Posts Tagged ‘business capital’
True Cost Of Capital
October 4th, 2010
“While There is Never Any Absolute Rules When It Comes To Pricing Money, Here Are Some Things To Consider When Trying To Understand The True Cost of Capital For Any Particular Application”
When seeking capital funding for any business venture, there can be a lot of different trade offs to consider with the different sources of capital that may be interested in funding a particular deal.
The most common forms of business capital come from debt and equity financing sources. And even though equity equates to ownership, there is still an implied cost of capital that needs to be factored in before accepting this type of money.
The most common problem business owners have when seeking capital is trying to locate money at a cost that does not likely exist. The second biggest problem is not properly comparing different forms of business capital when deciding on how to fund the business.
With problem #1, the business owner or manager does not understand the market and continually rejects potential offers to finance at rates above their target rate. There is nothing wrong with this approach provided that the target rate actually exists for the deal or will appear before the business runs out of time.
In order to avoid being in this situation, a more realistic perspective needs to be established. Remember that the cost of money always has to do with risk and supply with risk and supply typically being inversely related (as risk goes up, supply goes down).
As an example, its not uncommon for a business owner to seek unsecured business capital from private lenders at 10% interest or lower because they can’t secure anything from a bank and they have no assets to leverage. The proper perspective is that private lenders can lend their funds (and do) all day long on real estate and be fully secured and still lend at 10%+ interest rates. so why would they take on a higher risk (unsecured debt financing) for the same cost of capital?
With problem #2, the business fails to properly make an apples to apples comparison with different forms of business capital and defers instead to self created rules or assumptions.
For example, when a business requires business financing capital in a risk range that could be funded through debt or equity the costs and trade offs between the two forms need to be properly weighed.
Higher risk deals can command debt financing rates in the high teens. Most equity investments want a similar return or higher. Yet when a business owner sees an 18% interest rate as an example, many will immediately believe that’s too high and turn to an available equity solution that could actually be higher over time.
With debt, the best things about it is that you retain ownership and if you pay it back you retain control of the business. With equity, unless there is a buy out provision structured at the start, there may be no easy or cost effective way to pay out the investor as the business grows, creating a very expensive source of capital. Even with a structured buy out, the true cost of capital, if anyone spent the time to figure it out, could be substantially higher than the original debt financing solution.
If the cash flow is available to service the debt, the high interest rate loan option should not automatically be dismissed.
The search for capital often times tends to be left too long so business owners are forced into taking what they can get. But when choices are available, being realistic on your expectations, and crunching the numbers to better understand the true cost, can mean a tremendous saving in the long run.
Click Here To Speak With Business Financing Specialist Brent Finlay
Business FinancingHave You Made Adjustments To Your Business Financing Positioning?
April 30th, 2010
With all the changes that have taken place in the capital markets over the last 18 months, there is now a need to change the way that requests for capital are positioned with lenders and investors.
In the recent past, applications were primarily based on historical financial statements and a decent attempt at cash flow projections to support the request for additional or new business capital coming into the business.
But things have changed whereby there is a much greater demand by lenders and investors for the business owner and manager to put forth commercial financing requests that are more thoroughly supported by source documentation and spend more time on risk management than forward thinking marketing strategies.
From a lender point of view, we have moved into a commercial lending era of loan security, lender mitigation, and business risk management. While there still is money available in the market for businesses to acquire, there is a great deal more work involved in convincing someone that you’ve thought through all the major risks that could impact the business going forward and have a plan to mitigate the risks either in a proactive or reactive sense.
In the past, a lot of the details which have always been important to a business financing deal were glossed over by lenders or investors due to the strength of the economy and the unlikelihood of many types of risk to be of an issue or concern to many business owners. This saved on the due diligence process and was supported by decades of portfolio analysis that identified what areas of risk a lender or investor needed to focus on the most.
With the impact of the current deep running recession, most of that logic is thrown out the window as its a little more of an every man for himself type of world where the business owner now has to actually think about all the things that could go wrong in advance of asking for money.
In my opinion, it the financing world had taken more of this type of security and risk first approach years ago, the current recession would not have run so deep. But in better economic times, everyone wants to get in on the lucrative capital financing markets so lenders develop more aggressive portfolios to get their share of the growing pie.
But things are different now. Lenders and investors have made the necessary adjustments, which are akin to their survival as viable business organizations.
Unfortunately, for the most part, business owners have not adjusted the way they manage their business from a financial risk point of view and as a result their business financing positioning when asking for new capital can be way off the mark.
Its really a return to good solid business fundamentals that we are seeing in the market. Over the long run, this should be a good thing. In the short run, it looks more like pain and confusion to those trying to locate and secure business capital.
Click Here To Speak With Business Finance Specialist Brent Finlay
Business Financing