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How To Mix Business Capital Sources in a Cohesive Business Funding Strategy

June 22, 2010 by Frank Goley, Business Consultant

Understanding how to mix equity and debt, as well as, combine various business funding sources and capital is necessary in determining an effective business funding strategy. Putting together a cohesive funding strategy prior to your capital campaign is absolutely essential toward finding the right amount and type of business capital necessary to reach your business goals.

I.  The Relationship between Debt and Equity

Concept of Leverage:  Utilizing a Low Rate of Interest Debt Structure to leveraging into Investing the Loan Proceeds into an opportunity at a projected higher Rate of Return. Compare the relationship of using Debt verses Equity.  Variables would be the Interest on the Debt, the Effect of Taxes and the Economic Reality.  Equity and Debt should not be an either/ or proposition but a proper mix to meet your Financial Modeling Scenarios Goals.

– Calculate Return on Equity:   Earnings divided by Equity. Consider the effect of Harvesting the Asset in an upside & Downside market. So while a Debt structure, allows you to leverage Equity, in an Economic Downturn, the Loan Interest can cause the Equity Investment to lose money.

The Cost of Debt Finance:  Cost of Debt = Interest Rate x (1.00 – the Effective Income Tax Rate).

The Cost of Equity Capital:  Cost of Equity = Earnings Participation divided by Investment or Earnings per Share divided by Selling Prize per Share.

Comparing Equity and Debt Capital:

– Cost:  Equity Capital is more costly than Debt Capital, as the Investor is exposed to much Higher Risks than the Lender, and to justify the Risk, the Investor seeks a High Return.

– Investor Risk verses Lender Risk

·         Interest deducted from earnings prior to distribution to Investors.

·         Legal requirement to repay debt, not equity.

·         Lender has greater access to collateral and liquidity availability.

·         In the event of business failure, Lenders are paid before Investors.

– Risk:  Equity risk lies with the Investor, yet, Debt Capital Risks are high to the Company:

·         Interest penalties.

·         Repayment demand during low Cash Flow Period.

·         Collateral Claims.

·         Personal Guarantees.

·         Unsuccessful Re-Finance or Expensive Re-Finance Terms.

– Flexibility:

·         Equity Capital much more flexible and efficient.

·         Alternative Debt Sources (Hard Money, Bridge Loans, Factoring, etc.) are Expensive but offer Flexible Debt on a short term acquisition schedule for a short term period (i.e. Rent Money).

·         Equity can limit Debt and vice versa depending on Covenants and Agreement Terms.

·         When combining Equity and Debt, Equity can make Debt much more Flexible, Attainable and Economical.

– Control:

·         Equity has Board Seat and Share Ownership.

·         Hybrid Debt Products (Hard Money, Mezzanine Finance) can have an Ownership Component.

·         Debt can control a business with a high Loan to Value/ Cost, high interest rate and steep penalty/ default terms.

·         The proper Mix of Debt and Equity is the answer.

II.  Combining Capital Sources

Typical Mix Considerations

·         Internal Cash Generation:  Retained Earnings Maximization, Good Asset Management, Solid Cost Control, etc.

·         Trade Credit / Supplier Credit

·         Matching Principle:  Short-Term Debt for short term needs and Long-Term Debt for long-term needs.  Utilize the Current Ratio Formula.

·         Debt to Equity Mix:o    Founder and Angel Investor Contribution = 20%o    Long- Term Debt = 40%o    Short- Term Debt = 10%o    Equity Capital = 30%

o    Other successful mixes:

§  10-50-10-30

§  10-60-10-20

·         Debt Capacity = Acceptable Debt to Equity Ratio x Equity

o    A typical Acceptable Debt to Equity Ratio is 1.00.

o    The above Formula measures the proper level of Debt to Equity with the injection of additional Equity.

III.  Pulling It All Together in An Effective Business Funding Strategy

How to Develop an Effective Business Funding Strategy

·         Good Communication with Lenders and Investors:

o    Realistic, Well- Developed Facts and Figures.

o    Bridge the Gap with a Well Developed, Presented and Packaged:

§  Business Plan 

§  Loan Package

§  Executive Summary

§  Investment Overview

·         Understanding Business Plan Development Relationships:  Company Experience & Track Record = > Product Development => Marketing Analysis & Plan => Strategic & Sales Plan = REALISTIC Financial Projections & Forecasts.

·         Integrate your Funding Structure & Strategy into your Cash Flow Statement, showing the effects of different Capital Structures based upon your Strategic Plan Findings. The Cash Flow Statement shows the Banker how your Loan will be repaid and the Investor how much and when Investment Proceeds will be accumulated and disbursed, all based on Realistic, Believable numbers via a solid Business Plan Development Process (see above Flow Chart).

·         An Effective Funding Strategy begins with an effective Business Plan Process which incorporates excellent Financial Analysis and runs various Financial Model outcomes via Cash Flow Statement Development and Analysis.

·         Understanding the right mix of Financial Instruments, is key when modeling your Cash Flow Scenarios.

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