Business basics Part 4: evolution

In the final instalment of his series, Ricky Ghosh looks at how a company might develop – or die

In the first three articles of this series we looked at the reasons for creating a company, the rules governing company decision making, and the growth of a company through debt and equity finance. In the corporate jungle, businesses never stand still - over a period of time they will either succeed and evolve, or fail and die. So in this issue we examine some of a company's options in the latter stages of its lifecycle, when it's faced with the choice of evolution or death. The main routes are: for a successful company, a merger, acquisition or flotation, and for an unsuccessful one, insolvency.

M&A

Mergers (the combining of two companies) and acquisitions (where one company buys another) happen for various reasons. Buyers may want to enter into an M&A deal to expand into a new product or geographical area, bring a service in-house to reduce cost, or simply as a financial investment. Sellers may want to raise capital for other investments or to exit a particular business.

Merger and acquisition transactions are either share sales or asset sales. The former involves a transfer of shares in a company (that is, the transfer of the ownership of the company). The latter is where all of a company's assets are sold to the buyer, leaving behind a corporate shell without any assets. Deciding which type of transaction to use is a complex decision where many factors, particularly tax implications, need to be considered, and which requires in-depth professional advice.

Flotation

In a flotation, the company "goes public" by issuing shares which are listed on a stock exchange for potential sale to investors. The process, known as an initial public offering (IPO), is a highly complex transaction.

In order to protect investors, who might include members of the general public, companies must comply with many rules to gain and keep their listed status. There are detailed legal and accounting restrictions which place limitations on how the business can be operated. There are also requirements to make public disclosures of sensitive commercial information which may help competitors. However, if the business is successful, the reputational advantages of being a "plc" and access to a deep pool of investors more than compensates for this potential disadvantage.

Insolvency

Many companies become insolvent, meaning that they are unable to pay creditors or fulfil their obligations, so are no longer able to operate as a viable businesses.

There are two strict definitions of insolvency used by insolvency professionals (for example, accountants, lawyers and liquidators). These are known as the "cashflow test" and the "balance sheet test". Under the former, a company is insolvent where it is "unable to meet its liabilities as they fall due", for example, being unable to pay for supplies on the relevant date. Under the latter test, a company is insolvent where its assets are not sufficient to meet its liabilities.

Insolvency has serious consequences for a company. If a company is technically insolvent when it enters a transaction and formal insolvency proceedings are commenced within a specific time, the transaction may be open to being legally challenged. Directors owe certain extra duties to the company when it is insolvent. Most importantly, failure to meet one of the tests means that formal insolvency proceedings can be initiated by the company's creditors.

The worst case scenario for a company is compulsory liquidation. Unpaid creditors can apply to court to wind up the company in order to recoup some of their money. If the application is successful, the court will make a winding-up order and appoint a professional liquidator who collects in all the company's assets and sells them off. The proceeds must be distributed in a strictly set order. Certain creditors may have been granted rights over particular assets (secured creditors). Set amounts must be paid out to preferential creditors, such as employees, and to cover the liquidators' expenses. Unsecured creditors, such as trade suppliers owed for products, are in a weak position and usually recover minimal amounts.

Rescuing a company from insolvency

Because of the poor return for creditors in a liquidation (often only a few pence in the pound), creditors will often try first to work constructively with the company, taking measures to get it back on its feet. These may include:

Restructuring its debts:

This may involve consolidating various debts into one loan repayable over a longer term. Doing so eases the immediate financial pressures on the borrower at the cost of higher interest long term.

Creditor Voluntary Arrangement (CVA):

If the management is seen as reliable, the creditors may enter into a written agreement with the company allowing it to get over temporary financial difficulties in the short-term. A CVA is a relatively informal process and has the advantages of being less high-profile than other options.

Administration:

A professional administrator may be appointed (by a court or otherwise) to take over the running of the company, and is often used where the directors are seen as not sufficiently competent. The administrator must act in the best interests of the company's creditors as a whole and is legally responsible for carrying out its functions as quickly and efficiently as reasonably practical.

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