Over the last few weeks, we have been increasingly asked to express ourselves on financing. To be more precise, how can businesses raise the capital they need to grow. Consequently, we decided to post an article that tries to answer this very straight-forward yet often complex question.
From the ROKC point of view, the business requesting financing has to place themselves in the supplier’s shoes. In other words, how does the capital provider get their return on the capital invested.
To keep things simple let’s say there are only two forms of financing: debt and equity. The difference between the two is an equity financier takes possession of the business while a debt provider only makes their cash available to the business.
In the case of debt, a loan is made with a payment schedule and an interest rate so most of the unknowns are taken out of the relationship. If the lender is a financial institution usually some form of guarantee is required on the principal (the amount lent). This is achieved by taking a lien on another asset owned by the business or its owners. Of course, there are other forms of debt financing but we want to keep things simple here. Well, we mention just one other. That is vendor financing; vendors extend credit to the business by selling it goods and services however asking for payment at some future time, like: 15 days, 30 days, 90 days, and in some countries 180 and even 360 days. Vendor financing is actually the least expensive form of financing for a business because there is no explicit interest rate to pay; it is built into the price so you don’t see it. Anyway, in this case, a business that is able to receive money from its clients faster than it pays out to its vendors will find itself in a cash positive position allowing it to use those resources elsewhere.
Now for equity financing, or those taking ownership in the business. More often than not business owners over-estimate the value of their business. Kind of natural since they are the ones who usually saw it through inception and growth. As a result of this experience and over-valuation, they never truly think about how a third-party investor will get their money out of the business. This works against them in almost all financing rounds beyond “friends, family, faithful and fools”. It is because of this erroneous mindset that we ask the business owners to think about equity financing not from the point of view of making an investment in the company but from that of an exit.
Let’s use a recent example we have from our mentoring activity to illustrate the point. A couple of entrepreneurs came to us with a business plan for a restaurant requiring a $350,000 investment. This is a significant investment so they wanted to raise the funds. However, when we asked them how their investors would get their money back they looked back at us with blank stares. To help them out a bit, we suggested two ways: (1) pay all investors back their initial investment out of the profits, (2) they could buy back the equity invested by the third-party investors effectively owning 100% of the business after a predetermined period of time, or (3) the business could buy the third-party investors leaving them once again with 100% ownership. The basic idea we were trying to get across to them was simply an investor can get their money back either from the business or by selling their ownership instruments to someone else.
Oh! We won’t even go into how the equity is valued because that is whole other subject. We want to keep this simple.
In another recent case, a consultancy asked us to review a financing white paper they had written to attract new customers. This paper was quite long because it tried to cover just about every form of financing that exists; and, there are quite a number of them. However, we did make a number of recommendations the most significant of which was to tailor it to the business life-cycle. The ways in which a startup is financed differs significantly from that of company in full expansion which is different still from a multinational. The business’s maturity is a very important consideration. Likewise, certain financing instruments depend upon the business’s legal form. A sole proprietorship can avail itself of equity financing by becoming a limited liability company or corporation. However, a corporation issuing more stock may dilute the value of the shares already issued thereby reducing the return of existing shareholders. Or, in the case of a “down round” the reduced value of existing shares is explicitly recognized making it challenging for existing shareholders to exit the company by selling their shares to another investor and make the return they expected.
As you can see, things can become complex very rapidly!
Another helpful way of looking at the subject of financing is to say those investors we are selling a share of our company to are buying in part what exists and in another part what will exist. In other words, part of the money reflects the value of what has already been achieved while the rest of the money will be used to grow the business. Therefore, the big question becomes, “Is the cost of the money used to grow the business equal to, less than or greater than the value that growth will generate?” This is a complex question, we know. Yet this question is the one all businesses are faced with at one time or another in their lifetime. And, this question will help the business owners to determine not only how much they are willing to pay for the outside financing but also, in many cases, this determine what kind of financing they will use, debt or equity.
In this article we are just scratching the surface of the issues surrounding financing since it can become very complex, rather quickly. However, if those asking for financing place themselves in the shoes of those offer the financial resources they will see how many risks first to the principal there are and then to the return on capital invested there can be.