Risk Of CapitalBig or small, public or private, foreign or domestic, one month new or 20 years old, it really doesn’t matter, securing and managing capital resources represents the lifeline of any company looking to operate in today’s challenging economic climate. This post outlines the process of raising capital, the different types of capital available, managing the risks associated with each type of capital needed to successfully secure the almighty dollar and to take an idea from a conceptual stage to a viable business entity.

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It is important to keep in mind that capital should not be perceived as just the amount of “cash on hand” but rather as “the amount of financial resources” available to support the execution of a business plan.

 

Raising Capital—Outlined

Raising capital really does represent the ultimate sale in terms of convincing a capital source to actually believe in your business and to then fork over the money. Terms such as “nerve racking”, “frustrating”, “euphoric” and “riding a roller coaster” will become commonplace, in addition to hair loss, stress, and joy. The following key points regarding raising capital capture the essence of the fund-raising process as quickly as possible:

Be Prepared: Like the Boy Scouts of America say, always be prepared. Capital sources expect and demand that the highestquality information, plans, and underlying support be made available when evaluating an investment opportunity.

Be Persistent: Capital sources are just looking for reasons to say no. The attributes of persistence and determination cannot be emphasized enough when pursuing and securing capital.

Qualify the Capital Sources: Don’t waste your time or theirs—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. And by all means make sure the capital source is capable and accredited to support the request.

Communicate: Communication efforts are critical to successfully securing and managing capital. It is extremely important to keep the capital sources up-to-date with all relevant information, good or bad.

Document and Disclose: Do not underestimate the importance of properly documenting all capital-raising activities, from the initial communications to the final agreements. In addition, full and complete disclosures are a must in today’s litigious environment.

Exit Strategies: Remember that all capital sources will 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 will be present at the end of the tunnel (hoping that it’s not a freight train barreling down in the other direction).

Risk/Reward Relationship: To a capital source, equity investments carry more risk than debt investments do; 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. If this sounds familiar it should—cash flow represents the ultimate lifeline of any business operation.

Understanding how a business generates and consumes cash represents the single most important item in determining if 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).

 

 

Managing The Risk Of Capital

Raising or securing capital is without question one of the most difficult and time-consuming tasks the executive management team of a company will undertake. Preparing, packaging, marketing, negotiating, and closing the “deal” can easily consume 50% to 100% of an executive’s time, depending on the stage of the company. For a start-up operation, chief executive officers (CEOs) and other senior executives often find themselves closing on one round of financing, resting for a day or two, and then starting the process all over again, looking for the next financing source. For a chief financial officer (CFO) of a publicly traded company, the majority of her or his time may be consumed in preparing information for the capital sources and markets and then managing the capital sources expectations, inquiries, and/or other needs. 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 this element of capital risks is more intangible in nature, as it is geared toward relationships and communication efforts as opposed to hard financial and accounting data. Now, let’s turn our attention toward the more tangible elements of managing capital risks from an accounting and financial perspective.

Below table illustrates these capital risks for an Equity scenario and a Debt scenario:

Managing Risk Of Capital

As is evident from the information provided, all elements of this business are exactly the same except for the way the business was capitalized:

  • Under the equity scenario, a total of $2,000,000 of capital was raised, all in the form of equity.
  • Under the debt scenario, a total of $500,000 of equity was raised and $1,500,000 of debt was secured (of which $300,000 was repaid during the year).

 

The Income Statements are exactly the same except for the fact that the debt scenario has interest expense present.

The Quick Financial Analysis highlights the key differences and indicates that by using debt the company was able to generate better returns for the equity owners as follows:

  • Returns: The debt scenario produces a return on equity of 24.74% compared to a return on equity of 14.21% with the equity scenario while the return on assets is almost identical for both scenarios.
  • Earnings: The debt scenario generates earnings per share of almost four times that of the equity scenario ($.82 per share compared to $.23 per share).

The only real downside lies in the fact that the debt scenario has a much higher debt-to-equity ratio present of 1.45 compared to 0.38 for the equity scenario in addition to having a debt service coverage ratio of approximately 1.1 [i.e., total earnings of $410,983 divided by the company’s total annual debt service including loan principal payment of $300,000 and interest payments of $72,000].

While using debt was beneficial in terms of enhancing returns, it placed the company in a higher risk status due to the amount of debt leverage used. This will be clearly illustrated when the next year’s operating results are realized as presented in the next table:

Capital Structure Comparison Table

 

The company has gone from having a robust year with strong margins and profitability to having to deal with a recession driving sales and margins lower. While its selling, general, and administrative expenses were reduced as a result of the difficult times, it was not enough to enable the company to generate a profit, using the debt-financed scenario. However, under the equity-financed scenario, the company is able to generate a small profit and to produce positive returns on assets and equity while the debt-financed company incurs a loss and negative returns.

Making matters even worse is that the debt-financed company may now be in violation of certain debt covenants and in default of the loan agreement. For example, the loan agreement may read that the company needs to maintain a debt coverage service ratio of at least 1.0 and/or to produce profitable results on an annual basis (both common covenants for lending sources).

Because the company may have violated both covenants, it may be in technical default on the loan, a situation that will require a fair amount of management attention moving forward. And just to add a little more insult to injury, the real damage may not be realized until the coming year and beyond. While the equity-financed scenario provides the company with a strong balance sheet and ample financial resources to expand after the recession ends, the debt-financed scenario places the company in the difficult spot of having to restructure its balance sheet to satisfy its creditors. Thus, it may miss significant growth opportunities in the coming year and beyond, costing the company both sales and profits.

In summary, debt and equity financing strategies cut both ways. While debt financing strategies can enhance returns, they also increase the company’s operating risks by leveraging its assets.

 

In good times, when profits and cash flows are ample and everyone’s making a buck, debt financing strategies look great. When the tide turns and profits dry up and cash flows become restricted, debt financing can look like the evil stepchild that nobody wants around but who must be fed.

Remember, debt financing sources are focused on providing loans that generate sound returns and are repaid in a reasonable time frame. You won’t get much sympathy from a bank if you ask it to suspend debt payments so you can keep a business unit open on the hopes of an eventual rebound. Conversely, equity capital offers a chance to strengthen the balance sheet and to help manage the company’s operating risks through good times and bad. Maintaining a strong balancesheet can really provide a competitive weapon when expanding a business into new markets or exploring a unique business opportunity.

However, having too much equity without being able to generate adequate returns can dampen investor enthusiasm and produce a rather restless group of shareholders and board members. Remember, equity financing sources do not invest capital to watch it generate below-average returns. Equity capital, although representing a lower perceived risk to the company, is by its nature a higher-risk capital source (to the providers) and must produce a satisfactory investment return. If not, the equity capital will find an opportunity that does provide the necessary return.

A business needs to invest in a variety of assets to carry on its profit-making operations. Therefore, a business must raise the capital (mainly money) needed for investing in its assets. This is no easy task, to say the least. A business must persuade others to put their capital in the business, which invariably involves some risk to the capital provider. First and foremost, a business needs a sound business plan to convince sources of capital that it will be a good steward of the capital and will earn operating profit sufficient to pay for the use of their capital. The essential elements of a sound business plan, from the perspective of raising capital, are discussed in this post.