Securing capital for a company represents one of the most painstaking and time-consuming efforts a business undertakes. It’s one thing to get a party interested in providing capital to your organization, but it’s an entirely different event to actually receive the commitment and secure the capital. Securing capital represents a full-time job requiring the undivided attention of a company’s senior management team and, ultimately, the CEO. Through this post, I discuss about Securing and Rising Capital For Business. At the end of this post, I reveal the key of rising capital. Enjoy!
The Basic Types Of Capital Resources [The Debt and Equity]
When implementing a new business concept, only one definition captures the real essence of capital: “It takes money to make money.” From the aspiring entrepreneur designing a new software product in a home office to an executive of a multinational corporation looking to expand foreign distribution channels for new product introductions, launching any new business concept requires capital, or money, as a basis to execute the business plan. One of the most common reasons businesses fail is due to a lack of or inappropriately structured capital resources.
For the sake of simplicity, capital is the amount of financial resources needed to implement and execute a business plan. Before a business sells its first product or delivers a service to the market, it needs financial resources for product development, sales, marketing and promotional efforts, administrative support, the company’s formation, and countless other critical business functions.
Capital should not be perceived as just the amount of “cash on hand” but rather the amount of financial resources available to support the execution of a business plan. While financial resources come in countless forms, types, and structures, two main basic types of financial resources are available to most businesses “debt” and “equity“:
- Debt represents a liability or obligation of a business. Debt is generally governed by mutually agreed upon terms and conditions as provided by the party extending credit. For example, a bank lends $2 million to a company to purchase additional production equipment to support the expansion of a manufacturing facility. The bank establishes the terms and conditions of the debt agreement including the interest rate, repayment term, the periodic payment, collateral required, and other elements of the agreement. These terms and conditions must be adhered to by the company, or it runs the risk of default.
- Equity represents an investment in the business, usually doesn’t have set repayment terms, but does have a right to future earnings. Unlike debt, equity investments aren’t subject to set repayment terms, but the owners of the equity investments may be paid dividends or distributions if profits and cash flows are available. For example, a software technology company requires approximately $2 million in capital to develop and launch a new Internet-based software solution. A niche venture capitalist group invests the required capital under the terms and conditions present in the equity offering, including what their percentage ownership in company will be, rights to future earnings, representation on the board of directors, preferred versus common equity status, conversion rights, antidilution provisions, and so on. Under this scenario, the company isn’t required to remit any payments to the capital source per a set repayment agreement but has given up a partial right to ownership (which can be even more costly).
Of course, many variations, alternatives, subtypes, and classifications are present within each type of capital. If it were as easy as debt versus equity, there wouldn’t be much of a need for bankers, accountants, investment bankers, venture capitalists, and the like (which, of course, to most business owners would be a welcome change).
You may be wondering whether debt or equity capital is best suited for a company. Well, this decision really depends on the company’s stage in terms of its operating history, industry profile, profitability levels, asset structure, future growth prospects, and general capital requirements, as well as where the sources of capital lie.
Let’s get into more details about “debt and equity” the basic capital resources. Read on…
Debt is best evaluated by understanding its two most important characteristics:
- Maturity refers to the length of time the debt instrument has until repayment. In the case of trade accounts payable, vendors often extend payment terms of net 30 to their customers, which requires repayment within 30 days of receipt of the product or service. Any debt instrument requiring repayment within one year or less is classified as current or short term on the balance sheet. Logic then dictates that long-term debt is any obligation present with a repayment due date of one year or greater.For example, mortgages provided by banks for real-estate purchases are often structured over a 30-year period and are considered long-term in nature.
- Security refers to the type of asset the debt is supported by or secured with. If a bank lends $2 million to support the expansion of a manufacturing facility, the bank takes a secured position in the assets acquired for the $2 million loan. That is, the bank issues a public notice that it has lent money to the manufacturing company and that it has a first right to the equipment financed in the case of a future default. This notice provides the bank with additional comfort that if the company can’t cover its debt service obligations, it actually has a tangible asset that it can attach to and liquidate if it needs to cover the outstanding obligation.
Other forms of security also include intangible assets, such as a patent or rights to intellectual property, inventory, trade accounts receivable, real estate, and future cash flow streams, such as a future annuity payment stream that guarantees X dollars to be paid each year.
You may assume that most companies that provide credit to businesses would prefer to be in a secured status to reduce the inherent risks present. However, this scenario is logistically almost impossible due to the nature of how most businesses operate on a day to-day basis. Hence, secured creditors tend to be associated with credit extension agreements that are both relatively large from a dollars committed standpoint and cover longer periods of time.
On the opposite end of secured lenders are the unsecured creditors. This type of creditor tends to be the mass of vendors that provide basic goods and services to a company for general operating requirements. Examples of these vendors are professional service firms, utility and telecommunication companies, material suppliers, general office services, and so on. Unsecured creditors obviously take on more risk in that a specific company asset is not pledged as collateral to support the repayment of the obligation. This risk is mitigated by the fact that unsecured creditors tend to extend credit with shorter repayment terms (for example, the invoice is due on net 20 day terms) and in lower dollar amounts. In addition, if unsecured creditors are concerned about getting paid, then they can use other strategies, such as requiring a deposit or a prepayment.
Beyond the maturity and security elements of debt are a number of additional attributes:
- Personal guarantees, where a party outside of the company guarantees the repayment of a debt similar to how a cosigner works. Personal guarantees are often required by the owners of the business due to their relatively high net worth status but also to display a willingness to stand behind their business.
- Priority creditors, where business creditors achieve a priority status due to the type of obligation present, such as payroll taxes withheld for the IRS.
- Subordination agreements, where a creditor specifically takes a secondary position to a secured lender.
- Default provisions, where, in the event of a loan default, the remedies of the parties involved are specified.
- Lending agreement covenants, where the company must perform at a certain level to avoid triggering a default.
Equity is best evaluated by understanding its two most important characteristics:
- Preference refers to the fact that certain types of equity have preferences to earnings and, if needed, company assets over other forms of equity. For example: a series A preferred stock may be issued to investors that have an interest in making an equity investment but want to protect or prioritize their investments in relation to the common shareholders or another series of preferred stock. A series B preferred stock may hold a lower preference to the series A preferred stock in terms of asset liquidations, but may have a slightly higher dividend yield attached or offered with a warrant that allows it to purchase common shares at a later date at a favorable price. The features built into preferred stock are almost endless and can create a large number of different types of preferred stock. For common equity, so, too, can preferences exist. Common stock type A may have full voting rights and dividends (after the preferred shareholders receive their dividend), whereas a common stock type B may have only rights to dividends but can’t vote. Equity investors will attempt to secure as many preferences and features that protect their interests as possible. While this situation may be good for them, it may not be in the best interests of the company and can restrict its ability to operate farther down the road.
- Management influence is centered in the fact that when equity capital is raised, the provider of the capital is considered an owner or shareholder of the company. By its very nature, this ownership entitles the shareholder to have a say in the company’s operations (unless otherwise restricted) with the ability to vote for the board of directors and on other critical matters, such as approving the company’s external auditor. This management influence can be extended significantly when preferences are factored into the equation. It’s very common for early stage equity investors to secure the right to influence the board of directors more actively. For example: if a company has determined that five board members are needed, the early stage investors may carve out the right to elect two of these board members and the other investors the remaining three. This right provides the early stage equity investors with additional management control of the business during its critical formation years.
Finding Sources of Capital
“Show me the money!”. These four words sum up the capital-raising process as best as any because until you have the money in hand, a business concept is really nothing more than the paper the business plan is written on.
Fortunately, many potential sources of capital are available to launch your new business, open a new product/service niche within a corporate conglomerate, or acquire a pesky competitor. The sources listed in the following sections are by no means an all-inclusive list but rather an overview of the variety of avenues available to raise capital.
. Family, Friends, and Close Business Associates [FF & CBAs]
Family, friends, and close business associates (FF&CBAs) have been one of the primary capital sources to launch new business concepts since the beginning of time and will most likely continue to fill this role in the future. The range of capital-raising options from FF&CBAs stretches from the founders of a business tapping their own credit worthiness or resources (savings, home equity, or credit cards) to Mom and Dad or a trusted business associate stepping up with the needed seed money to launch the company.
Generally, this type of capital tends to be for lower dollar amounts, geared toward equity as opposed to debt (given the uncertain nature of the business and higher risks present in terms of generating cash flow), and provided to closely held and/or familyoperated businesses. However, debt can be effectively utilized with more mature businesses generating solid profitability with some type of security present (such as real estate).
The good news is that raising capital from FF&CBAs can often be completed quickly without a significant amount of legal paperwork and/or similar investor creditability issues being present.
The bad news is twofold:
- The amount of capital available from these sources is often restricted. It’s one thing to pull together a couple of hundred thousand dollars, but when a business concept needs a million or two, not too many FF&CBAs have this type of liquidity available (unless your last name is DuPont or Getty).
- Having unsophisticated FF&CBAs provide capital to a business carries with it unforeseen risks and emotional elements that can explode. Reporting to a seasoned investor that a business concept didn’t work and that their investment is worthless may not be the most pleasant task in the world, but at least the investor was aware of the risks. Telling your aunt and uncle that you’ve just blown through their nest egg and the business has failed is another story. The external costs of losing a family members’ investment can be ten times the actual internal amount of capital invested.
Be very wary of FF&CBA capital sources and the subjective costs that are often attached. Approach and evaluate as capital sources only FF&CBAs that clearly understand the investment process and business in general and that can afford the potential loss. Nothing is worse than having a business fail and then watching the family disintegrate as a result.
. Private Capital
In the business world, a large number of private capital sources are available and include such sources as venture capitalists (VCs), investment bankers, angels or white knights, and similar types of private investment groups.
Private capital sources come in a variety shapes, sizes, and forms, but all tend to gravitate toward a common set of criteria:
- The dollar size of the capital commitment is generally much larger. These groups are comprised of highly trained and sophisticated professionals responsible for managing large pools of capital and, as such, apply the concept of economy of scale frequently.
- These groups tend to be more risk-based capital sources and look for higher returns from equity driven transactions. These groups are comfortable with making equity investments in relatively early stage businesses without proven profitability (but with significant potential) or structuring risk-based debt facilities to support a “higher risk” business opportunity (in other words, the debt is secured by nothing more than goodwill). Just remember that higher investment returns will be expected for taking on the added risk.
- These groups aren’t looking to invest in a company with a revenue potential of $10 million after five years (similar to a solid regionally based construction subcontracting company). With the types of capital these groups have available, the business opportunity must be relatively grand to pique their interest. While the next Microsoft isn’t needed, these groups look for opportunities that produce in excess of $100 million in annual revenue (over a reasonable time) and generate strong profits or earnings. Companies that offer rather novel product or service concepts with serious market potential are favorites of these groups.
- Private equity sources or groups tend to be very focused on the eventual exit strategy available to realize their ultimate return. Reasonable timelines or horizons are expected from the point these groups invest to the time they realize their final return. The final return generally comes from the company being sold or by utilizing public investment markets to provide these groups with a readily available market to dispose of their holdings.
The good news with private capital is that larger capital amounts are available, the groups are generally very sophisticated and can provide invaluable management support, and the capital is often equity-based so that aspiring businesses in need of large capital infusions have a resource.
The bad news is that these groups tend to ask for (and receive) a higher ownership stake in the business and thus can exert a significant amount of management control and influence. In addition, these groups retain highly trained professionals who are very demanding when they’re undertaking their investment review/evaluation process. If your case isn’t ready to be presented, then don’t, because private capital sources won’t even give you the time of day without a business concept or plan that can stand a punishing evaluation.
. Banks, Leasing Companies, and Other lenders
Debt capital sources including banks, leasing companies, government-backed programs, asset-based lenders, factoring companies, and the like have evolved over the past 100 years into one of the most sophisticated capital source groups around. For almost any debt-based need, some type of lender is readily available in the market.
These groups, similar to private sources, tend to look for a common set of characteristics when extending capital in the form of debt:
- Security of some sort — an asset or personal guarantee, for example — must be present. Lenders like a secondary form of repayment in case the borrower can’t cover the debt service requirement.
- Debt providers tend to look for more stable business environments where a company has been in business for an extended period of time and has a proven track record. Businesses don’t have to necessarily generate a profit to secure debt financing, but it certainly helps.
- Debt capital sources are more conservative in nature. Their goal is to ensure that the debt can be repaid while generating an adequate return. Maintaining solid financial returns and strong ratios is more important than watching the company double in size, placing too much pressure on its leverage ratios. From a positive perspective, debt capital sources cover a broad spectrum of financing requirements ranging from as little as $50,000 (a niche factoring or leasing company providing capital to small businesses) to billions of dollars (the world’s largest banks providing financing for a multibillion dollar public company buyout). In addition, management control isn’t relinquished because debt providers generally don’t have a say in an ongoing business.
On the flip side, security in some form is usually required, which places business (and potentially personal) assets at risk. Also, the debt must be repaid per the terms and conditions established, regardless of whether the company’s performance allows for the repayment. Unlike equity investments, which tend to generate only a distribution of earnings or dividends when the company’s performance dictates, debt repayment terms must be adhered to, and, if not, the company can suffer the wrath of its creditors demanding repayment.
Businesses often secure capital from more than one source on a periodic basis. For example, risk-based capital (in the form of equity) may be secured to develop a new product and support the initial launch into the marketplace, whereas debt-based capital may be secured to support an increase in inventory and to carry trade accounts receivable as customers purchase the products.
Both forms of capital aren’t only appropriate for this company’s needs, but, in addition, the lenders may be more willing to step forward and provide the necessary capital knowing that another partner has made a commitment.
The herd mentality holds true for capital sources because they view the opportunity in a more positive light (with a higher degree of success) knowing that the right amount and types of capital have been secured.
. Public Capital
Almost every business owner, professional, and manager is aware of the public markets available to trade stocks and bonds, including the New York Stock Exchange, NASDAQ, and similar venues. Both equity (such as the common stock of Microsoft) and debt (such as United States Treasury Bills) instruments are actively traded in these open markets.
While the allure of the public markets is very appealing to business owners and often is viewed as the end game, the reality of operating in a public market can be very different.
As such, public capital sources have developed a unique set of qualifications in terms of making it the most appropriate capital source to pursue:
- Think big. Public markets are better suited for companies thinking in hundreds of millions or billions than millions.
- Think public. Basically, all your company’s information, financial records, activities, and so on will be available for public viewing. You must not only be prepared to disclose the information, but also make sure that the disclosure is prepared in the proper format.
- Understand risk. Are the returns and rewards for being public adequate in relation to the risks you and your business assume?
- Think expensive. It’s very expensive to “go public” and then maintain and support all the tasks necessary to stay public, including more frequent reporting requirements, federal government antifraud measures compliance, such as the Sarbanes-Oxley Act of 2002 (SOX), production of public reports and documents, and added professional fees.
Public capital market’s positive attributes include having access to extremely large capital levels that can tap the widest range of sources available (stretching the globe). There really isn’t any deal too big for public markets as the United States $9 trillion of outstanding debt clearly displays. The liquidity public markets offer the ability to establish fair market values almost instantaneously, as well as access to both debt and equity sources also represent positive attributes.
As you know, there is no utopia from a capital sources standpoint, so there must be downsides to public capital as well:
- Cost: Staying in compliance with all the public reporting requirements can be extremely expensive.
- Added management exposure: Even when no fraud exists, investors in public debt and equity instruments can turn into a company’s worst nightmare when things aren’t going as planned. The additional burden placed on the management team can be extensive and detract the company from actually running its business.
- Misconception about liquidity: Just because your company is publicly traded doesn’t mean that liquidity is present. The stock of smaller companies — those with less than $100 million of market capitalization —are often not actively traded on the open market, which can make selling or buying a large block of stock difficult (not to mention the scrutiny insiders received when undertaking these transactions).
Although plenty of small companies are publicly traded, public markets are generally best suited for the big boys of corporate America.
. Other Creative Capital Sources
Sometimes you need to get a little more creative with identifying capital sources and tapping potential nontraditional capital avenues. The number of creative capital sources are endless, so rather than attempt to cover every trick of the trade, we offer a diversified list of creative ways to manufacture capital:
- A company generates positive internal cash flow and reinvests this asset internally as needed. Countless examples of this strategy exist, including a medical company, such as Merck, using positive cash flow from one line of pharmaceutical products to support research and development on a new drug to a gold mining company, such as Newmont, using its cash flow from a proven gold ore reserve to explore and develop a promising new gold ore reserve. Positive internal cash flow is a real source of capital available to finance business operations that is both readily available and, logistically, much easier to secure. However, it should be kept in mind that positive internal cash flow must be managed and invested appropriately within the best interests of the company and its shareholders.
- A company utilizes creative forms of unsecured financing from vendors, partners, customers, and so on to provide a real source of capital. For example, a company may require customers to prepay 20 percent of their order as a requirement to start the production and future delivery process. Or it may ask key product suppliers to grant extended terms from 30 days to 90 days during certain seasonal periods.
- A company looks for gifts. Governments, universities, and nonprofit organizations have resources available in the form of grants, low interest rate loans (with limited downside risk), incentive credits, and so on, which are intended to be used for special interests or purposes. The general idea is to provide this capital to an organization that will use it in the best interest of the general public. Biotechnology companies often secure research grants for work being completed on disease detection, prevention, and possible cures. Educational organizations may receive a grant that helps retrain a displaced group of workers or poorly educated work force. Under either scenario, the same concept is present in terms of committing the capital for a common good.
Other creative capital sources are available to companies as well, one of which we summarize in the following example.
A software company is developing a new fraud protection system for use in the banking system. Not only does the development of the system need to be capitalized, the initial marketplace launch requires additional capital to ensure that the end customers (mainly banks) can review, test, evaluate, and, when appropriate, implement the systems. Internally, the company doesn’t have enough capital to support this project, so it completes an acquisition of a sister company that was producing strong internal cash flows to support the project. The company issues its equity in exchange for all the assets of the target company (which, in effect, was the future cash flow stream). This scenario provides the company with enough ongoing cash flow from the acquired business’s product sales to both fund the system development and market it to the banks.
To a certain degree, managing the capital sources, after the capital is secured, can be even more challenging and difficult than raising the capital itself. Managing the capital sources tends to be more intangible in nature as it’s geared toward relationship support and communication efforts as opposed to just presenting hard financial and accounting data.
Keys To Raising Capital
Raising capital really does represent the ultimate sale in terms of convincing a capital source to actually believe in your business and then forking over the money. Terms such as nerve-racking, frustrating, euphoric, rollercoaster, and the like will become common place in addition to hair loss, stress, and joy.
So, in order to capture the essence of the fund-raising process as quickly as possible, I provide the following tips:
- Be prepared. Like the Boy Scouts of America say, always be prepared. Capital sources expect and demand the highest quality information, plans, and underlying support when evaluating an investment opportunity.
- Be persistent. Capital sources are looking for reasons to say no. We can’t emphasize enough the attributes of persistence and determination when pursuing and securing capital.
- Be patient. Raising capital often takes much longer to finalize than most people realize. You need to anticipate delays in the capitalraising process as rarely do deals close on time. Your business will need to be prepared to manage the inevitable delays that will occur.
- Qualify the capital sources. Make every effort to qualify your capital sources to ensure that the most appropriate avenue is pursued in relation to the operating status of your business. Don’t waste your time or theirs and by all means make sure that the capital source is capable and accredited to support the request. Researching and understanding capital markets represent integral components of qualifying the capital sources.
- Communicate. Communication efforts are critical to successfully securing and managing capital. Keep the capital sources up to date with all relevant information, good or bad.
- Document and disclose. Don’t underestimate the importance of properly documenting all capital-raising activities, from the initial communications to final agreements. Full and complete disclosures are a must in today’s hostile economic environment.
- Develop exit strategies. All capital sources want their money back with a solid return at some point. Offer clear and reasonable exit strategies to provide the capital sources with comfort that a light is present at the end of the tunnel (and hope that it’s not a freight train barreling down the other direction).
- Risk rewards relationship. To a capital source, equity investments carry more risk than debt investments, and, as such, the return realized on the investment must be higher. To a business, debt can expose the company to greater risks but also higher returns. The trick is to find the right balance.
The heart of raising capital lies in a business’s ability to generate a profit and positive cash flow. Cash flow represents the ultimate lifeline of any business operating. Understanding how a business generates and consumes cash represents the single most important item in determining whether a company will be economically viable and gain the interest of capital sources, or die a natural death and be discarded to the mass grave of dead business plans.