Finance - Finding the right note

Usually, by the time debt and equity structures are in place it is expensive or impossible to change them if they do not deliver. Some structures are built in for emergency situations or other short-term purposes, which means that they are rushed and their long-term implications are not considered fully.

The side effects of badly planned structures may be felt where there are operational changes in the business: possible pitfalls include tax, cash flow, ownership and regulatory problems. You should therefore review your position and consider future debt or equity transactions carefully.

From an accounting perspective, share capital and debt are classified as financial instruments. Most situations that necessitate disclosure on or the discussion of debt levels or equity, such as requests from the Financial Services Authority, HM Revenue and Customs, Companies House or the banks, require you to present debt or equity in accordance with the relevant UK accounting standards that classify financial instruments.

There is a fine line between the classification of a financial instrument as either debt or equity: a critical point to be aware of. Where there are problems it is likely that firms will believe they have an instrument that is equity but that is actually debt. This is often the case with preference share arrangements, so make sure you know the exact classification of your financial instruments.

As a business you should ensure that all the necessary share capital paperwork is in place, including internal and publicly available documentation that gives the structure its legal standing. This includes ensuring the memorandum and articles both contain the clauses you need for commercial and strategic purposes, for instance the right to buy back shareholdings from employees when they leave. Disparities between your intentions and the legal reality of your structure can lead to external parties doubting the ability of your management; in the worst case you may find that you do not actually own the company.

Share structures

After reviewing your financial instruments and clarifying their legal position you can then identify any redundant shares structures, such as spurious classes of shares or inconsistencies. These can lead to problems down the line as and when the reasons for these structures existing become a distant memory. If you can, rid your firm of these classes and consolidate the share capital into the simplest structure available.

You should be in a position where your current share capital structure is simplified, achieves your business objectives and is legally sound, leaving you in a good position to address changes in share structures.

There are common errors in group reorganisations or start-ups where the business owners have implemented a share structure without considering its future implications or seeking potentially more suitable alternatives. In any planned transaction involving share capital you should consider the following:

- The nominal value of the shares. To raise a fixed level of capital, consider reducing the nominal value of the shares and having more flexible share premium.

- Share capital ties up funds, so resist the urge to over-capitalise.

- Grouping for tax purposes. The key levels of share ownership are 50% and 75%. Companies can be grouped for tax purposes through common individual ownership as well as corporate ownership.

- Wealth transfer. Selling or shifting shares from one person to another is potentially a taxable event.

- Implied valuations. If one party buys shares at one rate then it implies a market rate for shares. Consider the implications of this when issuing shares to an individual as a bonus or incentive.

Once familiar with the implications of share issues, apply the same logic to future dealings of the same sort. However, beware that The Companies Act (1985 and 1989), which provides the legal framework for companies, is changing with the implementation of The Companies Act (2006); adjustments that will be implemented in stages until 2009.

Debt

As with equity, it is a good idea to review your existing debt arrangements. Many firms have informal loans sourced from connected companies or directors that are often intended to be convertible or subordinated agreements, however, the legal paperwork is frequently not in place.

The FSA recognises subordinated loans only where the correct legal forms are in place, so any informal arrangement is likely to come undone if the firm is reviewed in detail. Fortunately, the paperwork required to put in place the subordinated loan is relatively straightforward and should not prove costly to firms.

Once you have established that your debt financing is in the correct form and bears the correct paperwork, you need to pay it back. To achieve this and assess the feasibility of any further loan finance you need to assess the impact of your debt servicing and repayments.

The constraints on firms have increased thanks to the FSA's capital resources calculations, making the traditional focus on working capital insufficient. Any firm, even those without debt finance, should have a well-constructed cash flow, profit and loss and balance sheet forecast for a term that is at least as long as the debt that requires servicing. You may find that you have plenty of cash but that your capital resources are not sufficient. This monitoring should include analysis to ensure that you are meeting any banking covenants undertaken. Sometimes, banks do not ask for covenant information to be provided each month, however you could need to demonstrate covenant compliance for any external reviews. Keep your records up to date to avoid unpleasant surprises.

When seeking new financing smaller firms tend to go for the easiest form of loan financing, typically a director's loan or an overdraft. However, there are other debt financing options available. Longer-term external loan financing is easier to obtain if you are a firm with, for example, more than £1m in commission income, but smaller firms can take on more structured finance if they demonstrate that it works. Firms should move away from overdrafts and directors' loans where financially feasible.

Brokers can choose between specialist providers and general commercial providers. There will be a variation between the headline terms and ancillary costs such as arrangement fees or due diligence fees, so it is best to discuss your requirements with a number of different providers. Make sure you have credible forecasts prepared before you discuss debt finance with anyone.

- John Needham, Partner, CLB Littlejohn Frazer

EQUITY ESSENTIALS

- Know the financial instruments on your balance sheet

- All legal documentation, both internal and publicly available, should support your desired structure. The memorandum and articles of the company should not restrict or impede commercial and strategic decisions

- Identify opportunities to simplify the existing share structures

- Understand the implications of share issues on your business as well as your existing and potential shareholders

- Keep an eye open for the changes coming from The Companies Act (2006)

DEBT DANGERS

- Review debt finance, particularly debt that is provided on anything less than a fully formal basis. Only subordinated loans can be included as capital for FSA capital resources purposes

- Ensure your forecasts include profit and loss, cash flow and a balance sheet. Financial resources are particularly important

- Keep a record of how you have met loan covenants

- Take on the right kind of debt and understand the implications of each type. Move away from short-term financing

- Shop around when considering new debt finance and back up your discussions with credible forecasts.

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