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Is your capital pie large enough?

Capital allocation’s role in enhancing shareholder value begins with quantity

What ingredients should your board be baking in? Jeff Gerrish explores tapping debt versus equity and the issue of shareholder dilution. What ingredients should your board be baking in? Jeff Gerrish explores tapping debt versus equity and the issue of shareholder dilution.

“Enhance shareholder value.”

This has been my mantra over nearly the last 40 years as it relates to the obligation of community bank directors and officers.

“How do we do that?”

Thanks for asking. In a big picture sense, enhancing shareholder value requires allocating financial and human capital in a way that, when compared to the baseline:

• Increases earnings per share.

• Improves return on equity.

• Provides liquidity for the shareholders.

• Provides cash flow to the shareholders.

• Allows the bank to operate in a safe and sound manner.

I have written about many of these matters in this blog.

Today, I want to focus on the capital allocation component.

Where you don’t begin

Enhancing shareholder value occurs primarily through the allocation of human resources and financial capital towards strategic matters that will, over the long-term, enhance one or more of the items noted above.

Most community bankers hear “capital allocation” and jump right to the outflow of capital—that is, how capital can be used to support balance sheet growth, repurchase shares, provide additional cash flow to shareholders, purchase another bank, purchase a branch of another bank, etc.

The alternatives in this regard are many. However, this is the second step of the capital allocation process.

Where to start

Strategic capital allocation starts with the determination of available capital, whether this is in the form of existing excess capital at the bank or capital that is potentially available to the holding company through debt, equity offerings, subordinated debt, and the like.

The first topic in any discussion about the allocation of capital has to be whether there is existing capital to allocate.

Most often, this involves a consideration of whether excess capital exists at the bank level. (Excess, in this case, being defined as the amount of capital over and above the board’s minimum capital comfort level.)

Some key questions to settle:

• What if there is no excess capital?

• What if the bank needs capital to move forward with certain strategic initiatives that would, over the long-term, enhance value for their shareholders, but does not currently have any such capital available?

• Then where does it come from?

First stop is debt

Where do you go when you need more capital?

My general recommendation for community banks and their holding companies, particularly those with consolidated assets under $1 billion, is to look first to debt capital. (Please note that that $1 billion figure will rise to $3 billion if the recent reform bill passed by the Senate is approved in similar form by the House.)

• This could come in the form of debt from a rich, smart director.

• It could be debt in the form of a bank stock loan from a correspondent bank, bankers’ bank, or another community bank.

• It could be debt from an independent third party.

• It could also be subordinated debt.

If debt cannot meet the need (or at least not all of it), the next step in my recommendation is to look at equity.

Going the equity route

Equity is generally more complicated than debt financing. Anytime a community bank issues shares of holding company stock to raise equity, the company cannot do so without either registering those shares with the Securities and Exchange Commission or issuing the shares pursuant to a valid federal and state registration exemption. That’s the rule. You cannot simply, for example, redeem shares from one shareholder and issue them out to another shareholder without taking any other action.

The good news is that there are a multitude of ways to issue shares to new or current shareholders without registration. (A full discussion of each of these available alternatives is beyond the scope of this blog. Our firm has put together a Clients and Friends Memorandum that discusses each individually. If you would like a copy, let me know.)

For our purposes, the most common exemptions from S.E.C. registration are the intrastate offering exemption and the Rule 506 exemption.

The intrastate offering exemption exempts from federal securities registration the offer and issuance of company stock if the company is organized in or has its principal place of business in a state, only makes sales of the stock in that state, and gets some type of written representation from each investor that attests to the residency of the investor. The state in question will also have some requirements, so make sure to check your state’s laws as well.

The Rule 506 offering exemption is slightly more complex. This exemption allows the company to raise an unlimited amount of money so long as the company does not generally solicit or advertise the offering; does not sell to more than 35 “non-accredited” investors; provides detailed disclosure statement (referred to as a Private Placement Memorandum) to investors to allow them to make an informed decision; and provides certain required financial information.

If the company is able to successfully utilize either of these exemptions, then the company can issue shares of its stock without having to register with the S.E.C. (and without having to medicate the resulting headache).

Another wrinkle: dilution

Regardless of the specific exemption that is utilized, any community bank board considering the issuance of shares to shareholders has some very practical considerations directors should bear in mind.

The first major consideration is ownership dilution. Unless an existing shareholder purchases his or her pro rata portion of any new stock issuance, then that shareholder’s ownership in the company would be diluted.

If the shareholder only owns between 7% and 10% of the stock, then it may not make a significant difference. It will, however, make a significant difference if the shareholder is a 51% shareholder. For this reason, ownership dilution has to be considered.

Another major consideration is book value dilution. If shares are sold at less than book value (which we hope would not be the case) then that will result in book value dilution for the remaining shareholders.

The more common scenario is that shares are sold at above book value, which results in book value accretion for the existing shareholders. There are always exceptions, though, so make sure to keep book value dilution in mind as well.

Remember the name of the game

As your board considers the potential sources of capital, remember that the goal is to enhance shareholder value.

Again, my general recommendation is to first consider existing capital; then debt leveraging ability of the holding company; then an equity offering (either registered or ideally exempt from registration).

Make sure at each step along the way you are considering what is in the best interests of the shareholders.

If an allocation alternative makes sense with existing capital or debt, but it does not make financial sense if it requires the issuance of additional stock to new shareholders, then the board has the responsibility to draw that line in the sand.

Some things only make good sense from an “academic” perspective. If at any point along the path of bringing a capital alternative to fruition it stops being in the best interests of the shareholders, then the board should choose a different path.

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