By Adam Bernstein, Monday 05 March 2018
In the heady times immediately following the setting up of a new business, beyond the signing of contracts, few really take the time to step back and assess the new entity for structural weaknesses that could sink it before it has a chance to swim.
Experience has shown that there are plenty of opportunities for potentially damaging events to happen, whether through a stiff penalty following a health and safety incident (such as the £100,000 fine suffered by Euro Packaging following an incident that involved a lack of guarding on a machine); the closure of Express Printing following the departure of key staff who allegedly took sensitive client information with them; and the recent closure of The Henna Press after its biggest customer went into administration.
But now the print sector, as noted by Antalis in October last year, is facing Brexit uncertainty. The paper supplier reported at the end of October that it had experienced a sales slowdown in the first three quarters of 2017 and was expecting a similar decline in Q4 as Brexit-related worries reduced demand across the UK and Ireland.
It’s clearly impossible to deal with every eventuality, but taking a step back to examine a business through a process that is termed a ‘legal audit’ – a business health check – should help minimise risk.
But what should a business look at first? According to Mary Elliott, a senior associate at law firm Fox Williams, “this will completely depend on the company in question and their priorities. But taking the example of Brexit itself, currency exposure, immigration and supplies and the like will be the most important, but really only for those who have EU staff, international contracts and significant import/export costs.”
She makes an interesting point: that the media and political focus (and occasional hysteria) about Brexit can “lead companies to overlook other areas of concern that need to be dealt with in equal measure”.
On Brexit, Philippa Dempster, a commercial and disputes partner at Freeths, suggests that firms use the legal audit process to ensure that where they do have overseas dealings that currency risks and duties are dealt with.
Other areas for concern are ownership and management succession, checking that the legal structure and associated matters are in order, that employee terms and conditions are properly set out and up to date, and that property portfolios, for example, have been evaluated for risk (such as leases ending with no prospect of renewal or a rise in the cost of borrowing on a commercial mortgage).
Most of the problems and risks that printers face are the same as for other sectors, but competition in the face of market consolidation and leaps in technology can significantly impact the printers who fail to invest. But even investment is not a guarantor of success as the administration of sheetfed commercial printer Anton in March 2017 illustrates. The acquisition of a customer to avoid a bad debt led to a loss of unsettled customers, which was then followed by a fruitless attempt at a sale. A multimillion-pound investment in new print kit at the end of 2016 could not prevent the firm’s demise, and may even have pulled management’s attention from the company’s more urgent issues.
BPIF chief executive Charles Jarrold knows that the print sector is competitive and fast changing. He says businesses must not only focus closely on the day-to-day running of the business, but also take the time to understand and anticipate broader long-term changes in markets and technology. “That means gathering as much information as possible, spending time out of the business, meeting suppliers, customers, and reading the trade press to understand the current and likely future environment as much as possible.”
Dempster too believes that “the ever increasing use of digital media in preference to print” is a risk. “However,” she adds, “while the latest research shows that people still like tactile products and print will always have a role, innovation is very important to stay current and many customers still value a more personal service.”
In relation to investments in plant and equipment, she says that a legal audit can ensure that commercial contracts protect a firm. “I have seen too many printers buy equipment that doesn’t work to specification and then struggle to get any real remedy from the supplier.”
The lack of leverage stems from contracts with limitation of liability clauses that excluding liability for loss of profit, loss of savings and loss of business. She adds: “There’s no point spending huge sums to be more efficient only to find that the benefits have been oversold.”
Similarly, as a supplier, she believes it important that contracts need checking to limit risk – “with profit margins being tight a big claim could be disastrous”.
The problem, as Elliott sees it, is that firms fail to forward plan when they are ready to take the next step forward, to seize a new opportunity or step up a gear: “I have seen company investments fall over because of a failure to ensure proper contracts with key customers and suppliers are in place. I’ve also seen one stubborn shareholder refuse to sell their stake and bring in a multimillion-pound deal due to a lack of shareholders’ agreement and ‘drag/tag’ provisions.”
In a situation not unlike that of Express Printing, Elliott’s also seen, due to an old, overly simplistic employment agreement, the head of sales and marketing of a large manufacturer able to walk out of the door and join a competitor. Dempster has found the same, which is why she says that it’s particularly important to “ensure that the management and sales team have restrictions in their contracts to prevent them poaching customers”.
In one case she saw there were no restrictive covenants in a sales director’s contract so he was free to take customers to a competitor.
“I cannot emphasise enough,” says Elliott, “that the sooner you get lawyers onside, the easier it is to navigate any process and avoid unexpected pitfalls and damaging surprises.”
Take checking the corporate structure. When it was published, the Companies Act 2006 was infamous for being the longest act in parliamentary history. This has now been surpassed by the Corporation Tax Act 2009 but it illustrates that as much care and attention should be paid to a company’s corporate transactions as to its financial audit and tax position.
Both Jarrold and Dempster say that external advisers are particularly useful in relation to shareholder agreements as they set out the rules on how the business should be run, when shareholders should be consulted, and also what happens when one or more want to exit.
Another common failing that Elliott often sees “is just how few companies correctly maintain their statutory books”. Now that companies can be incorporated within minutes online, all too often they fail to create the books in the first place. However, it is still a key point of law that legal title to the shares of a company is governed by the company’s register of members contained in its statutory books.
But how to choose an adviser? Jarrold says that trusting word of mouth and your local and industry networks to get an understanding of who’s good is often the best method. “Most importantly, you need a really clear understanding of why you’re using advisers and what you want from them.”
Legal audits can require significant time and investment. While one of the key benefits is to establish a proper documentation and legal affairs record and management system, once in place, time spent on legal and corporate affairs on a day-to-day basis should be relatively minimal.
The timetable and resources applied to a legal audit need to be agreed from the outset. Naturally the fewer resources allocated, the longer it will take and if the process drags on too long some of the information provided will become stale. It will also depend on how large the company is, and which areas of its business or corporate affairs it wants to focus on.
Dempster suggests that a desktop legal audit can be done in a couple of days inexpensively: “It’s a basic ‘health check’ on the business and lawyers should provide a checklist of questions and interview the finance and managing directors.” At the other end of the spectrum is a very in-depth probe which Elliott says means information provision which could take a few weeks with the audit process running alongside and a report completed a week or so thereafter.
The reality for most, as Dempster sees it, is basic housekeeping – “it’s not very sexy but will save you money in the long run”.
Even where a legal audit fails to unearth any significant issues, it should leave the company with a very useful document management system. “Commonly for the legal audit,” says Elliott, “clients would upload all documents to a data room with various headings in a similar way to a sale or acquisition process. Companies can then continue to use such systems to ensure their future documents are well stored and monitored.” And when the company next feels it needs an audit, or is ready to take on a specific transaction, the former process will save it immeasurable time and money as all the key information will be to hand.
Horror stories do exist and it’s not unknown for lawyers to discover that the company is not owned by those who think they own it. Elliott says: “This can happen with older companies where there have been purported share transfers in the past, or where shares have been given to employees who have long since departed.” Dempster has seen other unpleasant situations including one, involving a medium size print business, where there was no shareholders’ agreement and so getting an underperforming shareholder director to leave was problematic.
A legal audit is not a legal requirement. It is, however, good business practice and one which will leave a firm in good stead for times of trouble. As Jarrold concludes: “It’s vital for directors to understand the risk profile of the business and to take steps to forward plan, setting aside time on a regular basis to check that the business is not over-exposed.”
GETTING THE BASICS RIGHT
There are a number of areas of risk that firms need to be aware of when undertaking a legal audit. These include:
Checking and considering a company’s structure and constitution
Making directors aware of their legal duties
Establishing and understanding the position of key employees
Stepping back to see if management has become removed from the shop floor
Protecting the position of the company against undue dependence on key customers and suppliers
Taking a nuanced view of company finances
Checking the status of the business premises
Potential non-compliance risks
Obligations for directors
Keep adequate books and records Maintaining management accounts and adequate books and records is a legal obligation of all directors. Well-kept minutes, accounts or cashflow projections could stop a wrongful trading claim or repel an unfit conduct investigation.
Following professional advice No director can be completely aware of what’s required of them and their company to ensure that everything is above board. This is why most have access to legal, accounting and other experts to offer professional and accurate advice on any number of matters. If your company is facing financial difficulties and you receive such advice it is vital to ensure that you get it confirmed in writing and follow it or have (and record) good reasons not to. Remember that advisers can only recommend a course of action. The final decision remains your responsibility.
Don’t bury your head in the sand If you allow your company to carry on trading while incurring losses and running up additional credit after clear indications that it was headed for liquidation you could become personally liable. Take advice to eliminate that risk.
Directors’ duties The risk of being publicly exposed as a negligent company director goes up exponentially if your company is insolvent or has gone past the point where it cannot avoid insolvent liquidation. The key warning signs are not being able to pay creditors as they fall due; having a negative company balance sheet; and not having a credible plan that shows a company can trade out of financial difficulties.
Apart from looking at the legal structure and risks facing a business, a legal audit is also an appropriate time to dig down into cashflow and forecasts and compare financial performance to forecast targets and the industry average. It will open opportunities for renegotiation with suppliers that are reliant on the company and will also put into sharper relief dependence on late paying customers. Look for those constantly asking for discounts or who change the goals but want the same price as it may be time to sever ties with them – you may need the business but you shouldn’t take on every job that comes through the door.
Consider written agreements with all customers. These should establish clear expectations for when payments are due and what happens when payments are past due, such as charging interest or referral to collections. You could also consider collecting deposits from new clients or ones who are chronic late payers.
In terms of costs, sales, prices and profits, in performing an audit it’s possible to examine sales for signs of year-on-year growth that are not keeping up with inflation while looking at those services that are not making the right level of profit. Similarly, the process should help establish the true break-even point of the business. Don’t assume that cutting staff will bring the balance sheet into rude health.
A legal audit should lead to a greater understanding of how business expenses affect your business. It will also suggest a proper working cash reserve for unexpected events while noting how up to date the business is in paying its bills and if there’s any scope to look for better finance deals. Firms should always benchmark everything that the company buys – not just paper and ink, but everything including insurances, coffee, pens and loo roll.
Fixing issues with working capital
Identifying an issue with working capital management is one thing. Doing something about it is another. If you recognise any of sign of an issue – holding too much stock, cash tied up in equipment, pressure from suppliers to pay faster, or a greater reliance on bank overdraft – a number of actions will need to be taken including:
Ensuring senior accountability and operational responsibility for working capital management
Being proactive in all areas of working capital management, from sales forecasting through to cash collection
Prioritising attention and effort through ongoing segmentation of customers, suppliers and inventory
Using a short-term cashflow forecast as a proactive management tool, not a retrospective measure of cash
Setting cash and working capital targets – monitoring them using a combination of simple key performance indicators and cash calls
Focusing on the day-to-day and not just the period end.
Bookkeeping and accounting systems need verification. Consideration needs to be given to how easy it was to gather financial data to conduct the legal audit. When you can’t access accurate financial data quickly, you run the risk of letting problems spiral out of control before you are aware of them.
Sources of advice
Undertaking a legal audit will require specialist advisors.
The BPIF offers members a number of services that can help with advice on health and safety, human resources, environment, and legal matters (www.britishprint.com/membership-services). Another body that may be able to offer advice is the Federation of Small Businesses (www.fsb.org.uk/benefits).
A good specialist lawyer and accountant is essential. Either ask for recommendations or seek a lawyer from the Law Society’s website at (solicitors.lawsociety.org.uk). It’s possible to drill down by location and area of speciality. In terms of accountants, they can be found via one of the professional accounting bodies, such as the Association of Chartered Certified Accountants, the Institute of Chartered Accountants in England and Wales and the Institute of Chartered Accountants of Scotland.