Financing

I

For Locally Owned Businesses in
Central / East European

Whether a business is seeking finance in the USA or Eastern Europe, the world is becoming one market place, so the requirements for obtaining finance are converging. The days of the dot.com era are also over.

How will local companies get financing? It's no secret. Justify, justify and justify. In other words, prepare financial, business and marketing projections and presentation of historical financial statements in a Western format. Show reality, not a myth. Some people think one just takes local format accounts and applies simplistic formulas. In reality, the fundamentals have to be examined so that investors and financiers can understand the business and how their funds will be used to improve the business.

In all places, the financial and commercial analysis of the business are important. In all places, bankers must know their customer and the customer's business.

The US and Eastern Europe do it differently and for differing reasons.

In the USA, the penalties assessed against bankers for lending money (or just opening bank accounts) for customers involved, directly or indirectly, in illegal activities (such as drugs and money laundering) are very high. Consequently, the bankers, need assurance that they, the bankers, are not contravening the law.

In Eastern Europe, the domestic bankers may rely less on financial information, but more on personal friendship with management. Nevertheless, in our opinion, the Eastern European model is moving rapidly towards the Western one, with its reliance on financial statements, budgets and plans.

Just as there are differences between the US and Eastern European banker, so there are differences between the US and Eastern European investor.

Typically, the US investor or the investor's representative will have been to business school or gained some other form of professional / business education. In the centrally planned economies, the educational needs and process were very different. Whilst, there are many well trained engineers from the traditional Eastern European environment, the same can not be said of the "professions" and of business training, but this is also rapidly changing.

The above differences leave a gap between expectations and reality, between requirements and the ability to deliver. In the short-term, since the change from the centrally planned economy to the "free market economy", the typical method of making acquisitions has been different within the two systems.

The US system need not be described, the Eastern European system has, in my opinion, relied heavily on insider trading, bank finance provided to borrowers of dubious quality and acquisitions where the selection of the buyer did not necessarily seem to match the best price being offered.

Financing

The western world has developed many different financing products. Many of these products have already come to Eastern Europe. Some have not yet arrived because of legal infrastructure, such as being unable to gain suitable mortgages over property. Others have not arrived because the tax law does not encourage certain transactions.

In the following section, the optimal information requirements for the sale of a business is discussed. In reality, many of such factors may also apply to financing. However, where financing relies on security in assets, the information requirements may not be so important.

Some western financiers have found that in Eastern Europe, management conceptually understands the obligations and expectations related to loans, better than those related to equity. Perhaps it is understandable. If all property belongs to the nation and all the nation's assets belong to the people, then in a funny sort of way, corporate assets do not really belong to the shareholders!

If the above is true, then the Eastern European borrower needs to ascertain the future way of obtaining finance, its conditions, its requirements and how to make the lender comfortable.

If one examines the traditional analysis undertaken by such institutions as the International Finance Corporation "IFC" , before loans are granted, then one realizes that the informational requirements are very similar as those described for the sale of a business.

In fact, it is our understanding that many western bankers have had difficulties in making certain loans, for such items as working capital, because the expected information or "comfort" is not available or was not presented.

Sale of a business or shares in a business

The local fund manager who owns shares in companies, which are frequently traded on the local stock exchange, will not have a problem to dispose of those shares at the market rate.

But where the above is not the case or where private owners wish to sell a business (which is not quoted) or issue shares to raise additional capital, then a different path has to be followed.

In this case, a buyer has to be persuaded that they need the shares / business. The reason is likely to be that they see:

• Profit potential. For example, through future business generated earnings, additional investment resulting in greater profits, reorganization, merger or simply holding the investment as a speculation
• Marketing, manufacturing, technology or similar synergy with the buyer's existing business.

In either of these cases, the buyer must completely understand the business being sold. Unless the buyer is a longtime experienced expert in the specific industry (with the event of business school education, there are fewer and fewer of such experts), then the seller must provide sufficient information so that the buyer can fully understand the business.

Additionally, in many cases, the person negotiating to buy the shares, will have to persuade others that it is a good investment. Such parties may include external individuals such as bankers or internal departments such as finance, marketing, sales, manufacturing, research or the board of directors.

So how does one do it?

• One way is to go to potential buyers, give them brief details and let them decide what information they need.
• A better way, is to give the potential buyers a complete package. Not only will they understand that they are dealing with profession and competent management, but it will make many more potential buyers interested.

After all, if an investor has many options, which one will be chosen? The one where the investor is provided with all the information or the one where the investor has to spend time and money working out if the investment is interesting?

Unless the business being sold is the "family silver", then there is really no option, the seller must provide the information or be prepared to sell at a discount or simply not be able to sell the shares / business.

So what must the sellers prepare?

There is no one fixed package, but generally it may include:

• Business, marketing, sales, operating, personnel and technology plans
• Extracts of legal documents, contractual and other obligations
• Financial plans and budgets / projections
• Historical financial statements

The financial statements should probably be in an international format, with sufficient disclosures so that the buyers can really understand the business. Of course, international financial statements may not be the sole requirement. It might be necessary to provide detailed "management style" financial information.

Typically, we find that many managers from the Central and Eastern European markets do not have the experience or knowledge to prepare the above without guidance.

Some areas are easier for local experts to prepare than others. In many cases, the local management or experts will simple need to be given overall ideas, directions and help. In other cases, they may need  consultants to prepare all the information.

One of the major areas of confusion is financial information. In most cases, converting the information to western format can be complex. It is not simply putting it in a spread sheet and having the numbers reformatted. In fact, many material figures may have to be recalculated and restated. For example think about:

• Consolidation of subsidiaries (typically, elimination of inter-company transactions is not understood)
• Leasing transactions are often treated very differently
• Disclosure notes for US "GAAP" are much more extensive than for local requirements. GAAP financial statements prepared without  disclosure notes would be meaningless.
• Analysis between cost of goods sold, sales and marketing, operations and overhead may be intermingled
• Bad debts and obsolete inventory may not be provided for
• "Reserves" may actually be "provisions"

As one can assume from the above, such packages are not easy or cheap to prepare.

Not only must the detail be there, but the presentation must be outstanding!

II

For Foreign Owned  Businesses in
Central / East European

Needing local financing

Probably the best source is a local foreign owned bank, where the lenders will base their lending criteria on factors which foreign management understand. As time goes on there are more and more of such foreign operated banks.

Locally owned companies have not historically been exposed to the Western way of assessing how companies justify loans, equity or other forms of financing. It has been our experience that in the Eastern Block loans have been based on criteria other than business principals, however, this is now changing.

In the future, new financing and renewal of existing facilities will go towards the Western and especially the European Union model.