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1- What are your biggest concerns about the prospects for this business?

2- Select Does Troika Potato Chips look like an attractive investment opportunity? Why or why not?

3- Select If additional information should precede the decision to invest, what is that information and where should he obtain it?

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Troika Potato Chips (A)1 St. Petersburg, Russia J ohn M irren drummed his fingers impatiently on the dashboard as he sat in the usual M osco w tra ffic jam. He w as a managing director o f a Britisho w n e d, M osco w-b ase d invest me n t f u n d t h a t ma d e investments in various businesses throughout Russia. John sa w many business plans, written w ith various degrees o f competence, every w eek, and he had to decide w hich ones w arranted f urther investigation. As part o f his job, he visited companies that seemed especially promising. John le f t his job at a London investment boutique in 1990 to take a job in Russia at a time w hen Russia w as considered the land o f unlimited opportunity. He had a background in the region because he studied Russian history, literature, and language in university and had spent a year in St. Petersburg writing his senior thesis. As managing director o f the investment f und, he had been extensively involved in evaluating and managing many projects, a f e w o f w hich turned out to be spectacular successes, but many o f them barely broke even and some w ere complete f ailures. That w eek he w as considering several plans. There w as a f urniture f actory in Novosibirsk that w as making good quality copies o f Russian Empire f urniture, as w ell as more modern f urniture, and it needed investment money to expand operations. A n interesting proposal — to open a f ast f ood restaurant in Yekatrinburg — had come into the o ffice last w eek. That seemed very promising since the potential manager had considerable restaurant experience, both domestic and international. There w as also a proposal to open sorely needed self-service laundries in M osco w. Ho w ever, that propos- 36 al needed care f ul examination since they w ere asking f or a considerable sum o f money. A m ore m o d est b usin ess pla n h a d co me fro m St. Petersburg. Three diff erent legal entities with experience and expertise in diff erent fields had joined together to propose a company to produce and sell potato chips to the St. Petersburg market. T he f ormal business plan f or this proposed startup f ollo ws. John had to decide if the business w arranted his investment, given all he had learned about investing in Russia (see A ppendix). Business Plan2 Summary T he proposed project envisions the establishment o f a ne w enterprise that will produce high-quality, co m p e titively-price d p o t a t o chips in t h e to w n o f Komarovo, not f ar from St. Petersburg. 3 The initiators have f ormed a separate legal entity called “ Troika ” specifically f or the purpose o f realizing the project. Th e p o t a t o chips w ill b e sold u n d er t h e “ Troika ” brand name. The initiators hope to attract an outside equity investor and use the invested f unds to purchase specialized, high-quality, imported processing equipment that will enable them to produce and package w orld-class potato chips to be sold through both w holesalers and retailers in the Leningrad O blast (region). The preparatory stage has been completed, and practically all key aspects have been w orked out by the ini- TROIKA POTATO CHIPS (A) tiators. The enterprise has acquired a production site (building and land) and a specialized potato storage f acility. W ith the purchase and installation o f processing equipment, and a complete renovation o f the production site, production can begin. A preliminary agreement to purchase equipment has been reached with a Dutch firm considered a leading producer o f f ood processing equipment. The principal ra w ingredient, potatoes, w ill be supplied by the agricultural consortium Komarovo w hich is one o f the f ounding partners in Troika. The financial requirements f or the realization o f the above project are as f ollo ws: an equity investment o f $803,600 f or the purchase o f production equipment, and a short-term credit o f $236,000 f or startup capital. The time frame f or the realization o f the project is 10.5 years. The expected net pro fit at the end o f this period is $2,269,000. Pro fits w ill be reinvested to modernize or expand existing operations or used to start a ne w venture. The Enterprise GENERAL INF ORM ATIO N Troika is registered as a closed joint-stock company in the to w n o f Komarovo, Leningrad O blast. 4 The venture’s principal activity is the processing o f agricultural products, specifically, the production o f potato chips. Troika’s f ounding partners are three independently regist ere d org a niz a tio ns. Th e first is t h e a gricult ural Consortium “ Komarovo, ” a closed joint-stock company w hich w as a state-o w ned f arm until 1994. Komarovo o w ns 11,500 hectares o f f arm land, and it is the largest producer o f potatoes in Russia’s north w estern region. The second is “Baikal, ” a joint-stock company f ormed in 1995 by a group o f producers, w holesalers, and retailers o f f ood products. 5 Together, Baikal’s shareholders make u p a d evelo p e d distrib u tio n n e t w ork coverin g St. Petersburg and the surrounding region. The last is “ Znamya, ” also a closed joint-stock company w hose principal activity is processing agricultural products. Baikal - access to a distribution net w ork coverin g t h e CIS, co n trib u tio n valu e d a t 40,000,000 rubles; Znamya - potato storage f acility valued at 20,000,000 rubles. The initiators agreed that Baikal w ould withhold its cash contribution o f 40 million rubles until the purchase and installation o f production equipment. Thus, as o f July 1, 1995, 60 out o f 100 shares o f common stock w ere paid f or in f ull. APPRAISING M ARKET VALUE O F STOCKH OLDERS’ EQ UITY Since Troika is a ne wly created enterprise, it has not incurred any debt or losses. The fixed assets o w ned by the company are as f ollo ws: land building potato storage f acility 1.5 hectare 420 sq. meters 480 sq. meters In ord er t o minimiz e t axes, t h e Fo u n din g Ch art er assigns to assets the lo w est possible value allo w ed by Russian la w. The actual market value o f these assets is significantly higher. 6 For example, the cost o f property in the area is bet w een $10,000 and $15,000 per hectare. The cost o f constructing a similar building is $84,000, and the storage f acility has been appraised at $60,000. Thus, the actual market value o f Troika’s fixed assets is approximately $159,000 but that w ould fluctuate as the political and economic climate in Russia changes. DECISIO N M A KING Regular shareholder meetings are to be held t wice a year. A dditional meetings can be initiated by a shareholder holding a minimum of 25% of common (voting) shares. Decisions can be approved provided shareholders holding a minimum of 50% of voting shares are present. Critical decisions, such as changing the Charter, re-organization, and liquidation of assets, require a 75% presence. Troik a w ill b e m a n a g e d by a Bo ard o f Direct ors, appointed by shareholders, with A lexander I. Ivanov serving as chairman. CO NTRIBUTED CAPITAL PRO FIT SH ARING As o f July 1, 1995, st ock h old ers’ e q uity t o t als 100,000,000 rubles [US$1 = 5,000 rubles at that time]. There are 100 shares o f common stock, each w ith a n o min al valu e o f 1,000,000 ru bles. K o m arovo a n d Baikal each o w n 40 % o f the shares, and the remaining 20 % is held by Znamya. Net pro fits w ill be distributed among shareholders as dividends. The dividends are to be approved at general shareholder meetings. Th e f o u n d ers o f Troik a co n trib u t e d t h e f ollo w in g assets, in lieu o f cash, f or shares in the enterprise: Komarovo - building and land to be used f or production, valued at 40,000,000 rubles; The Product Troika potato chips w ill be produced and packaged with equipment manu f actured by a Dutch firm, Florigio Industrie, using only natural, high-quality ingredients. The principal ra w ingredient is potatoes, not the customary processed potato concentrate, so as to give the finished product a more natural potato taste and smell. 37 CASE STUDIES Florigio Industrie is a leading producer o f f ood-processing technology. This technology will enable Troika to produce both regular chips and flavored chips up to the highest w orld standards. The chips will be packaged in 100 gram plastic packets bearing the company logo. Highest quality packaging materials (also Dutch) w ill be used, ensuring the chips remain fresh f or up to six months. Package labeling w ill be in Russian. Since potato chips are neither a staple nor a luxury product, demand is determined by price and quality. Troika chips will be cheaper than imported brands and o f higher quality than domestic brands, so it is expected that they will be very popular. Analysis of Market and Competition Potato chips w ere produced locally in the 1960s and 1970s, t h e n disco n tin u e d u n til 1992. Local m ark e t research indicates that the product currently enjoys a 90 % a w areness among the population. In St. Petersburg, Western-style supermarkets selling brand name, imported products carry the w idest assortment o f potato chips. These supermarkets cater to consumers with high purchasing po w er. Potato chips are also available in f ood stores selling primarily Russian products and in 10 to 15 % o f all kiosks. 7 These stores o ff er a narro w er range o f products and usually carry no more than t w o brands o f potato chips. M arket research sho ws that about 60 % o f the local population consumes potato chips with some regularity. A large segment o f potato chip consumers is aged bet w een 5 and 18. A t the moment, the market has no obvious leader. Since market research indicates that potato chips are a price elastic product in high demand, it could be concluded that expanding the consumer base by lo w ering the price w ould greatly increase sales. A consumer survey conducted by the St. Petersburg State University Economics Department con firms this f act, sho wing that 90 % o f potential buyers o f potato chips re frain from buying due to high price. The remaining 10 % choose not to buy because o f perceived lo w quality or f or some other reason. The survey also f ound that lo w ering the price o f potato chips by 30 % makes them a ff ordable to 20-30 % o f potential consumers, compared to the 10 % potential buyers w ho can a ff ord to buy them at today’s prices. Troika’s main competitors are f oreign producers, f ollo w ed by domestic producers. Domestic competition is not likely to become a f actor f or at least 3 to 4 years. Presently, the region is supplied by Finnish, Dutch, Isra eli, a n d A m erica n pro d ucers. Re t ail prices f or imported potato chips sold in elite supermarkets are bet w een $.95 and $1.65 per 100 g package, making 38 them a ff ordable to only 7-10 % o f the population. O ther stores sell chips at comparatively lo w er prices, from $.75 to $.90 per 100 g. These chips are produced by Russian, Baltic, and Polish companies. Some w idely distributed brands o f potato chips and their prices per 100 g package are as f ollo ws: SUPER (Holland) $1.12 to $1.52 SPECIAL SN ACKS (M osco w) $ .56 MINI SN ACK (Israel) $1.43 RA FFLES (Poland) $1.74 Koloss, another major domestic brand, is also relatively inexpensive. Due to a number o f f actors, primarily high tariffs, retail prices o f imported chips are kept relatively high. Thus, only a limited number local w holesalers can a ff ord to purchase potato chips from abroad. In f act, a survey o f the w holesale market sho w ed that imported potato chips are distributed by only three o f the 15 largest w holesalers o f f ood products in the area. O f the 20 largest supermarkets in St. Petersburg, only f our sell potato chips. These figures demonstrate that choice and availability o f potato chips in St. Petersburg and the surrounding area is limited. A t the moment, no local producers o f potato chips use imported, high-quality equipment. In general, the simple, lo w-tech processes employed by these companies make them incapable o f producing on a mass scale. Furthermore, the packaging o f local chips is not consistent w ith w orld standards. A care f ul pricing strategy, a high quality product, and good packaging w ill enable Troika to successf ully compete w ith local as w ell as f oreign producers. Troika chips will diff er from imports in price (30-40 % cheaper), and from domestic substitutes in quality and packaging. Until more local mass-producers o f potato chips enter the market, w hich is not likely to occur f or the next three to f our years, the demand f or the product w ill remain unsatisfied. By the time equilibrium is reached, Troika is expected to have gained a 5 % share o f the local market, producing and selling 289 tons o f chips per year. In summary, the market situation can be characterized as f ollo ws: absence o f a clear market leader limited choice and availability o f high quality potato chips high price elasticity f or the product slo wly but steadily increasing demand increased domestic competition in the next three to f our years TROIKA POTATO CHIPS (A) Marketing and Pricing Strategy develop strategy and manage all marketing e ff orts. The marketing plan consists o f three general components: (1) pricing strategy, (2) advertising campaign, and (3) continuous analysis o f the changing market situation and integration o f ne w in f ormation into overall strategy. It is estimated that within the first t w o years o f the project, the cost o f advertising will reach approximately $15,000 annually. As local competitors enter the market, advertising expenditures will be increased and the advertising strategy will be modified accordingly. A t this stage, advertising w ill become more aggressive, f ocusing on maintaining market position as w ell as on attracting buyers o f other brands. A dvertisements on local radio and television will be added at this time. By the third year, advertising expenditures are expected to increase to about $25,000 annually. The product’s competitive advantage is based on its: • high quality • image (modern, eye-catching package design) • lo w production cost (use o f locally gro w n potatoes) • being ahead o f domestic competition Since m ark e t rese arch sh o ws t h ere is u n m e t local demand, Troika chips will be marketed initially in the St. Petersburg region using Baikal’s distribution net w ork o f over 400 selling points. W hen the local market is saturated, other regions w ill be explored. Troika has obtained all necessary licenses, including certification from the M inistry o f A griculture, to produce and sell its products. Organization of the Production Process In the first five years, gro w th in sales will be based on the expansion o f the consumer base rather than on the elimination o f competition. Troika chips w ill be priced on average 35 % cheaper than imports, and 10-20 % ch e a p er t h a n d o m estic su bstit u t es, m a kin g t h e m a ff ordable to a larger segment o f population. The initiators have w orked out all key operational aspects. A ll actions w ill be perf ormed according to the schedule sho w n in Exhibit 1. The preparatory stage, during w hich equipment w ill be installed, building renovated, and personnel trained, will last six months. Full production capacity is expected to be reached f our months a f ter the start o f production. The minimum w holesale price o f $0.4125 allo ws retail prices to be maintained at competitive levels. The use o f local potatoes minimizes expenditures on the principal ra w in gre die n t, since p o t a t o es su p plie d by o t h er regions have a 10-15 % mark-up re flecting added transportation costs. Ra w material expenses (potatoes, oil, spices, etc.) constitute 80 % o f total production costs (Exhibit 6). Competitive pricing will allo w Troika to realize its sales objectives. The production line requires a space measuring 200 square meters with a height o f 3 meters. W ith the completion o f renovation, w hich includes replacing electrical and w ater provision systems, the production site will satisfy all technical requirements. Beyond housing the production line, the building will contain an o ffice, kitchen, bathrooms, and space f or storing packaging materials. The site is easily accessible from a major highw ay. Product image w ill play a significant role in attracting potential buyers. The chips will be packaged in multicolor polypropylene packages that prominently display the Troika brand name. The packaging will be modeled a f ter Western standards both in quality and presentation and in guarantees o f freshness. In order not to alienate Russian buyers, in f ormation and company logo displayed on the package will be in Russian. 8 The product w eighs 100 g and will be distributed to retailers in cardboard boxes. A n agrarian specialist will be hired to ensure that the potatoes purchased are o f the highest quality. To prevent rotting, the potatoes will be stored in a specially adapted w arehouse. A permanent contract w ith the potato supplier Komarovo is in e ff ect. The Consortium o w ns 300 h ect ares o f f armla n d, e ach pro d ucin g bet w een 16 and 18 tons o f potatoes per year. Vegetable oil will be supplied by ARK O , a company located in a city about 400 miles south o f St. Petersburg. The initiators o f Troika have close ties with this supplier as w ell. The product w ill be promoted through a multi-stage advertising campaign utilizing printed and electronic media. The first stage o f the campaign w ill f ocus on gaining maximum exposure and creating brand a w areness f or Troika potato chips. The product w ill be introduced with printed advertisements placed in buses, metros, trains, and points o f purchase. Promotions will be held at trade f airs, at local civic celebrations, and in schools. A qualified marketing manager will be hired to The production equipment supplied by the Dutch firm Florigio comes w ith enough spare parts f or one year o f operation. The choice o f Florigio as equipment supplier is based on (1) its competitive price among imported analogues, and (2) its higher quality compared to similar domestic equipment. The production line is capable o f processing 400 kg o f potatoes per hour, resulting in 100 k g o f finish e d p o t a t o chips every h o ur. A pproximately 5 % o f completed product is expected to 39 CASE STUDIES be de f ective. Florigio w ould also supply packaging materials that come imprinted w ith the company logo and product in f ormation in Russian. Production will go into recess during July and A ugust w hen harvested potatoes are unsuitable f or potato chips. The enterprise plans to hire a 22-person sta ff. The technical personnel w ill undergo a training session conducted by Florigio experts w ho w ill remain t w o months at the Troika production site. Training expense totals $7,500 and is included in the budget. A ll equipment maintenance w ork w ill be perf ormed by specialists trained by Florigio. Risk Factors The f ollo wing list identifies some o f the risks f acing the enterprise. 1. Hig h ra t e o f in fla tio n, co u ple d w it h fre q u e n t changes in tax and licensing requirements, encumbers long-term financial planning and cost estimation. stabilized, they are seeking an outside investor. This investor will be o ff ered ne w ly issued stock in the enterprise. The total amount required o f the investor is $837,100. The initiators w ill contribute $132,700. Funds w ill be invested in the enterprise in the f ollo wing order: 1. Baikal will contribute 40,000,000 as payment f or its shares in the enterprise (40 shares at nominal price o f 1,000,000 rubles). 9 2. Redistribution o f common shares: Komarovo and Baikal will purchase 10 and 5 shares each, in that order, from Znamya. 3. The second stock o ff ering will be organized, and an equity investor brought in. A f ter the outside investor is brought in, common (voting) shares w ould be distributed as f ollo ws: 2. The initiators have no experience in potato chip production. 3. A bad potato harvest could have a negative impact on quality, quantity, and price o f potato supplies. 4 The break-up o f the f ormer Soviet Union has ruptured old inter-regional ties that f ormerly guaranteed a regular supply o f ra w materials. 5. The start o f production could be postponed due to delays in delivery and installation o f equipment or a delay in the completion o f building renovation. 6. The initiators could encounter difficulties in obtaining financing. 7. Competitio n from d omestic pro d ucers may have greater impact than expected. A ll o f the above f actors are taken into consideration in making financial projections. The organizers are engaged in a search f or an additional so urce o f p o t a t o es in case t h ere are pro ble ms with the contracted suppliers. Competition from local producers w ill not be a f actor f or at least three to f our years and there f ore will have no negative impact on the economics o f the project in the first stages. W hen competitors do enter the market, Troika w ill have established a strong market presence w ith its products enjoying wide brand a w areness. investor: up to 40 % Baikal: 25-30 % Komarovo: 30 % Znamya: up to 5 % Limiting the investors’ share to a maximum o f 40 % o f common stock is a condition set at the insistence o f the Leningrad O blast A dministration, w hich is a 49 % o w ner o f Baikal. A ll pro fits will be distributed as dividends in proportion to o w nership stake. Priority will be given to shareholders w hose contribution financed the purchase o f equipment and the renovation o f production site. Troika proposes to issue 65 additional shares o f common stock and 43 shares o f pre f erred stock o f Type A and Type B. The holder o f pre f erred shares has no voice in the management o f the enterprise, but has priority in dividend distribution. DISTRIBUTION OF SHARES AMONG THE STOCKHOLDERS AFTER SECOND STOCK OFFERING DISTRIBUTION OF COMMON SHARES BEFORE INVESTMENT Komarovo Baikal DISTRIBUTION OF COMMON SHARES AFTER INVESTMENT Number of shares % Number of shares 40 40 40 40 50 45 % DISTRIBUTION OF PREFERRED SHARES Type A Type B 30.3 27.27 —— —— —— 14 Znamya 20 20 5 3.03 —— —— Investor —— —— 65 39.39 29 —— 100 100 165 100.00 TOTAL 43 Financing and Distribution of Profits The initiators considered t w o possible methods f or financing the purchase o f equipment: leasing and equity investment. Since leasing la ws in Russia have not yet 40 The f ace value o f each share w ould remain 1,000,000 rubles. A f ter the second stock o ff ering, Troika’s stockh old ers’ e q uity w ill h ave a n o min al valu e o f TROIKA POTATO CHIPS (A) 208,000,000 rubles. 10 Pre f erred stock w ould constitute 20.7 % o f total capital, w ell within the bounds o f the la w w hich places a 25 % cap on pre f erred shares. Shares w ould be sold at a price o f $8,905 per share. The investor w ould acquire 94 shares (65 common, 29 pref erred) f or a sum o f $837,100; Baikal w ould purchase 14 ne wly issued pre f erred shares f or $124,700. Setting the actual price above the nominal price w ould have no tax implications. According to Russian securities la w, w hen shares are sold to raise starting capital, the diff erence bet w een nominal and actual price paid f or each share is considered additional paid-in capital, not as taxable revenue. Net pro fit w ill be distributed in the f ollo wing order: (1) fixed dividends are paid to holders o f pre f erred stock Type A , (2) dividends are paid to holders o f Type B shares, (3) the remainder w ill be distributed among holders o f common stock. Common and Type B stock holders will not receive any dividends until the holders o f Type A stock are f ully reimbursed the amount o f investment ($837,100). A f ter the f ourth year, the 29 shares o f pre f erred stock type A guarantee the investor a dividend income o f $160,000 (Exhibit 9). Holders o f Type B shares w ould receive yearly dividends o f $9,000, starting in the fif th year o f operation. Since there is no undistributed income (retained earnings) at the end o f the ten year realization period, the value o f o w ner’s equity w ould equal the nominal price o f shares plus additional paid-in-capital. Initial stockholders’ equity w as f ormed with each partner’s contribution (land, building, etc.). The maximum market value o f stockholder’s equity be f ore the second stock o ff ering is appraised at $159,000. Taking depreciation into account, this value is reduced to $123,000 at the end o f 10 years. The total market value o f Troika’s assets is there f ore $1,084,800: $123,000, the depreciated value o f stockholders’ equity be f ore second o ff ering, plus $961,800, the increase in stockholders’ equity a f ter second stock o ff ering. A t t h e e n d o f t h e 10-ye ar o p era tio n p erio d, t h e investors will have the option o f selling back all pref erred shares. Type A shares will be re-purchased f or $692,000, and Type B shares, held by Baikal, f or $32,000. Th e su bse q u e n t m ark e t valu e o f Troik a’s co m m o n shares will be $369,000. 11 Holders o f pre f erred stock w ould also have the option to convert their holdings into common stock. Financial Planning A ll major expenditures will be made in accordance with the w ork schedule (Exhibit 1). Funds w ill be used primarily to: • purchase equipment • renovate the production site • purchase transportation vehicles • create a reserve f und The three sources o f financing are as f ollo ws: equity invest m e n t, initia t ors’ co n trib u tio n, a n d sh ort-t erm credits. Short-term credit is needed to satisfy initial w orking capital requirements. The first credit, totaling $188,000, will be f or a three months and w ill be used to pay the VAT on the imported equipment. The second credit, totaling $48,000, w ill be f or f our months and will be used to purchase potatoes, oil, and other inputs. Principle and interest expense (30 % annually) on these loans will be paid out o f sales revenue. The initiators will purchase automobiles f or delivery o f the product and pay the f ull cost o f renovating the building out o f their contributed f unds. Equity investment w ill be used primarily f or purchasing production equipment. Financial projections are provided in attached Exhibits 2 - 9. Exhibit 6 sho ws production expenses with a 5 % de f ect rate. Purchases o f ra w materials, particularly potatoes, make up the largest portion o f expenses. Results o f an analysis o f potato price movements sho w that prices are stable, indicating that the market is in equilibrium. Potato prices in St. Petersburg re flect the average w orld price o f the commodity. 12 Prices o f ra w materials and maintenance costs are projected to rise 2 % per year, beginning in the third year o f production. Salaries are projected to rise 5 % per year in the first f our years, and 3 % per year f or the remainder o f the ten year period. By basing projections on rising cost f or inputs and stable selling price f or the product, the initiators compensate f or the possibility o f an unexpected adverse turn o f events. Break-even analysis sho ws that the enterprise must produce 121 tons o f potato chips per year to break even, only 42 % o f its capacity. Cash flo w projections (Exhibit 8) sho w that sales revenue will be su fficient to cover all production and dividend expenses and f uture pre f erred stock repurchase. Troika’s projected income statement (Exhibit 9) also sho ws positive results, even in the first year o f production. Income is projected to gro w from $126,000 in the first year to a $263,000 in the f ourth year, and gradually decrease to $216,000 in the tenth year. Income gro ws as a result o f increased production e fficiency and then declines because projected expenses rise w hile selling price is maintained constant. The enterprise is expected to generate an average return o f 23 % on investment. A portion o f these earnings can be reinvested to modernize and expand current operations, or as starting capital f or a ne w enterprise. 41 CASE STUDIES Attitude toward Law and Contracts Appendix CULTURAL AND SOCIOLOGICAL NOTES The Russian Sense of Time A Russian’s sense o f time may diff er markedly from an A merican’s. W hile A mericans w atch situation comedies w here everything ends happily in a half-hour, the traditional Russian pre f ers three hour-long operas and theater pieces w here a bad situation gets w orse, people get emotional, and apparently nothing is resolved at the end. W hile A mericans like to come quickly to the point and summarize their interests in a f e w sentences, Russian general managers usually choose to explain their corporate history and general philosophy be f ore talking about specifics. This is o f ten due to the Russian need to establish a relationship w ith a potential business partner. Ho w ever, this diff ering sense o f time can lead to con f usion and a sense o f distrust during initial meetings. Openness versus Secrecy Russia is a country that has been invaded many times during its history. Because o f this legacy, Russians tend to keep their w ealth and their business dealings secret. Just as a Russian peasant hid his grain, a Russian business tends to conceal its income, assets, and technological secrets. Russians are o f ten reluctant to share in f ormation over the phone or in letters, and pre f er at least a f ace-to-f ace meeting be f ore going f orw ard with details. Obedience versus Autonomy A nother pain f ul legacy o f Russian history is servitude. Up to the middle o f the 19th century, the majority o f Russians w ere peasants, w ho essentially w ere the property o f local lando w ners. The peasants f ollo w ed the lando w ner’s orders and w ere not permitted to move or change jobs without his permission. Under the Soviet system, the entire economy w as centrally planned. A t the time o f this case, Russian decision making, particularly in large organizations, still came from the top. The Russian employee traditionally had little or no autonomy, and, during this transition to capitalism, many Russians w ere still reluctant to make decisions w ithout consulting superiors. This cultural diff erence ba ffles and frustrates many A mericans. The Russian decision-making process w ill seem very slo w to an A merican, with inexplicable starts, stops, and reversals. A merican managers o f ten must w ait f or months f or a final decision to come from the top on matters already revie w ed by layers of Russian managers. During the first fe w months w orking for a Western firm, ne w Russian employees often exasperate their A merican managers with their continual requests for precise instructions and direction. 42 For many years, Soviet la w vie w ed capitalism and business as a social evil. For many Russians, the idea that la ws could actually help build companies is relatively ne w concept. W hile A mericans pre f er to base their busin ess rela tio nships o n le g ally e n f orce a ble co n tracts, many Russians still doubt the value o f and lack respect f or business la ws and contracts. M any Russians pre f er to keep their business dealings and accounts as f ar from government scrutiny as possible. The Importance of Relationships M ost Russians business dealings are based on personal rela tio nships. W h e n m a kin g b usin ess d ecisio ns, A mericans tend to f ocus on comparing contracts and prices. Russians, on the other hand, compare the depths o f personal relationships. M ost Russians pre f er to do business with people w ho are close friends. W ithout a close personal relationship, o f ten one that seems so close as to be claustrophobic to a Westerner, a Russian business deal is on shaky ground. For A mericans, the contract is usually the centerpiece o f negotiating sessions. For the Russian, the relationship is the f ocal point, and contracts and protocols are o f ten merely thought o f as polite ceremonies and starting points f or f urther negotiation. Because Russians consider their business partners to be friends, Russian business leaders o f ten have trouble saying no, and w ill promise things they cannot — or do not w ant — to deliver. M ost deals are done on the basis o f a verbal agreement, w here both sides actually appear to be embarrassed to bring any f ormalities into the process. This is one o f the major f actors contributing to an enormous crisis in the early 1990s stemming from the f ailure o f almost everyone to pay their debts. The combined debt that enterprises o w ed to each other amounted to trillions o f rubles, and a significant part o f that w as not supported by proper documentation. Organized Crime Dealing with organized crime is f undamental to doing business in Russia. Typically, banks have in f ormers w ho tell the M a fia organs about incoming f unds (sums above 10 million rubles.) Equipped with this in f ormation, the M a fia attempts to extort money from the enterprise. Insistent young men approach the management, in teams o f three or f our people. Having made an appointment, they announce that they have come to discuss the topic o f “ protection ” or are representatives o f tax authorities or the police. They o ff er their “services” in the f orm o f protecting the lif e o f the firm’s o w ners and sa f eguarding o f goods and property o f the firm. If the o w ner re f uses, they start explaining, very politely, that they can provide very e ff ective personal security, and then, depending on the reaction, they st art givin g o u t in f orm a tio n a b o u t t h e co m p a ny TROIKA POTATO CHIPS (A) obtained from the bank, about the goods stored in the w arehouse, his w if e’s place o f w ork, the time his children are in school and all sorts o f compromising in f ormation. If there is still no reaction, direct threats are brought into play. Ultimately, most enterprises conclude security agreements with organized crime groups. According to standard contracts, the director has to make a monthly payment on a strictly de fined day to a particular person. The sum is set depending on the turnover and the amount o f compromising in f ormation about the firm. In t h e eve n t t h a t re prese n t a tives o f o t h er gro u ps approach the firm, the directors must prove that they already have protection or krysha (roo f), so that representatives o f the M a fia groups sort out bet w een themselves questions concerning turf and w hat belongs to w hom. If a company does not have a krysha, it becomes difficult to conduct business, especially receiving payments, and the company is totally exposed. But if one does have krysha, one is breaking the la w, placing oneself outside o f it in the realm o f the in f ormal and vague. The relationship w ith one’s krysha is very important, but at the same time it makes one a part o f a net w ork, thereby severely restricting one’s freedom. Working with Russian Partners A lthough each investment opportunity presented its o w n unique set o f characteristics and challenges, John f ound that there w ere many common elements and pitf alls w hen dealing w ith Russian partners as a f oreign investor. For example: • M ost Russian entrepreneurs do not have a current, updated packet o f in f ormation about their enterprise and/or project. A t the initial meeting, they w ill most likely present old in f ormation and explain the project-at-hand orally, or as the Russians say, “ using their fingers. ” Because written data seldom matches w hat is transmitted orally at the initial meeting, a f oreign investor, upon revie w ing the in f ormation packet, could become con f used and distrust f ul. • Russian citizens have gro w n accustomed to b ein g secre tive, a survival trait d evelo p e d w hile livin g u n d er a t o t alit aria n re gim e. Consequently, the Russian entrepreneur is psychologically unprepared to reveal immediately all required in f ormation about his enterprise or project. He provides partial in f ormation, assuming that is su fficient f or analysis. If obtaining in f ormation about a project or company begins to f eel like pulling teeth, the investor may become suspicious and reluctant to proceed f urther. • Russian entrepreneurs are not used to the language and protocol f or attracting equity financing. They may ask potential investors to specify their requirements and then come up with a project to fit those requirements. • Russian businessmen vie w un f avorably the Russian assistants employed by f oreign consulting firms and investment f unds. M ost o f these jobs are filled by young bilingual Russian “consultants” w ith some rudimentary kno wledge o f Western finance, but with virtually no experience in managing a business in Russia and a limited understanding o f Russia’s business climate. In w orst cases, they become a bu ff er bet w een the investor and the entrepreneur, filtering and sometimes misrepresenting in f orma tio n a b o u t t h e invest me n t project. Generally, Russian businessmen pre f er to stay in direct contact with the investor. • The majority o f Russian entrepreneurs are n o t accust o m e d t o valuin g o t h er p e o ple’s time, or paying f or in f ormation or consulting services. Working and investing in Russia is a continual learning process. The road to success is o f ten paved w ith mistakes. During his stay, John made plenty o f mistakes. He w as able to identify the f ollo w ing lessons or “ guidelines f or practice ” learned through his experience: • A t the initial meeting, set the tone and language f or f uture discussions (w hoever has the money gets to make the rules). • M ake a clear and firm request f or all necessary in f ormation. If the requested in f ormation is not presented at the f ollo wing meeting, end the meeting, clearly explaining the reasons f or doing so. • If you receive the necessary documents and, a f ter evaluating them, re f use to finance the project, return the packet o f in f ormation with an o fficial letter explaining your decision. • Be f ore m a kin g a ny d ecisio n, co nsult a Russian expert. The most qualified experts are la w yers w h o are o n t o p o f curre n t le g al changes and kno w the system, or entrepreneurs w ho have had first-hand experience running a business in Russia. Some caution should be exercised in taking advice from f oreign or Russian consultants w ho have no experience managing a business in Russia. • The quality o f management takes precedence over financial projections as the most 43 CASE STUDIES important f actor in evaluating potential projects in Russia. Because the instability o f the Russian market makes long-term planning virtually impossible, most Russian entrepreneurs regard the business plan as a f ormality in attracting f oreign capital rather than an actual blu e prin t f or ru n nin g t h eir b usin ess. There f ore, the investor should concentrate on those sections o f the business plan w hich give some indication o f management’s style and degree o f pro f essionalism. These sections may deal with marketing research, risk assessment, sensitivity analysis, and project realization. • In order to live through the years o f economic transition, w hich is f ar from complete, Russian business people developed certain survival traits and habits. A dearth o f in f ormation, un f air taxation, and rampant corruption h ave m a d e t h e m very ca u tio us, w hile a n unstable legal and economic in frastructure has made them extremely competent in analyzing and quickly responding to ne w risks and obstacles. Consequently, a Russian entrepreneur can quickly assess and exploit any w eakness or incompetence he perceives in a potential business partner. N OTES 1. This case w as w rit t e n by Ge n e G u t e n b erg o f Corn ell University. It is intended as a basis f or class discussion rather than to illustrate either e ff ective or ine ff ective handling o f an administrative situation. 2. Actual business plan presented to investors. A ll names have been changed. 3. Second largest city in Russia with a population o f 5.5 million. 4. Enterprise w hose shares are not publicly traded. Similar to a limited partnership. 5. Enterprise w hose shares are publicly traded. 6. It is beyond the scope o f this case study to discuss the intricacies o f the Russian accounting and tax systems. It is highly recommended that a qualified Russian la wyer be consulted in all commercial transactions. 7. A small street shop that primarily sells snacks, cigarettes, and alcoholic and non-alcoholic beverages. 8. So m e pro d ucts h a d act u ally b e e n less successf ul w it h Russian labeling, as Russian’s equated Western products with higher quality. For example, Pepsi Cola’s sales dropped w hen it labeled its products in Russian. 44 9. It w as agreed that Baikal w ill hold its cash contribution until the purchase o f equipment. 10. [(165 + 43) x 1,000,000]. 11. These figures add up to $1.093 million, w hich contradict the $1.084 million total stockholders’ equity amount given in the previous paragraph. The amounts are taken from the actual business plan. 12. Potato prices on the London and A msterdam commodity exchanges ranged bet w een $215 and $271 per ton during 1994-1995 season. TROIKA POTATO CHIPS (A) Exhibit 1 OPERATION SCHEDULE FOR THE FIRST YEAR TYPE O F W ORK YEAR 0 (IN M O NTHS) 7 8 9 10 11 YEAR 1 (IN M O NTHS) 12 1 2 3 4 5 6 Preparation Preparation o f agreements to purchase ra w inputs Preparation o f agreement to purchase equipment Placing order f or package design M arketing and product promotion Preparation of Production Site Completion o f architectural redesign Replacement o f electrical and w ater systems Assembly o f production line Installation o f production line Equipment and Supplies Purchase o f trucks O rder and delivery o f cardboard boxes, oil, flavorings, etc. Production Line O rder Delivery Customs control Delivery to production site Human Resources Hiring o f management and technical personnel Hiring o f drivers Hiring o f production line w orkers and other personnel Arrival o f f oreign specialists Training Start o f production Sale o f potato chips 45 CASE STUDIES Exhibit 2 GENERAL INFORMATION Project duration Defects 10.5 years 5 % Prices: Potatoes (VAT not included) Production cost (VAT not included) $196/ton $4,125/ton Taxes: Revenue tax 34 % Tariff o f imported equipment 0.0 % VAT on equipment 21.5 % Equity investment in overall long-term financing structure 86 % Short-term credits Interest rate 30 % Term 7% Required equity investment 46 $837,100 TROIKA POTATO CHIPS (A) Exhibit 3 CAPITAL EXPENDITURES (in US$ thousands) INITIATORS INVESTOR TOTAL CO NSTRUCTIO N W ORK Building and land 1) Completion o f architectural blueprints 2.5 0.0 2) Land and road improvement 3.0 0.0 3.0 3) Building renovation 21.3 0.0 21.3 4) W arehouse renovation 28.6 0.0 28.6 5) A dditional construction expenses (heating, ventilation) 19.8 0.0 19.8 6) Total 75.2 0.0 75.2 7.5 0.0 7.5 17.8 0.0 17.8 100.5 0.0 100.5 7) Unexpected expenses (10 %) 8) VAT (21 % o f 6+7) 9) Total for construction 2.5 EQ UIPMENT Storage 10) Sorting and control equipment 0.0 4.0 4.0 11) Dusting and spraying equipment 0.0 1.3 1.3 12) Total f or storage 0.0 5.3 5.3 Production Line 13) W asher 0.0 39.4 39.4 14) Cutter 0.0 107.2 107.2 15) Fryer 0.0 158.9 158.9 16) Heating unit 0.0 121.2 121.2 17) Control panel 0.0 52.0 52.0 18) Packaging equipment 0.0 152.0 152.0 19) Spare parts 0.0 42.2 42.2 20) Delivery and maintenance expense 0.0 50.3 50.3 21) Total f or production line 0.0 723.2 723.2 22) Total f or production and storage equipment (21+12) 0.0 728.5 728.5 23) Tariff 0.0 0.0 0.0 24) Delivery from port to site 0.0 2.0 2.0 25) Total (22+24) 0.0 730.5 730.5 12.0 0.0 12.0 2.2 0.0 2.2 14.2 0.0 14.2 TRA NSPORT 26) Trucks (2) 27) Insurance (18 % o f cost) 28) Total for transport OTHER EXPENDITURES 29) O ffice equipment 1.6 0.0 1.6 30) M aintenance and assembly f ees (3 months) 13.5 0.0 13.5 31) Total for other expenditures 15.1 0.0 15.1 32) Total (25+28+31) 29.3 730.5 759.8 2.9 73.1 76.0 33) Unexpected expenses (10 %) 34) Total for equipment (32+33) 32.2 803.6 835.7 35) VAT on domestic eq. (reimbursed 6 months from start o f operation) 6.9 0.0 6.9 36) VAT on imported equipment (reimbursed at start o f operation) 0.0 172.8 172.8 132.7 803.6 936.2 GRAND TOTAL 47 CASE STUDIES Exhibit 4 FIXED ASSET DEPRECIATION, INSURANCE, AND MAINTENANCE EXPENSE ORIGIN AL PRICE LIFETIME IN YEARS YEARLY DEPRECIATIO N US$1,000 Building % SALVA GE VALUE US$1,000 INSURA NCE US$1,000 % US$1,000 M AINTEN A NCE % US$1,000 100.5 40 2.5 2.5 75.4 1.7 1.7 2.0 2.0 32.2 10 10.0 3.2 0.0 1.7 0.5 5.0 1.6 equipment 803.6 10 10.0 80.4 0.0 1.7 13.7 5.0 40.2 Total 936.3 - - 86.1 75.4 - 15.9 - 43.8 Russian equipment Imported Exhibit 5 OPERATION PLAN Number o f shif ts: 2 Number o f w ork days in a month: 20 Number o f hours in a shif t: 8 Number o f w ork months in a year: 10 YEAR 1 2 3 4 5 6 7 8 9 10 Total First shift: Number of months 10 10 10 10 10 10 10 10 10 10 100 Number o f w ork hours 160 160 160 160 160 160 160 160 160 160 1,600 0 0 0 0 0 0 0 0 0 0 0 Second shift Number o f months 7 10 10 10 10 10 10 10 10 10 97 Number o f w ork hours 112 160 160 160 160 160 160 160 160 160 1,552 0 0 0 0 0 0 0 0 0 0 0 Work hours per year 272 320 320 320 320 320 320 320 320 320 3,152 0 Efficiency rate Actual w ork hours per year 0 0 0 0 0 0 0 0 0 0 0.80 0.85 0.90 0.95 0.95 0.95 0.95 0.95 0.95 0.95 - 217 272 288 304 304 304 304 304 304 304 2,905 6 0 0 0 0 0 0 0 0 0 6 870 108 115 121 121 121 121 121 121 121 1,162 8 2 6 6 6 6 6 6 6 2 De f ects (5 % in tons) 218 272 288 304 304 304 304 304 304 304 2,906 Finished products net 11 14 14 15 15 15 15 15 15 15 145 207 258 274 289 289 289 289 289 289 289 2,760 854 106 113 119 119 119 119 119 119 119 1,139 4 0 2 2 2 2 2 2 2 2 Ra w potatoes (tons) Finished goods (tons) de f ects (tons) Sales revenue — without VAT at US$4,125 per ton 48 TROIKA POTATO CHIPS (A) Exhibit 6 PRODUCTION COSTS Variable costs f or producing 1 ton o f potato chips (without defects) Potatoes Chemicals O il A dditives Packaging material Cardboard boxes Electricity Total Variable costs f or producing 1 ton o f potato chips (with 5% defect rate) Variable costs f or producing at full capacity: 289 tons o f chips per year (with 5% defect rate) Fixed annual costs Depreciation M aintenance Insurance Utilities W ater Fuel Salary M anager Accountant M arketing director M echanic/electric A grarian specialist W arehouse f oreman Sorter Sales person Driver M anual w orker (2 shif ts) Production controller (2 shif ts) Line operator Packaging operator A dditional w orkers (2 shif ts) Total salary expense Other fixed costs A dvertising (first t w o years) A dvertising (subsequent years) Training (first year) Transport maintenance Total other fixed costs First year Second year A f ter Total fixed costs First year Second year A f ter A M O UNT PRI C E P E R U N I T W I T H O U T V A T, U S$ T O T A L PRI C E ( W IT H O U T V AT) U S$ 4 tons .25 liters 400 liters 20 kg 50 kg 200 800 k W 196 15 1.25 0.10 8 0.30 0.02 784 4 500 2 400 60 16 1,766 1,859 537,160 86,100 43,800 15,900 10,000 cubic meters 20,000 liters 0.01 0.15 100 3,000 1 1 1 1 1 1 2 1 1 2 2 2 2 4 3,600 3,000 3,000 2,160 2,160 1,920 1,680 1,800 1,700 1,440 1,680 1,800 1,800 1,440 3,600 3,000 3,000 2,160 2,160 1,920 3,360 1,800 1,700 2,880 3,360 3,600 3,600 5,760 41,900 2 trucks 15,000 25,000 7,500 1,550 15,000 25,000 7,500 3,100 25,600 18,100 28,100 216,400 208,900 218,900 Total operating expense at full capacity First year 753,560 Second year 746,060 A f ter 756,060 49 CASE STUDIES Exhibit 7 FINANCING (US$1,000) YEARS 0 1 Total 961.8 - 961.8 188 - 188 Interest payment - 14 14 Debt repayment - 188 188 48 Investment Short-term credit (3 months) Short-term credit (4 months) 48 - Interest payment - 5 5 Debt repayment - 48 48 1,197.8 (255) 942.8 Total 50 TROIKA POTATO CHIPS (A) Exhibit 8 CASH FLOW PROJECTIONS (US$1,000) YE A R 0 1 2 3 4 5 6 7 8 9 10 Total 854 1,064 1,130 1,192 1,192 1,192 1,192 1,192 1,192 1,192 11,392 REVENUES Sales 0 Salvage value 0 0 0 0 0 0 0 0 0 0 75 75 Reimbursed VAT 0 180 0 0 0 0 0 0 0 0 0 180 Total 0 1,034 1,064 1,130 1,192 1,192 1,192 1,192 1,192 1,192 1,267 1,1647 EXPENSES M anagement cost 43 0 0 0 0 0 0 0 0 0 0 43 Investment activities 936 0 0 0 0 0 0 0 0 0 0 936 VAT on equipment 180 0 0 0 0 0 0 0 0 0 0 180 O ther expenses 0 33 8 3 2 0 0 0 0 0 (46) Variable costs 0 385 480 508 536 547 558 569 581 592 604 5,360 M aintenance (Exhibit 4) 0 44 44 45 45 46 46 47 47 48 49 461 Insurance (Exhibit 4) 0 16 15 14 13 12 11 10 9 8 7 115 Utilities 0 3 3 3 3 3 3 3 3 3 3 30 Salary 0 42 44 46 48 51 53 55 57 59 61 516 O ther fixed costs 0 26 18 28 28 28 28 28 28 28 28 268 Total production expense 0 516 604 644 673 687 699 712 725 738 752 6,750 Income tax 0 74 115 124 135 131 128 124 120 116 112 1,179 O ther taxes 0 29 31 31 31 29 28 26 25 23 22 275 1,159 652 758 802 841 847 855 862 870 877 840 9,363 Net income (1,159) 382 306 328 351 345 338 330 322 315 427 2,284 Total be f ore financing (1,159) (777) (472) (144) 207 552 889 1,219 1,542 1,857 2,284 - Total expenses Financing (Exhibit 7) 1206 (255) 0 0 0 0 0 0 0 0 0 0 951 351 345 338 330 322 315 Net income a f ter financing 47 127 306 328 427 3,235 Total a f ter financing 47 173 479 807 1,158 1,502 1,840 2,170 2,492 2,808 3,235 - Dividend payments 0 123 219 236 257 250 243 235 228 221 212 2,224 Earnings a f ter dividends 47 4 86 92 93 95 95 95 95 95 215 1,011 Total 47 50 173 229 322 417 512 607 701 796 1,011 - Repurchase o f pre f erred stock Type A - - - - - - - - - - 692 692 Repurchase o f pre f erred stock Type B - - - - - - - - - - 32 32 Remainder 287 51 CASE STUDIES Exhibit 9 INCOME PROJECTIONS (US$1,000) 10 Total 0 854 1,064 1,130 1,192 1,192 1,192 1,192 1,192 1,192 1,192 1,1392 Variable cost 0 385 48 508 536 547 558 569 581 592 604 5,360 Depreciation 0 86 86 86 86 86 86 86 86 86 86 860 M aintenance 0 44 44 45 45 46 46 47 47 48 49 461 Insurance 0 16 15 14 13 12 11 10 9 8 7 115 Utilities 0 3 3 3 3 3 3 3 3 3 3 30 Salary 0 42 44 46 48 51 53 55 57 59 61 516 M anagement f ee 0 4 4 4 4 4 4 4 4 4 4 40 O ther fixed costs 0 26 18 28 28 28 28 28 28 28 28 268 Total expenses 0 606 694 734 763 777 789 802 815 828 842 7,650 Earnings be f ore interest and taxes 0 284 370 396 429 415 403 390 377 364 350 3,742 11 12 12 12 12 12 12 12 12 115 YEARS 0 Sales revenue 1 2 3 4 5 6 7 8 9 Expenses: Taxes: Building and property tax 0 Tax on advertising 0 1 1 2 2 2 2 2 2 2 2 18 Road tax 0 3 4 5 5 5 5 5 5 5 5 47 Asset tax 0 16 15 13 10 10 9 7 6 4 3 95 Total tax 0 29 31 31 29 29 28 26 25 23 22 275 Income be f ore taxes 0 219 339 365 398 386 375 364 352 341 328 3,467 Income tax 0 74 115 124 135 131 128 124 120 116 112 1,179 Income a f ter taxes 0 145 224 241 263 255 248 240 232 225 216 2,288 Interest expense 0 19 0 0 0 0 0 0 0 0 0 19 Income a f ter taxes and interest 0 126 224 241 263 255 248 240 232 225 216 2,269 (2 % o f revenue) 0 3 4 5 5 5 5 5 5 5 4 45 Dividend payments -Type A 0 123 219 236 257 162 160 160 160 160 160 1,798 Dividend payments -Type B 0 0 0 0 0 7 9 9 9 9 9 52 Dividend payments - common 0 0 0 0 0 81 74 66 59 52 43 374 Total dividend payments 0 123 219 236 257 250 243 235 228 221 212 2,224 Retained earnings 0 0 0 0 0 0 0 0 0 0 0 0 Contribution to a reserve f und 52
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