools, equipment or vehicles our business may require. A typical manufacturing startup can cost over $100,000.
Exploring Business Expenses
For most small businesses, the owners personal compensation is far and away the largest operating expense for the business. This is your contribution toward the “business burden”. But there are potentially many other business expenses you will face. Among the most common are: Rent, utilities, telephone and telefax charges, supplies, computer software and repair, insurance, bookkeeping fees, auto expenses, dues and subscriptions, travel and entertainment and sales promotion expenses. Some new business need an employee right from the beginning, so you would have to add in wages and withholding taxes.
You find out what expenses your business will have to pay by talking with owners of similar businesses, through magazine and newspaper articles and from trade associations, just to mention a few. Also apply some common sense: ask yourself what expenses seem normal for my type of business? I suggest that you add 20% to your estimate of monthly business expenses.
To discover what magnitude of starting capital your business will need, take your “business burden” and multiply by three. Add in the one-time startup costs. Multiply the monthly business expenses by three and add to the other two groups of costs. The total is known as “initial capitalization” — the money you had better have access to before you open the door of your new business, Don’t kid yourself; new businesses are very hungry — for money. Try to starve them and they perish!
Picking A Business Name
Up to this point, you have probably only spoken about your new business to your family and yourself. But now it is time to prepare to talk to the outside world. The first step in communicating all the wonderful things your business can provide is to create an identity for it by carefully selecting a business name and address.
I have long believed that there is no such thing as the perfect name for a new business. After all your customers are largely buying you in the beginning. But a cleverly selected business name goes a long way toward making your new company more memorable. Here are some tips for selecting a business name:
Keep it Short – no more than four words
Make sure It can be easily pronounced
Use either your own name or one that says what your business does
Look in the Yellow Pages to avoid a name that is confusingly similar to an existing business
Make sure that is looks as good on a business card as it does on a piece of letterhead. A way to do this is to use a graphic artist to sketch the name business card size.
Be aware that some businesses not only legally register their business names but also trademark them. Trademarking is a legal technique made available by states and the federal government to give you the right to a particular name if you can prove you publicly used it before anyone else, To receive national protection you must file for a trademark through the U.S. Trademark Office (part of the Commence Department). This is much more expensive and time consuming. See an attorney before taking this step.
Selecting a Business Address
You now need a business address to go along with your legal business name. While you have been researching your startup costs you should have thought about where you will locate your business office. Will it be in your den? In a local office building? A retail store? Or in an industrial building?
The simplest and least expensive way is to use your home address as your business address also. But before you decide to do this remember the following tips about selecting an address.
Analyze who you want to sell. Would they think you are less professional if they see a residential address on your business card?
Are there potential zoning problems if your city or town finds out about your home business?
Will your suppliers or customers be corning regularly to your house? is there enough parking space so as to not annoy your neighbors?
Can you easily receive UPS, Federal Express, etc. at your home?
If you don’t locate at home, what are your other options? There are three basic alternatives:
#1 Post office box. I don’t like them because they are used by scam artists, Also, you can’t get to your box 24 hours per day and customer service at the Post Office is less than great.
#2: Private mail box store: A little more expensive than P.O. boxes but offer many more business services such as shipping of all kinds, telefax, photocopying, passport photos, office supplies, to mention a few. The largest number of stores are the Mail Boxes Etc. outlets springing up all over. Costs start at $12-$16 per month for a mailbox.
#3: Shared service office suites: Many traditional office buildings are setting up areas with small offices which share services, such as the receptionist, mail room, telefax, photocopy and a conference room. Rents start at $400 per month, but some buildings offer an abbreviated version, known as identity programs where you keep your office at home, but rent their address for your mail, have their receptionist answer your business phone line and meet with clients in their conference room. Costs start at $75 per month.
Picking A Legal Form of Organization
When you open a business, your life becomes more formalized because you are now subject to more laws and regulations. One of the first legal requirements you will face is deciding how to organize the business from a legal point of view. There are three major ways to do this:
#1: Sole Proprietorship — Single owner or husband and wife. All business profit goes on your personal tax return. You are personally liable for all business debts and legal disputes. Very little regulation by the government. Over 70% of all small businesses are proprietorships, often because it is the easiest, fastest and cheapest way to legally organize.
#2: Partnership — Two or more owners joining together to invest in and to run a small business. Similar legally to a proprietorship in that each partner is personally liable for business debts and disputes. In addition, each partner is bound by the business actions of the other partners, even if they don’t know about them. In our experience it is hard to hold together a partnership because it is rare that two (or more) people share the same values, grow at the same rate or see risk the same way. We strongly urge that you review a written partnership agreement (sold at office supply stores) before you talk seriously about joining together.
#3: Corporation – A lot of new entrepreneurs think that they need to be a corporation. But in reality, few new businesses need to be incorporated. The first step is to realize that your life becomes more regulated if you incorporate. We also estimate that it will cost you $700-$1000 more per year in accounting and legal bills to be a corporation. However, there are many potential tax savings for corporations. The second step is to decide with whom you will organize the corporation (incorporators). The third step is to decide if you want to operate as “plain vanilla” corporation (“C” corporation) or as a “S” corporation (requires approval of the IRS). For the next steps see “How to Register” which follows.
No matter what legal form your new business takes, some branch of government (or several) wants to know about it, But note: before you attempt to legally register, you must have selected a business name and address.
How to Register Your Company
Proprietorships and Partnerships Most proprietorships and partnerships use a business name other than the name on the owner’s birth certificate. This business name is known legally as a fictitious name, assumed name or as a DBA (Doing Business As). The county in which you live requires you to register this assumed name. The procedure usually goes as follows:
Call your County Clerk’s Office and request an Assumed Name Registration form and ask the fee.
Fill in all forms with the legal name of the business, its official address, your real name arid your home address. One of the forms may have to be notarized, so see the accompanying instructions.
Usually you send back one form, the longer one, and keep the shorter form. Include a check made our to the County Clerk for the registration fee.
Take the shorter form to any newspaper in your county (call first to get their rate for an assumed name ad) and place an ad for three consecutive weeks. The newspaper will give you proof that the ad ran.
Send proof of ad placement back to your County Clerk, right away.
In three to four weeks you wilt receive a registration certificate.
Corporations Registering a corporation is more involved than the assumed name registration. Here is the procedure commonly found. It may vary in your state:
Call your Secretary of State and ask for Corporate Name Registration.
Have two or three name choices written down by the phone. Ask if the first name is available. If not, go to the next, and the next. Hopefully one of the three is available.
While you have them on the phone, request two copies of the registration paperwork known as the Articles of Incorporation (or similar name).
Use an attorney or one of the Small Business Development Centers for help in filling out the Articles of incorporation. They are pretty easy, but the section on issuing stock can be a little tricky. Check the form for how to calculate the incorporation fee.
Send two copies of the Articles with a certified check or money order for the incorporation fee made out to the Secretary of State at the address in the instructions.
In a few weeks you will receive the official notice of incorporation. After this time whenever you use your business name it must be ended by one of four suffixes: “Inc.”, “Corp.”, “LTD”, or “Co.”. Place the certificate in a safe place. You will need it for a number of purposes but most importantly you must show it in order to open a corporate checking account.
Learn how to become the master of your own business, in just a few short weeks
Calvin
Comments Off
Apr
01
bulabate asked:
Working poor,unemployed anyone who has fallen prey to a failed system of business & representative Govt.
Working poor,unemployed anyone who has fallen prey to a failed system of business & representative Govt.
If they want to see bail-out business plans, then i want to see business plan for the legal citizens or the supposing owners.
Orlene
