Small Business Finance: Equity, Debt, Cash Flow and IPO
January 17, 2010 by Frank Goley, Business Consultant
The Business Success Blog is sponsored by ABC Business Consulting
Often times Financing a Small Business can be the hardest, most time consuming activity that a Business Owner and/or a CFO do when running a business. Needless to say it can be the most important element of growing a business, but one must be careful not to allow it to consume the business. How do you achieve that?
First, write a solid Business Plan that has a well developed Strategic Plan which translates into very realistic and believable Financials. Before you can finance a business, a project, an expansion or an acquisition, you must develop precisely what your Finance needs are. This is only accomplished initially through a good Business Plan Process.
Second, finance your Business from a position of strength. This means good old cash. As a Business Owner you should illustrate your confidence in the business by investing up to 10% of your Finance needs from your own coffers. This also puts you firmly in the driver’s seat. Ten percent cash investment (or Equity) isn’t enough cash. So the remaining 20-30% of your cash needs should come from Private Investors or Venture Capital. Remember, Sweat Equity is expected and is a major contribution, but it is not a replacement for cash. Ok, so you bring 10% of the finance needs to the table as cash investment and the Private Equity/ Venture Capital component invests 30% of the finance needs. That means, you have a cash position of 40% of your Total Finance needs from the get go. This puts you in control of your Financial Destiny.
Depending on the valuation of your business and the risk involved, the Private Equity/ Venture Capital component will want an average of 30-40% equity in your company on a semi-short term basis (3-5 years). Giving up this Equity position in your Company, yet maintaining clear majority ownership will bring you exponential leverage in your remaining 60% of your Finance needs. (Not to mention, the expertise and connections VC brings to the table to help you become successful). Another good reason to have a solid Business Plan is to seek and secure this private investment.
Third, now that you have developed a good Business Plan, invested your own cash into the business and obtained the necessary Private Equity/ Venture Capital cash, you are in a strong position to obtain the remaining 60% of your Finance needs. This remaining Finance can come in the form of Long-Term Debt, Short-Term Working Capitol, Equipment Finance and Inventory Finance. By having a strong cash position in your company, a variety of lenders will be available for your picking to fill your Finance needs. It is advisable to hire a good, experienced Commercial Loan Broker to do the “shopping” for you and present you with a variety of options. Just as a Business Plan is important to secure the Cash Investment you require, a good Loan Package to secure the remaining Finance requirements. It is important at this juncture that you obtain Finance that fits your business needs and structures, instead of trying to force your structure into a Financial Instrument not ideally suited for your operations. Having an initial strong cash position gives you the power, flexibility and option to choose a Financial Products Package that suite your needs.
By having a strong cash position in your Company, the additional Debt financing will not put an undue strain on your Cash Flow. 60% Debt Capacity is a very healthy level of Debt which will allow a business to grow and cash flow successfully. This Debt Finance can come in the form of Unsecured Finance: Short-Term Debt, Line of Credit Financing and Long-Term Debt. Unsecured Debt of this nature is typically called Cash Flow Financing and requires credit worthiness. Debt Finance can also come in the form of Secured or Asset Based Financing: Accounts Receivables (or Factoring), Inventory, Equipment, Real Estate, Personal Assets, Letter of Credits, and Government Guaranteed Loans. A customized mix of Unsecured and Secured Debt, designed specifically around your Company’s Financial needs, is the advantage of having a strong cash position from the get go.
As a result of having the ability to generate strong Cash Flows, your strongest, most flexible form of Finance, will be self-investment. Or cash derived internally within your business. You can even ask your suppliers to extend the term of your re-payment period, so you can use this additional cash flow to serve your short term capital needs. In a new venture, it is always wise for the top executives, who have equity in the venture, to take minimum salaries in order to bolster self-investment back into the capital needs of your venture. Or let’s say an existing Real Estate Development Company can waive its “Developers Fee” during the construction phase of a project so that less strain will be exhibited on the early stage cash flows, which in the long term, will derive much better equity returns for the developers involved.
If you haven’t noticed, the Cash Flow Statement is your most important Financial in tracking the effects of certain types and terms of Finance. It is critical to have a firm handle on your Monthly Cash Flows, along with the Control and Planning elements of a Financial Budget, in order to successfully plan and monitor your company’s Finance Requirements and overall picture.
Let’s take a moment to review Financial Structuring. It is important in your Business Planning Process to run a few scenarios of Equity and Debt mixtures to see what is favorable for your type of business, but it is important to keep that structure Open in the Funding Business Plan for Private Equity and Venture Capital audiences. PE/VC are often put off by entrepreneurs forcing financial structures down their throats as they are the true experts in this field. Let their expertise and experience help you determine an Equity Structure that makes sense for everyone involved. Having thought out and analyzed different Financial Structures ahead of time, will allow you to contribute intelligently to this negotiation, yet not be overbearing. With the Equity Structure in place, you can easily adjust your Debt Structure accordingly and seek out Debt finance to meet that structure.
It is important at this juncture to determine what Finance really is. It is the relationship between Cash, Risk and Value. In short, what Cash will do, how to manage Risk and how Value is derived. Some important considerations about cash:
1. An Entrepreneur’s Focus Outlook is Free Cash Flow (FCF).
2. Moreover, An Entrepreneur’s measure of profitability is Net Present Value of Future FCF (less) Investment.
3. As a result, Sales Growth is strongly supported by a Growth in Assets (Working Cap and Fixed Assets).
4. Yet, a Growth in Assets must be buoyed by increases in Stock Holders Equity and factoring in for Inflation Rates.
5. So the fundamental rule of Finance is don’t run out of Cash.
The Risk element of Cash:
1. How risky a Cash Flow Stream is, determines its value.
2. Risk is determined by: the uncertainty of FCF and Risk that can’t be diversified.
3. Therefore, Entrepreneurs and Investors alike want to maximize Returns and minimize Risks for a given level of Risk (for the former) and Expected Return (for the latter).
4. While keeping in mind, the Entrepreneur must have his focus on contributing to the Company’s Long Term Value and not being blinded by Short-Term Operating Results.
In a building block process, Value is determined by how Cash and Risk interact. Furthermore Value is affected by: A) Investments that create FCF and B) Finance Structures that do not unduly strain FCF to Investors and the Entrepreneur alike. Therefore, Finance is the process of “selling” certain claims about your business’ FCF. You must in essence “sell” the results that FCF generates through your business or simply put selling the Value of your Cash Flow. Finance is how you think about the relationship between Cash, Risk and Value, and when the Entrepreneur determines that value, it can be sold to lenders and investors alike to obtain the type and amount of funding your business needs.
Fourth, your Finance plan is a result and a very important part of your Strategic Planning Process. You need to be very careful of matching your cash needs with your cash goals. Using Short-Term Capital for long term growth and vice versa is a no no. Match the type and term of the Finance with the term of the Goal. Violating the Matching Rule can bring about:
1. Interest Rate Risk
2. Re-Finance Risk
3. Operating Independence Risk
Some deviation from this age old rule is permissible; for instance, if you have a long term need for Working Capital, then a permanent Capital need may be warranted. Another good Finance Strategy is having Contingency Capital on hand for freeing up your Working Capital needs and providing maximum flexibility. A mix is the best way to go about your strategy. For example, you can use a Line of Credit to get into an opportunity that arises speedily and then arrange for cheaper, better suited long term, permanent finance subsequently, planning this upfront with a lender.
Finally, Finance is not typically addressed until a company is in crisis. Plan ahead with an Effective Business Planning Process. Equity Finance does not stress Cash Flow and gives other lenders (like banks) confidence to do business with your company. Good Financial Structuring reduces the Costs of Capital and utilizing Specialists and Consultants in this area is very advantageous.
After you have successfully captured the Finance you require and successfully grown your company, businesses often start considering Going Public. Companies start thinking of this Finance Alternative when present funding structures fail to meet the Company’s Growth. Or put another way, Business Growth has exceeded Company Debt Capacity. It is interesting to note that a majority of IPOs come from companies with Assets Less than $500,000, with an average value of $2,000,000. Due to this phenomenon, the SEC has come up with different Registration Processes to simplify the very expensive process of Going Public. Specifically Form S-18 and Regulation D, exemptions , processes and structures allows smaller Companies to enter the once cost prohibitive process of raising funds via an IPO. There have been some significant changes to Rule 144 stock restrictions which will revolutionize how Private Equity and Venture Capital will view investing in smaller companies. This may very well be a reason for many companies to stay private, yet grow, without the added expense and reporting procedures of an IPO. Fees for an IPO can run $175,000-$400,000 plus an Underwriter’s Commission of 5-15%. Total Expenses can range 10-35% of the Gross Offering.
So you must be asking yourself, who should go Public? Some benchmarks are as follows:
1. High Growth, sustained at a rate to attract public investors. (Therefore, an IPO is typically not suited for a start-up company)
2. Have sustained Annual Growth of 25-50% for 5 years.
3. Underwriters seek IPO candidates with at least $10m in sales and $1m in profits.
4. Your Product or Service is highly visible and of interest to the Public. Must be unique.
5. Investment Risks have been minimized.
6. Can you meet the disclosure and reporting requirements?
If you determine an IPO is in your best interest, then you need a solid, experienced Registration Team of Managers, Upper Executives, Company Attorneys, Underwriter, Underwriter’s Counsel, Independent Accountants, a Financial Printer and a Financial Public Relations Firm. The Process takes several months and timing is critical to determining the Final Shore Price, so it is imperative to have an Underwriter experienced with your type of market and target investors. When Underwriters arrange meetings with Financial Analysts and Brokers for potential investors, it is very important the President of the Company handles the meeting, projecting credibility and the ability to respond to inquiries important to the offering’s success. Since it is very difficult to keep your market position post IPO, the need for a solid Financial Public Relations Firm is imperative.
The best advice we can make about the Financing of a Small Business is to start with a solid Business Plan and put your company in a position of Financial Leverage. Cash Flow early and reduce the impact of Finance on that cash flow. Use the strength of Equity to propel your company forward toward the Debt Markets, remembering the relationship of Cash, Risk and Value. Then when you have outgrown your Debt capacity consider raising funds through an IPO and/ or selling the company. An IPO doesn’t have to be the end for the Entrepreneur (but often it is as Entrepreneurs prefer early stage growth models), but it is often an exit for Venture Capital and the next stage in Growth from a Small/ Medium Business to a Medium/ Large Scale Business. If the Entrepreneur sticks with the Public Company, his role in the Company will change from making Venture Capitalists happy to answering to Share Holders. Therefore, Public Relations become an important factor going forward.
Please visit our Small Business Finance Resource for more articles and e-books on financing your Business.
For my 4 part series on Business Finance in a Recession go to: Recession Business Finance Tactics
About the Author
This article was written by Frank Goley, the ABC Business Consulting Chief Business Success Consultant, who has over 20 years experience helping companies start, grow, turn-around and succeed. Please visit The ABC Business Consulting Website for more information on what a Business Consultant can do for your Company.
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