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Hudson & Young Blog

Undoing the benefits of structuring

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Our friends at Worrells clearly explain what we deal with on a day to day basis. The lesson is clear - ask before making any major decisions.

Business owners and their advisors often spend considerable time and energy making sure that the correct structure is adopted so as to achieve maximum protection and minimum risk. But sometimes decisions made in the crucible of ongoing trading can entirely undo the benefits of correct structuring. A recent matter handled by Worrells Brisbane is a good case in point.

The Structure

A well established and respected building company had developed high quality home designs, specifications and marketing systems and decided to offer these by way of franchises to other builders. The company reasoned that apart from the attractiveness of generating an additional income stream the franchise arrangement would effectively pass the trading risk inherent in any building business onto the franchisee. The company obtained advice that the franchisor should be a company separate from the building company,  as that company intended to continue operations. That advice was correctly predicated on the notion that if either company failed the other could continue in operation.  

Of course the director/shareholders had already taken a level of protection by opting for a company to carry on the building business. As well they had effectively protected their personal assets, including their homes, from risk by transferring them to trusts. This was done at a time when the directors were solvent and so the transfer was immune from the claw back provisions of the Bankruptcy Act.

So the structuring involved:

    1. A company operating the ongoing building business. This recognised that the building industry is inherently risky and made sure that if that company failed there should be no effect on any other property or trading.
    2. A separate company operated the franchise business. That company had less chance of failure but all businesses face some degree of risk, however effectively the majority of the risk had been transferred to the franchisees. As was the case with the building company the failure of this company would not impact on the financial stability of the other trading company or on the security of non-business assets.
  1. Personal assets were held in a series of non-trading trusts. By isolating these assets in trust they would be protected even if the trading enterprises failed.

This form of arrangement is very common and effective and would be familiar to most advisors and financier, as well as to many business people. 

How the Structure was undone

A.    It would be no secret that the building industry has been hard by the GFC. The first manifestation of this arose when one of the franchisees failed leaving many customers with houses half built. An insurance scheme operates in Queensland to protect customers from losses in these circumstances; however it can take time for the insurance claim to be actioned. Despite the insurance scheme being in place the directors arranged for the building company to take over the jobs on the basis that this would protect the goodwill of the brand. The building company was of course reluctant to take over the building contracts and only agreed to do so when the franchise company agreed to fund any shortfall in the unpaid contract price.

The cost of taking on this work was far greater than anticipated. To help meet its funding obligations to the building company, the franchise company ran up credit with its suppliers and suspended payments due to the tax office.

The franchise company has thus diluted its structuring advantage (that is passing the business risk to the franchisees) by voluntarily  taking on a franchisee’s financial responsibility.  

B.  Although the building company had suffered no loss from taking over the franchisee's building work (because the net costs were funded by the franchise company) it was impacted negatively by the down turn in the building industry and trade and other creditors began to blow out because of negative cash flow. This was alleviated to some extent by borrowing from the franchise company. Those borrowings were funded by the franchise company from trading income and by allowing that company’s obligation to the tax office to increase.

By lending money to the building company the franchise company negated the principal of separation inherent in the structuring. As a result the financial stability of the franchise company became tied to the fortunes of the building company, which is the very outcome which structuring was meant to avoid.

C.  Despite the funding from the franchise company the building company continued to make losses. Further it could not sell its property holding at any reasonable price. It could be argued that the ongoing losses would never have been incurred if the building company had been left to pay its own way, as this would have caused it to cease trading.

Not satisfied with having put the franchise company in financial jeopardy the directors of the building company then arranged to raise funds to go into the building company, on the security of the assets held in trust. These funds were advanced to the building company on an unsecured basis

The practical effect of that was of course that assets, which were put beyond risk by transferring them to trusts in a timely way, were now at jeopardy unless the building company was able to repay the advances secured on those assets. Again, this is an outcome which the structuring was meant to avoid.

D.  The building company continued to make losses and finally had to cease trading and liquidate. The net result is that the franchise company cannot recover its loans to the building company. As repayment of those loans were required to pay the debts of the franchise company that company (which was inherently profitable) also fails.

The personal assets of the directors (which were held in trust) are encumbered for non-recoverable loans to the building company and will need to be sold to repay the encumbrances.

Summary

The director’s actions in undoing the benefits of structuring were always taken for the best of intentions, and it’s only with 20/20 hindsight vision that we can discern what now seems to have been the problem in their actions and the inevitability of the final outcome.

And yet we need to pose this question: “what’s the point of structuring if clients choose to act in ways that ignore the benefits provided?”  

We regularly see variations of the picture just described. It may be that professional advisors should be more forthright in advising clients to ignore structuring at their peril.

Good business Ideas are worth it

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It is always positive to see small business idea receive funding. There are also a number of government grants available. This is a great example:

YING Wang is one of a new breed of Aussie businessmen.

He and his team have just received a $450,000 investment from Optus-Innov8 and a range of independent investors to take their creation, function venue website VenueMob, from Melbourne to Sydney and into South-East Asia.

And that was only two months after they started the seven-month Accelerator Program at the University of Melbourne, an accolade shared by personalised radio station and information provider 121cast, which raised $250,000.

Now here's the kicker - this is Wang's second venture, having sold his original business Crowdmass to group buying site Groupon for an undisclosed sum ("high six figures") in 2011.

Wang, now 24, says he has been "very fortunate" that his ideas have been successful so far but admits age - or rather the stakes and attitude taken towards risk - is a key player in that success.

"People are just too scared to take that kind of punt," Wang says.

"A lot of people have really good ideas but they get jobs, get high salaries and then they think it is too much of a risk to do their own thing."

Both businesses have been built upon taking care of the supply side first.

Build the clients (venues, suppliers) and that will attract the customers, he says.

Too many businesses fail to take care of clients once they have turned into revenue, he says, and therefore the relationship is broken early rather than contributing to the long-term growth of both parties.

While he may build another business, he is also looking at new activities.

These include building Australia's next generation of budding entrepreneurs.

"People shouldn't just think they should go to school, go to university and straight into a job," Wang says.

"Many people have ideas and they should build those ideas as much as they can."

How to make your good business great

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Marketing and chasing the next new customer can feel like a blood sport at times. Claire Heaney notes that the answer might be with your existing customer.

THINGS are chugging along nicely. You've kept your head above water, maintained customers, made a profit and retained your talented staff.

But why settle for good when you can be great?

By putting your head down and making some changes, you can overhaul your business and see real benefits in six months.

Review systems, processes and products

Streamlining your operation will save time and cash, while invoicing quickly and following up late payments will raise the cash you need to grow.

Above all, business owners need to take a step back and learn to delegate.

"You've heard it before. Focus on working on the business rather than being totally submerged in it," Consolid8 accounting firm director Tanya Titman suggests.

The experts say you get 80 per cent of your sales from 20 per cent of your products, so now is the time to have a good hard look at what's flying and what's flopping.

Do your sums "Now is a great time to re-assess business loans, consolidate credit card debts, talk to your accountant or mortgage broker, look more closely at costs associated with breaking a fixed loan and compare the potential savings over the life of the loan," Titman says.

Getting your financial house in order will mean that you will be in better shape to approach banks for more money for expansion.

Customers are king Acorro chief executive John Downes says that too many businesses run themselves ragged looking for new customers and clients.

"If they stopped that and focused on treating existing customers like gold, they would be better off," he says.

Consolid8's Titman supports the Pareto principle whereby 80 per cent of your business comes from just 20 per cent of your customers.

"By getting rid of the bottom 80 per cent of clients and taking the time you spend on them and spending it on your top 20 per cent, you drastically increase profitability and cut expenses," she says.

Discount dilemma Downes, who mentors and coaches small businesses, says that anyone can choose to discount but it is vital if you are a small player to protect your margins.

"The reality is that if you have the same product and the same service as what is available from China for half the price, your business model is doomed," Downes warns.

But if you are 10 to 15 per cent more expensive but you are local, reliable, easy to contact and people can easily communicate with you, you should be able to compete.

Get partners If you are looking to take the next step, start looking around for some partners. It might be people who can add a skill you don't have or others who may be silent or active investors.

Just make sure everything is documented so everyone knows where they stand.

Spike it up Downes says that businesses need to get in touch with their "hedgehog".

It's business speak for making sure three key drivers intersect. Do something you are passionate about. Be the best in the world at it. And, importantly, ask yourself if you can make money from it.

"If you are doing what you are passionate about, and earning money from it, you are in your sweet spot," he says.

Finally, don't panic.

Downes says the worst thing you can do is to make wholesale changes.

"There is no quick fix in business. Otherwise everyone would have done it."

How to avoid a credit black mark

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A timely reminder not to be silly during the silly season:

AUSTRALIANS who apply for credit in December are at a greater risk of being left with a black mark against their name.

Latest data from credit reporting agency Veda shows over the past five years the rate of credit defaults has risen in the December quarter.

Veda spokeswoman Belinda Diprose says consumers often turn to credit at Christmas time to help fund their excessive festive spending.

"What happens to these people in the new year is that there's an 8.5 per cent increase in the default rate," she says.

"This indicates people are overextending themselves and putting themselves into debt stress early in the new year."

Veda data also shows credit card application inquiries climbed by 10.3 per cent over the last five years in the December quarter.

Diprose says credit defaults occur when a customer fails to meet a payment that is more than $100 and is at least 60 days overdue.

This can extend to mortgage repayments, car loans, personal loans and utility bills.

Despite a drop in credit application inquiries - which fell by 5.6 per cent between January and October - Diprose says consumers should avoid overspending during the Christmas period and reduce their risks of running into financial trouble in 2013.

"It's easy to get caught up in spending, so it's really important for people to keep a handle on the amounts they are spending," she says.

"I don't think people realise the long-term impacts on their credit history if they do have a default.

H&Y have specialist consultants dealing with credit defaults and refinancing. Make sure you talk to us before the problem gets out of hand. Some handy tips from reporting agency, Veda:

TIPS TO PREVENT DICING WITH DEBT

* There are so many cards and loans on offer so ensure you research which one is best for you.

* Make a list of your credit card spending and crosscheck it with your budget.

* Keep a handle on what you owe.

* Pay on time and save interest charges.

* Stay up to date with your credit rating.

Source: Veda

Finger on fine print of contracts

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Many a small business has failed due to being caught up with (or caught out by) a major customer contract. There is some good advice in this article by Russell Emmerson and there are ways to protect yourself.

THIS is it. The one contract that will propel your business beyond its small roots on to the national stage.

However, before you wave your banners and shout your name from the rooftops, be warned: Look for the red flags before celebrating.

Understanding your dream contract can stop the nightmare, Kelly & Co partner Lisa Jarrett says.

"It is simple - you have to make sure you comply with its requirements," she says.

Nooks and crannies

Jarrett says businesses are likely to be aware of pricing, quantity and term of a contract but readily overlook essential elements. "Who has the right to terminate and when?" she says.

"If the other side can terminate with seven days' notice, you may get stuck with stock and unavoidable costs.

"Say to them: If you want extra flexibility, then we need something to meet those costs. "The same holds true of unlimited liability. If there are no dollar limits within the contract, you may get saddled with the worst of everything.

And while some elements cannot be set aside - think consumer liability and franchising laws - there are certainly enough risks to pay attention and ask questions.

"If you are sharing your business information or assets (under the contract) you need to make sure there are appropriate confidentiality and intellectual property protections in place," she says.

Are you ready?

PwC partner Michael Browne says businesses often underestimate the true demands of their dream customer.

He tells of wine suppliers who sign the ultimate deal - a contract to supply British supermarket chain Tesco with quality Australian wine.

However, what happens when the business ships three pallets of wine, only to find the order is for hundreds of pallets?

"You need to understand what the demands are going to be," he says.

Part of that answer lies in cold, hard cash.

Check the contract for payment terms. If you are stuck with huge stock purchases that are payable within 30 days while your key customer is only committed to paying every 45 days, you will quickly find your business starved of cash.

Invoice factoring - effectively borrowing on the strength of your signed invoices - is ideal for this situation, but talking with your suppliers, who will also be benefiting from your success, may also throw up alternatives.

Living the dream

Major customers often want their dues.

Check whether your contract demands exclusivity, whether it grants your customer the first right of refusal when you want to sell your business or even the right to buy it.

"It is about the customer being confident that he understands who he is dealing with," Browne says.

Jarrett says businesses need to determine whether contractual terms are reasonable.

"If it's unreasonable, it may be ineffective but it's better not to have it in the contract in the first place because you'll still need to go to court to prove it's unreasonable," she says.

The Australian Competition and Consumer Commission is the first port of call to assess restrictiveness, she suggests, while your lawyer will know more about your business to assess its impact.

That naked dream

Browne says it may also demand you open your books - allowing a customer to see how stable your company is, but also how much money you're making from them.

"They might ask for an audit statement or a statement from your accountant each year," he says. "But that's a risk you run.

"You might restrict them to gross sales and costs of goods sold, especially if they are just after financial solvency, but if you want the contract, it's something you will have to come to terms with."

Tough penalties aimed at superannuation schemers

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A timely warning from the Financial Services Minister:

People who illegally access their superannuation funds early will get almost half that money taxed under harsh new measures being proposed by the federal government.

Financial Services Minister Bill Shorten said the changes would impose the non-compliance tax rate of 45 per cent on any money released early from a super account by illegal means.

For example, if someone illegally accessed $10,000 of their super savings early they would incur a tax liability of $4,500, plus a 1.5 per cent Medicare levy.

Stronger sanctions were needed to deter those who promoted early-release super schemes as they undermined the government's retirement policy and harm members, Mr Shorten said.

Some of the schemes charged fees of up to 50 per cent on unsuspecting people, and in some cases dodgy operators have stolen the entire balance or used the members' identity for criminal purposes.

There are no specific penalties now for those who promote early-release super schemes.

But under another bill introduced to parliament on Thursday, Mr Shorten said those pushing such schemes could face up to five years in prison and fines of up to $340,000.

Australia's credit reporting regime is about to change for the better

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Veda has announced proposed changes to the way our credit card history is recorded:

"Laws that restrict what can be recorded on a credit report will be eased, allowing for five new additional data sets to be included on credit reports. Comprehensive reporting is one of the recommendations made by the Australian Law Reform Commission (ALRC) as part of its review of the Privacy Act 1988. The ALRC recommended that the following data be permitted in credit information files.:

  • Type of credit account opened
  • Date on which account was opened/closed
  • Current limit on each open credit account
  • 24 months account repayment history

Together, these additional sets will create comprehensive credit reports.

The most important of these is account repayment history, which will show whether a person has been overdue or missed payments on credit obligations.

Account payment history will be the single most powerful single predictive element of a person's credit report. It's predictive power will be twice that of all the other four new elements combined."

H&Y deal with credit card default issues on a daily basis and the comment form our Director is clear:

"given the number of errors that occur in reporting now, adding further, more complex data sets can only increase the error rate. Surely the emphasis should be on accurate date first, and then expanding the data reported."

How to sell your business

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Andy Brown sold his software business and now spends his days playing golf. Picture: Dean Martin

Selling a business is a particularly complicated process, particularly in the current environment where many businesses are struggling. Investment is difficult and banks are near impossible, what are the keys to getting the best price for your business. The better prepared you are for sale, the better result will be achieved. Russell Emerson has put together this step by step guide.

* Three years before sale

Matthews Steer associate Damian James says business owners must first agree they want to sell - and why and how.

"If you're going to sell to internal staff, that's totally different from selling to the market," he says. "There is less of a process, less information to hand over because they already have access to it."

Then comes the hard work, Ernst & Young transactions advisory service partner Don Manifold says - nailing down the facts and figures.

"People tend to look back to three years' (financial) history and forward one year, and it's easier to sell a business when you see profitability over that time," he says. "Selling profits is easier than selling hope."

PwC partner Michael Browne says an audit may make all the difference.

"You might be of a view you don't need to be audited because you're a private business ... but you need to make sure they are adequately reconciled and your profit is right year-on-year," he says.

"It may cost you $20,000 to $50,000 ... but increasing your multiple (at sale) can add $2 million." It will also reveal the "skeletons in the closet" that might later kill a deal, he says.

* Two years out

Small businesses have a tendency to have messy corporate structures, poor governance and a mix of personal and business transactions.

James says now is the time to clean house, moving the business from trusts and partnerships into one corporate structure and removing all personal assets from the business.

"The sooner you simplify a structure, the easier it is to report on," he says. "Start on it earlier rather than later."

It's also time to think about tax. Capital Gains Tax concessions are lost if a business is sold within 12 months of a new arrangement and stamp duty concessions (depending on the state) within two years.

"Poor tax arrangements can cost you 20 in the dollar if you get it wrong," Manifold says.

Owners should look towards the first separation at this stage, bringing in a manager and stepping back to an advisory role to make sure the business doesn't need you to survive.

* One year to go

Manifold says now is the time to write contracts for all major supply, customer and employee relationships and start the search for a buyer.

Cultivating relationships at a CEO level can ease a deal through but also raise competitive tension that might deliver a 20 per cent premium, he says.

* Six months and counting

It's time to appoint your corporate advisers - lawyers to advise on contracts and accountants to deliver the right reports. Make sure they're experienced in transactions because overlooking completion mechanisms such as accounting for profits between sale and completion or the treatment of working capital can cost dearly.

It should take your advisers about two months to prepare the underlying documents for any transaction including confidentiality agreements, contracts, an information memorandum and the cancellation of director guarantees.

* Four months

It may be tempting to tell staff, customers and suppliers, but hold off until the day the information memorandum is sent out, Manifold says.

"People hate keeping secrets because business owners have good relationships with their staff, but it can be disruptive and affect key relationships."

* Two months to go

Due diligence is likely to take place with one or two months to go and contracts signed with a month leeway.

Browne says vendors need to think about what they're likely to get in cash before signing.

Remember you still need to pay off debt and hand over assets. Do your homework and get good advice, he says.

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