Over the past decade of operating my advisory firm, Euro-Phoenix, I have encountered relatively few instances where a financial advisory firm knowingly breached laws, industry or ethical standards; instances of overt contravention are relatively few and far between.

That does not mean that users of corporate finance advisory services should just assume that the issue of ethics is not important. Ethics are of paramount importance. Allow me to mention some areas where ethical issues can arise:

A.Potential conflicts of interest on due diligence of a buy-side mandate
Several years ago, Euro-Phoenix was working on the buy side of a cable TV mandate in Bulgaria. We uncovered some hidden liabilities on the target company. We did not hesitate for a second to disclose this to our client, knowing full well that we were eliminating the possibility of a success fee, but if you think about it, any advisor on the buy side of a mandate has a similar potential conflict.

B.Setting fees
Fee structures agreed with advisors should be fully aligned with the interests of their clients. For example, if you hire an advisor to buy a company for you, and offer him a success fee based on a percentage of the purchase price, your advisor may have a conflict of interest. The higher the purchase price he negotiates, the higher his success fee will be, which is likely to produce an undesirable result. In my experience, a pre-defined lump sum fee works best in such circumstances.

C.Collecting a fee on the other side of a transaction
Euro-Phoenix was once engaged in selling a major asset for a multinational corporation. We received four offers. Three of those offers came with an explicit bribe from the offering investors: help ensure that a particular investor obtains the asset, and work on driving the price down rather than up - and the investor would be willing to pay us a success fee even larger than that offered by our client. (When we expressed our concern to one particular investor, he hastened to add, "Don't worry - you can collect the success fee from your client as well!") Are you sure that your advisor will resist temptation? Some jurisdictions (eg. the UK) specifically forbid financial advisors from collecting fees on both sides of a transaction.

D.Where a financial advisor is also in the private equity business
Can you be sure that there are strong Chinese walls in place? I am aware of one situation where a private equity firm related to a particular financial advisory firm made an acquisition in the cable TV area. Whereas previously the advisory firm had had a vibrant business in the cable TV sector, to the best of my knowledge it never achieved another mandate in that sector, because the owners or managers of cable TV firms could not be fully confident that their confidential information would not end up in the hands of a competitor.

E.When a financial advisor also provides audit or other services to a client
In a number of Central European jurisdictions (eg. Croatia), it is forbidden by law for a firm that provides audit services to a client to provide financial advisory services or any other services to the same client. (The US, UK, and France, also have restrictive regimes, preventing audit firms from deriving non-audit fees from audit clients). The potential conflicts of interest are numerous. Obtaining a generous success fee on a corporate finance mandate could just provide the right incentive to be more "flexible" with respect to some sticky points in the audit.

I hope that the five illustrations above have at least given you pause for thought. The ethics of your advisors are at least as important as their knowledge and technical skills.

On the one hand one could say that selling companies is the same anywhere in the world, and there is some truth to this: intellectually, the concepts are the same, the steps in the process are the same, and the reasons for the success or failure of a transaction have common elements all over the world.

Having worked on transactions covering more than 40 countries, I can testify to these similarities.

And yet, on the other hand, there are distinct differences to doing deals in Central Europe. But it is hard to put my finger on exactly what these differences are. Perhaps it has something to do with the fifty years of Soviet occupation of most of the region.

During this era, there was no M&A industry in Central Europe; there was a general lack of financial, marketing and other skills; there was a prevailing value that "information was power," and one held his or her cards very close to the chest, only revealing the minimum necessary information. Without giving an exhaustive list of all the characteristics unique to Central Europe in contrast to North America or Western Europe, these include:

• Good information about companies is much harder to obtain. For example, fewer companies, even of comparable size, have sophisticated Management Information Systems.

• Regulatory regimes are not as developed. While most Central European countries have converged considerably with EU laws and institutions, there are often still gaps in enforcement or interpretation of regulations. The regime for collection of debts in Croatia, for example, is remarkably poorly developed.

• Tax laws in most Central European countries are typically not as well conceived, are changed much more frequently, and their enforcement is more uneven.

• The authorities perhaps have more discretionary powers, making it harder to predict risks.

• There is also a much more prevalent grey economy than in Western Europe or North America. This means there is a need to look very carefully at companies that are being purchased, doing a very thorough due diligence. It also means that if an investor buys a legitimately operating company, it may experience unfair competition from those that are not.

For anyone attempting to do a cross-border deal in Central Europe, there are also a great deal of significant cross-cultural elements to doing a deal. The cultures of every single Central European country are highly unique. This is of course just as true for Western Europe.

Language in cross-cultural deals is another potential dimension of complexity. Recently, for example, I was involved in one deal that was negotiated in four languages.

Deals in Central Europe are typically smaller - market size is typically small, and few companies have become global or even regional.

Transactions typically take longer, due to the additional elements of complexity posed by the aforementioned factors.

So, as you can see then, doing deals in Central Europe has a flavor of its own. I do not mean this as a negative point. Doing a smaller mid-sized deal can be more exciting and intellectually stimulating than much larger deals in more developed markets.

From the perspective of multinationals and private equity firms, because Central Europe is generally undergoing much faster growth than Western Europe - a fact likely to remain the case for the coming decade or two - the additional complexity may be worth the effort.

There is also a convergence taking place. Deal sizes in Central Europe are becoming larger, ever increasing numbers of people are conversant in English, tax laws and regulations are gradually becoming clearer and their enforcement more predictable.

I have seen a huge evolution over the past 20 years, but it will probably take at least another 20 years before Central Europe fully converges with Western Europe.

Almost every business owner dreams of hitting the jackpot by going public on a stock exchange. Yet when many find out what is involved in taking their company public, they recoil in horror, rapidly coming to the conclusion that this is not for them. This article summarizes the pros and cons of going public for mid-sized businesses in Central Europe.

The case against going public

The case against going public could be summarized under the following headings:
(a) Costs and risks of going public. Taking a medium-sized company public on a Central European stock exchange can easily cost hundreds of thousands of euros, possibly even millions. The company must fund these costs prior to the IPO. If market conditions change and the IPO fails, the company will still be saddled with considerable expenses; despite the fact that the majority of costs are usually success related, there are still likely to be considerable fixed costs (eg. legal fees). The risk of such a public failure concerns some business owners, not just in terms of the money involved but also because of the possible negative publicity.

(b) Costs of ongoing information provision and compliance. A public company must be fully transparent. At the time of going public, an Offering Memorandum must provide full disclosure of all the information relevant to potential investors assessing the company. After going public, the company must generally file quarterly statements intended to update the shareholding public with respect to all material developments concerning the company. Collecting and disseminating this information has a cost, in terms of the staff time required to collect the information and create the reporting. Furthermore, giving your competitors detailed information on your operations may also have a less quantifiable but potentially very damaging cost. Also, there are various costs related to compliance: stock exchanges will generally require public companies to have a board of directors (who will in turn ask for liability insurance) and various committees of the Board (eg. Audit Committee, Compensation Committee, etc.) and the costs involved in these can be significant.

(c) Cost of shareholder communications and public relations. Once a company goes public, it must maintain ongoing communications with shareholders and the general public. The company must develop a core of analysts who follow and report on the company. This is generally only worthwhile for analysts once a company's market capitalization reaches a certain scale (e.g. often in the hundreds of millions of euros). If such a following in the analyst community fails to develop, the general public does not receive the information and independent verification that it requires in order to develop the confidence necessary to invest in the company's shares. This can cause the share price to languish far below the price at which the company initially went public, and also far below the real worth of the company. This in turn then may make it more difficult to raise additional financing or to engage in Mergers & Acquisitions, as any investors will tend to use the market capitalization of the company as a proxy for the value of the company.

(d) Possible liabilities. A company that does not give full disclosure (eg. where there is an error, omission or delay in information provision) may face potential liabilities. Class actions by shareholders are common in the United States. Fortunately, the Central European environment is not as litigious, but the possibility of liabilities still remains.

(e) New skill sets and corporate culture. Going public often requires new skill sets and corporate culture-more emphasis on reporting may diminish entrepreneurialism. The corporate culture may need to change to one of greater transparency, or to a more "short-term" way of thinking (e.g. meeting targets for the next quarter).

(f) Possibility of hostile takeover. Once the owner of a business sells more than 49% of their shares, he or she may wake up one morning to face the risk of losing control of his or her company in the event of a hostile takeover bid.

The case for going public

The main reasons for going public on the other hand can be summarized under the following headings:
Raising equity at favorable valuations. An IPO may allow shareholders to raise substantial fresh equity at favorable valuations. This may be used to fund the exit of one or more existing shareholders, or to raise fresh equity for the company. If the timing is right, when market conditions are good, the equity raised can be extremely cheap-for example, on the Warsaw Stock Exchange, at the peak of the market several years ago, IPOs were carried out at over 25 times EBITDA (Earnings Before Income, Tax and Depreciation).

Creating a currency for acquisitions or compensation. Where a company has an aggressive acquisition program, it may use its own shares to fund acquisitions, rather than cash. Similarly, it may offer shares rather than cash to management or other staff, in lieu of bonuses. This permits the company to conserve cash and may motivate management (or shareholders in the acquired company) to work hard in order to further improve share prices.

Conclusions

An IPO is not for every company. However, for a small minority of companies, it may be an appropriate step to take, consistent with the objectives and strategy of the company and its shareholders. An IPO certainly does not provide a solution for an owner/CEO to exit in the short-term. Generally, a compelling growth story as a necessary prerequisite for a successful IPO. An IPO is a decision which requires careful consideration.

If you are looking to undertake a transaction such as raising capital or selling your company, a lawyer will be a vital part of your team. This article will first describe the role that a lawyer will typically play in a transaction, then provide guidance on how to select a firm or individual who may best fulfill that role.

The lawyer’s role in a transaction

There are many legal dimensions to a transaction, including:

• Information disclosure to investors. The process of selling a company or raising capital involves an enormous amount of information transfer to investors – whether in the information memorandum, data room, or just questions answered informally. At a minimum, a lawyer should prepare or at least review all information disclosed to investors that is of a legal nature (e.g. information on ownership and clean title to real estate, assets, etc.; information about the regulatory environment in which your company operates; and information about litigation in which your company is involved, etc.) You may, as a matter of prudence, also wish to have your lawyer review all material information passed onto an investor.

• Deal structuring. Should the investor purchase assets or shares? Should the investment be by way of injection of fresh capital into the company? Is an “earn out” appropriate, and if so, how should it be structured? Skilled lawyers are experts on transaction structuring.

• Drafting legal agreements. There are numerous legal agreements which may be required in the course of a transaction: confidentiality agreements, term sheets, heads of agreement, employment agreements, shareholders’ agreements, non-compete agreements, and the sale and purchase agreement. Of these, the sale and purchase agreement is typically the most crucial and difficult, especially the portion pertaining to representations and warranties, and limitations to such liability, and implications of any breach. In other words, if the owner of a business sells all or a portion of the shares of a company, he or she will usually need to represent and warrant that the information provided was full, true and plain disclosure, and that there were no errors or omissions in the data room, and possibly in the information memorandum or other documents as well. The investor will typically reserve the right to claw back all or a significant portion of the purchase price in the event that there were material errors or omissions.

In other words, a significant portion of your purchase price depends on your lawyer. Select your lawyer carefully.

Selecting your lawyer

Your lawyer should be someone you know and feel that you can rely on – don’t hire a mercenary, but someone you can really trust, with sound judgment and advice. However, one of the most common mistakes a business owner may make is to select a lawyer with whom he or she may have a long-standing relationship (e.g. the company’s general commercial counsel) – who may have little or no transactional experience – to act on a transaction. This is no more appropriate than asking your commercial counsel to represent you in a divorce hearing.

The lawyer you select should have acted on at least half a dozen or a dozen transactions. Try to find out your lawyer’s track record with respect to those transactions. Did the transactions close successfully? Obtain some references.

Another important point: your transactional lawyer should be an excellent negotiator. Often the negotiation on representations and warranties is tougher and more challenging than negotiating price. All the legal knowledge in the world is of limited use unless your lawyer is a capable of projecting that knowledge and achieving positive results in negotiations.

Should you hire a sole practitioner or a law firm? Larger transactions definitely require an entire legal team, and hence require the services of a law firm. In such cases, you should select one lawyer within the firm and ensure that he or she personally has the requisite credentials, and that he or she will personally supervise all work and be present at important meetings.

It is important to find a lawyer who does not feel compelled to participate in or influence the commercial aspects of the deal – which should be left to the principals and their financial advisors – unless otherwise requested by the client. And your lawyer should not only point out the risks involved in any transaction, but be capable of offering solutions in risk management, for example through creative deal structuring.

In short, your lawyer can make a tremendous difference: between your transaction closing or not closing; between your becoming embroiled in litigation or not; and between a substantial portion of your purchase price being clawed back by the investor or not. Your choice of lawyer is one of the most important decisions you will make determining the success of your transaction.

A financial advisor, like a lawyer, may be an effective advocate of a client’s interests and provide valuable advice that can make the difference between success or failure of a transaction, or provide advice whose implications may be measured in the many millions of euros. And yet there seems to be a pattern of questions and expectations that reveals a lack of understanding of the limitations surrounding the role of financial advisors. I summarize these in the following three “don’ts” to bear in mind when hiring a financial advisor:

1.    Don’t expect an advisor to estimate the value of your company before you hire him

The potential for error in such a rapid, back-of-the-envelope valuation is enormous. A thorough valuation usually requires use of multiple methods (Discounted Cash Flow or applying appropriate multiples). A quick valuation is done solely on the basis of multiples, making it usually much less reliable than Discounted Cash Flow. Furthermore, when you apply multiples to perform a valuation, there is a risk of magnifying the error if you are multiplying the wrong number.

For example, if a business is valued at six times cash flow and the company’s owner pays himself a salary that is €100,000 below market salary, the company will be overvalued by approximately €600,000. The financial statements of a company must be carefully examined before applying multiples.

Furthermore, there may be a number of factors unknown to an advisor who has not had the chance to look at a company thoroughly. What if there is litigation or a threat of litigation against the company? What if the company is about to lose its most important client? What if there is new technology on the horizon that is about to disrupt the industry? In any of these cases, a quick valuation is likely to be highly inaccurate.

So how should a client handle the issue of valuation when hiring an advisor? Ask questions that ensure your potential advisor thoroughly understands the principles of valuation and has experience in the subject. If your decision to proceed with a transaction or not depends on valuation, the first few weeks of a mandate should permit an advisor to provide an estimate of valuation and the client’s decision to proceed with a transaction could be conditional on the advisor arriving at a threshold valuation.


2.    Don’t ask an advisor to introduce an investor before you give him a mandate

All too often, a client will ask an advisor to bring a potential investor to the table before giving him a mandate and proceeding with a transaction. This is usually an error, for two reasons:

First, in the event that the investor is interested, the company will typically be completely unprepared to follow through (i.e. it will be unable to provide the interested investor with the huge amount of information he is likely to require, a disclosure which typically requires months of preparation).

Second, if the company starts down the road of negotiating with one investor, it becomes more and more difficult to bring other potential investors into the process. In this way, the company foregoes the possibility of entering into a truly competitive process, a process which usually has the effect of driving up price, improving the terms and conditions of a transaction and improving the likelihood of closing a transaction (please refer to our previous entry on this subject).

So what should the owner of a company do? Simple: allow an advisor to prepare the company appropriately, then bring multiple investors to the table in a competitive process.

3.    Don’t expect an advisor to work for a success fee only

As the saying goes: if you pay peanuts, you’ll get monkeys. As with any hiring situation, ensure that the individual or company you are hiring is appropriately motivated. Given that a client usually has the liberty, at any point in a transaction, of refusing any offer, or indeed even calling off a transaction, an advisor working on a success fee alone is unlikely to invest the time necessary to do a thorough job or may be motivated only to “skim the cream” (e.g. try to opportunistically close a transaction with just the bare minimum of preparation or proactive marketing). This is seldom in the client’s best interest.

Under the socialist regime, tangible items had value; intangibles, including advisory services, were seldom if ever attributed value. Central Europe is rapidly evolving towards a capitalist market system, where it is becoming increasingly acknowledged that intangibles, including advisory services, are often at least as valuable as tangibles. While this understanding has evolved considerably over the past two decades, there is still a fair distance to travel.