Being a CFO and other topics

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Category: Cash Flow

Share Buybacks

Share buybacks are simple to explain. It is when the company buys (and hopefully cancels) shares that they have previously issued. The effect is to reduce shares outstanding and thus reduce dilution Andor creates additional demand for the stock while the buyback is in progress through the actual shares being purchased and potentially through a halo effect that the message that the company is buying shares can have on investor psychology and their desire to purchase shares.

The jury is always mixed on share repurchases. In general, they seem to happen more in good times when stock prices are high and seem to be greatly reduced when prices are low. There is no permanence to them. Unlike dividends, share buybacks are always announced as one time transactions with a budget and no promise that more will happen. This give management more flexibility but also gives no real promises to shareholders. Indeed, the actual buyback can be announced but never actually carried out. This is generally not by intent, sometimes there are maximum prices set and the stock moves above that price and nothing is transacted. But it is always possible that the maximum price was set with the intent that little to no stock would be purchased.

There is even a view that the last few years of stock market performance would have been flat without the demand caused by many large buyback programs. These programs also have been a source of supply for the debt markets as some companies borrow to repurchase shares. This makes some sense if much of your cash is overseas and repatriating the cash will cause a big tax bill. Plus the interest paid is tax deductible.

Before I discuss when and how I think you should do a stock buyback, there are plenty of times you should not. The market goes up and down and the same for all stocks. Eventually your stock will go down and if your stock has a fairly high beta, it may go down sharply. When that happens, there will be people that start demanding a buyback, often using the argument that if the company believes in itself, then it should show it by buying the stock. This is a terrible reason to do a buyback. Reacting to short term movements in your share price buy committing to a buyback does not show strength or belief in your company. If you did, you would be confident that the price will recover based on future results rewarding long term holders. Overreacting shows weakness, not strength.

I will be clear on my personal opinion. I think that buybacks have merit but are not often the best choice. I think for most growth or early stage companies they are pretty much always the wrong choice as normally you do not have excess cash and it is much better to spend your cash on internal growth rather than repurchasing shares.

As a general rule, if your share price is low for some reason and you have enough cash to consider a buyback, then first consider any convertible bonds you have outstanding. You might be able to retire debt at below the $1 face value of the bond (which should generate an income statement gain at the same time you are reducing debt) and reduce dilution at the same time. Bonds use the “if converted” method and often are dilutive even if not in the money.

Then, if you have cash on hand that exceeds what you can reasonably use to improve returns of the business and you are not sure it will be recurring well into the future (dividend might be better in that case), you can look at doing a buyback. You should look at the quality of suggestions on where to spend your cash, usually there are only so many good opportunities in front of you and if the quality drops too much and you are not willing to go outside of your existing business lines, then a buyback could make sense. A buyback can also help protect against activist investors. If you let too much cash pile up without doing anything with it, then you can attract activist attention and that is very distracting if it happens.

You will need Board approval to get a buyback done, so you will need to have good arguments prepared. Buybacks can be an emotional issue, so be prepared for some emotional pushback that is not connected to the raw numbers. You also will need a brokerage account and to negotiate the cost of the buy-out. Opening an account can take a little while because of the know your customer rules the banks need to follow. The cost to buy the shares should be pretty small, there are large market makers that do it for pennies on a share, but no real relationship benefit, or you can pay a little more and use one of your investment banks. Shop around a little, it can be much less expensive than you think.

Consult with your lawyers, but you typically cannot start a buyback if you have material, non-public information. That means that you need to commence it during an open window. You can set the share repurchase on autopilot as long as you do not touch it when your window is closed. Normally you do a formal plan where you instruct the broker to buy a certain amount at set prices and they execute. During an open window you can give individual instructions but a set program with pre-established prices is probably the best. Your lawyers can give you more specific advice, but if you do establish a formal plan so you can continue to buy in closed periods, then you should resist the temptation to tamper with it in open periods unless there is an absolutely compelling reason.

Almost every bank will have a specialized program that buys the stock based on volumes and prices being seen. Normally they will try and meet or beat the volume adjusted price every day. A good bank will give you market color and what sort of trading indications they are seeing during the day.

Typically you need to report on the progress of the share buyback on a quarterly basis. Probably no need to do a specific press release on the progress but you might have to formally announce that one is starting and when one ends. Normally you would set the period at one year at a set amount in total value you would repurchase and either announce it in its own press release or prominently in another press release like an earnings release. If you do a little searching on the Internet, it is easy to find statistics that show that actual repurchases typically trail announced and planned repurchases. They also tend to be more active in bull markets when stock prices are higher and less active in bear markets when stock prices are lower. That sometimes gets joked about in the press, but it makes a certain amount of sense. Bull and bear markets usually match pretty well with economic cycles. If you would only do a. Buyback when you felt you had excess cash and more was coming or available on the market, then it is highly likely that a company would start a buyback during a bull market and not start one during a bear market.

The publicity around the buyback often results in the company’s stock price going up, but this is very short lived in my experience. Any buyback would be a small percentage of the shares traded and it is more public relations than an addition of significant new demand for the stock.

My final point on share repurchase programs is that one reason often cited by companies is that they are doing the program to reduce dilution and the dilution often comes from their equity compensation plans. These same companies were ones that argued against expensing employee stock options because it did not cost the company cash.

Collections

Last week I discussed Credit, today I will discuss the rest of the phrase Credit and Collection. Like the Credit process, how you run your collections process is important and deserves your attention. If you have a good credit process up front, you are probably OK on the reasonable expectation of collection criteria for revenue recognition, but you still need to collect the cash for your sales.

I will assume that you have a good credit process and you are selling to customers with reasonable credit. I will also assume that you have a good sales contract. In place, but I will discuss that in a little more detail. If your credit process is broken, you will have collection issues. That time two months ago when you caved in and said yes to make a quarter even though the customer had bed credit? This is where you face the music and have to deal with the consequences.

Your sales contract and/or invoice needs to make payment terms clear. I mean very clear and spelled out in proper terms. Incoterms or International Commercial Terms is well understood and often used in international commerce. Because these are well understood and legal interpretations are clear, I highly suggest that you use them. Make sure the terms are in the contract and either on the invoice or the invoice references the contract for payment terms. Be especially careful what the customer purchase order says. Many countries defer to the purchase order when settling disputes regardless of what the contract says unless the purchase order says otherwise. It almost can become an arms race where there is a contract, then you receive a “standard” purchase order back that does not reference the contract, then you send an order acknowledgment reaffirming that the order is accepted under contract or invoice terms. Every country is different, so I suggest you consult your lawyer here, but you do need to be careful.

I know it sounds pedantic and overly detailed for the new, strategic CFO, but every company needs cash and you are not going to be able to be strategic if you don’t collect well. Getting the contract done well, even if just contained in your standard invoice terms, is something that can be done well once up front and then just needs a little bit of maintenance and supervision going forward, something that your billing team can handle without much effort from you. I always check this process when I start a new CFO job (applies to Controller as well). If it is in good shape, then I manage on a exception basis. If it is in bad shape, I put a lot of attention to it very early.

One last tip that can help later is to try and preserve title until payment is actually received. You need to be careful about affecting revenue recognition as one criteria is title has to transfer, but a properly worded term and the expectation that you will be paid is normally sufficient. You also need to be sure that it is clear that they are responsible for losses and need to insure the goods.

The next step to good collections is to get your sales force engaged. Hopefully you are already doing all the basic things that build trust and relationship with the sales team (I find adult reviews of expense reports that allow for some discretion and paying them quickly once submitted really helps here.

You need the sales team engaged because they are the ones talking to the customer and doing the negotiations. So if you want something built in up-front, then the sales manager is the one that will do it. If you want a purchase order that resets terms caught, it will be the sales team that sees it first.

I know of two ways to get the sales force to help. The first is training. Take the time to train them in the standard payment terms the company uses and why they are important. Educate them on the main cash flow levers the company has and what the time based cost of money is for your company. Show them using examples just how much a bad debt costs the company. Show them how a side agreement can throw all the prep work and standard contracts out the window. Side agreements are import enough that I will do a blog entry just on them. If you spend time educating the sales force, you greatly increase the chance to get them on board and engaged.

However, this is just not enough. Sales people are very motivated by targets and pay associated with the targets. If their bonus is only based on making the sale, then they will not be motivated to put potential barriers in their own way by protecting the company. You absolutely should tie some of their bonus to eliminating bad debt and collecting the sale. The best way I have found to make sure they are motivated to keep following up with the customer is to only give them credit for bonus purposes when the payment is made. This is the simplest and most direct way to tie their behavior the the company’s hoped for result. More mature companies can also have metrics for bed debt and finding costs for the receivables the sales group creates, but no credit for bonus until collected is the most straightforward.

I get pushback at times from sales managers on this (I always try and stay engaged with the sales team as they are the best and earliest warning system for forecasting and customer feedback). Normally them complain that our harder terms are bad for their customers. My answer is simple, a “customer” that does not pay is not a customer. If I am being less polite to really make the point, I remind them that people that take things without paying are thieves.

I am sure that you have noticed that many of my blogs emphasize the up front process and usually I spend a lot of time explaining what I do to get it right. That is my natural instincts coupled with Six Sigma training. In a factory, the worst process to follow is to inspect quality in at the end and the best is to start with your suppliers so that you receive good quality parts. It is the same for Finance processes. One topic I did not cover here is billing, your invoices need to be perfect or whatever mistake is present will be used as an excuse not to pay, but I will discuss that another time.

I have noticed over the years that you should have very nice, persistent and organized people actually doing the collections. As funny as it is to joke about breaking people’s legs and all the other loan sharks collection methods, people do not like to pay mean, threatening counterparties. All you really can do is threaten to sue and in the USA that is not much of a threat. If there is either a cash flow issue or some form of quality dispute with the customer, they are not going to care about a lawsuit.

What actually works is polite and persistent follow-up. The customer will claim missing invoices, terms being different than what is in the contract, quality issues, moon phases, sun got in their eyes, vacation schedules of people who can sign cheques, pretty much any reason under the sun as a reason for delay in payment. Your collection team needs to document that they were told, efficiently follow-up internally for anything that is under your company’s control and then get back to the customer. They need to sound sympathetic and be very polite about identifying inconsistencies in what the A/P person at the other end is says. Quite often pure embarrassment at being caught in a lie (that is never specifically claimed by your collection staff) can cause the customer to pay.

If your team is polite and professional and keeps good records (CRM is best but a physical file works), you will get prioritized for payment. If there is a real issue, your collection team will find out because the people on. The other side will tell them because of the good relationship that has been built up. Your collections team should either work closely with the credit team or report to the same boss so that you get realtime feedback and can stop further sales if a customer suddenly turns bad. I don’t consider a company being protective of their own cash flow to be bad. If your invoice to them was incorrect then you gave them an excuse not to pay. Anything that you would do yourself needs to be responded to with polite but firm follow-up.

Finally, if a customer does not pay you need to take legal action. Your sales team will protest about relationship, but a customer that does not pay you has already broken their relationship. If you have credit insurance, your insurer may take over this process, otherwise you need to sue. The steps are always the same. First a legal warning letter then you file a claim. You need to get paid, not a future promise of payment after the legal warning letter as you need to move quickly.

By doing what I suggest in this blog, I have consistently been able to deliver industry leading collection statistics wherever I have worked. By spending the time to work more directly with the credit and collections team and build a rapport with the Sales team I have been able to keep everyone happily working towards the goal of getting cash into our bank faster.

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