Posts Tagged ‘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 FinancingIn Business Financing, There Are Exactly 4 Uses of Debt And Equity Capital
September 30th, 2009
When seeking any type of business financing for any sized business, small or large, there are four and only four uses or applications of capital. I’m going to go over each of them and why this is important to know and understand.
First of all, why is this at all important? Identifying the exact use of capital creates greater relevance in the capital procurement process.
Ok, I’ll speak english. Locating suitable capital funds, either debt financing (business loans), equity financing(investor capital), or a combination of the two, will depend to some degree on how the funds will be applied in your business.
Lenders and investors can be very specific in deals they will seriously consider funding and one of their key criteria will be how the funds will be applied.
Certain applications of funds will completely remove certain lenders and investors from the mix. By understanding this at the outset, you can create greater relevance in your search to secure capital by screening out the sources of money that will automatically not be interested in your deal.
This doesn’t mean the deal is good or bad, its just not going to be relevant to certain sources of business financing. So you can save yourself a lot of time and aggravation focusing on relevant sources. There are of course other criteria that helps determine relevance, but for today let’s stick with use of funds.
So what are the 4 uses of debt financing and/or equity financing?
- Start Up. The start up of a new business venture.
- Acquisition. The acquisition of an existing going concern business.
- Expansion. The Expansion of the assets of an existing business for the purposes of growth.
- Debt Consolidation/Reorganization. The repackaging of existing and potentially new debt into a modified or new debt instrument or instruments. This predominately relates to businesses in some distress or downturn that need to either inject more capital into the business to cover losses or move short term debt to a longer term debt instrument to improve the balance sheet and security position of lenders.
Within each of these uses, there are even more specific sub uses such as:
- working capital to finance day to day operations
- short term capital to purchase and add value to inventory
- short term capital to finance accounts receivable
- longer term capital to acquire other tangible assets like equipment, buildings, and land.
- capital to acquire intangible assets
If you are seeking business financing for a start up venture, there are many sources of capital that don’t fund start ups. Identify them, and don’t waste your time asking them for money.
If you’re looking to acquire an existing business, don’t seek funds from someone providing trade credit related to working capital type assets only.
As I alluded to earlier, there are other twists to this as well as certain lenders and/ or investors will consider expansion funding, but have other criteria to determine if the deal is relevant to them (amount of funding, industry, debt to equity ratio of the balance sheet, debt service coverage, assets to be acquired, security ratio, etc.)
Each lender will have their own criteria set for each application of funds they will seriously consider. I say seriously consider because most lenders state at the outset they will look at virtually any deal to maximize their marketing efforts, but in reality, they all have a pretty narrow focus.
That’s why its important to understand how to accurately describe the business financing you seek and then qualify the universe of funding sources so that you’re only spending time with a relevant list.
But more in depth lender qualifying is a topic for another day. Stay tuned.
Small Business Financing Possibility Versus Probability
September 29th, 2009
Several times each week, I talk to small business owners who are seeking capital for their new or existing business and several times I have a very similar conversation with each of them that I thought I’d share today.
At the beginning of the conversation, I always ask the same two questions: How much money are you looking for? what’s the purpose of the funds?
I would say that at least 75% of the time, I have to re-ask these two questions two or three times before they’re answered. Most people think that telling me a long drawn out story of what they want to do and how they came to do it will be more important than answering these two questions.
What tends to come out after a few minutes is that the individual is hunting for what I call stupid money. You know, the kind that is prepared to write you a check on a very thin and likely non existent business plan where the lender is taking all or close to all of the financial risk.
Example. Someone has a great idea for a tennis equipment store. They have picked out a location and now need $300,000 for start up costs, working capital, and inventory. They have poor credit, personal debt, zero net worth, and no capital to contribute to the venture.
Is it possible that this individual could secure small business financing of some sort? Yes.
Is it probable? No.
That’s the great thing about the money business, virtually anything is possible, and I’ve seen enough to know first hand. After getting off the phone with me, this would be entrepreneur could go to the coffee shop, strike up a conversation with someone about his or her golf shop idea, and leave with a check in hand for the capital sought. Is is possible? Absolutely. Is it likely to occur? The odds would likely be lower than playing the lotto.
That’s why I’m always careful to not generalize about small business financing, as there is an infinite sea of money out there and strange things happen all the time.
But lets also get real. Just because its possible, doesn’t mean your new business financing strategy is to start going to coffee shops.
For the most part (can never generalize), money has a basic intelligence. If intelligence is not applied, the source of money will disappear very quickly based on making bad decisions.
People supply money to business ventures for a return. If you can show them a path to the return they seek within the level of risk they’re prepared to take, then eventually, you will find a source of capital for your small business financing requirements.
And here’s my tip of the day on this subject: You must have something to leverage and something to lose in order to have a realistic probability of getting business financing, whether it be for a new venture or existing business.
Something to leverage for low risk credit is your credit score, personal net worth, external cash flow, third party guarantee. Something to leverage for higher levels of credit risk would also include things like asset security, established cash flow, signed purchase orders from reputable companies, patents, intellectual property, contracts, etc. Remember also that something to leverage has to have a value to the source of money or there is no leverage.
Something to lose is at the very least the capital that you directly invest into the venture. 100% financing of anything is quite rare unless you’re taking about residential real estate and look what problems that has caused in the markets over time. Personal guarantees and corporate guarantees would also fall in this category if there was enough net worth to make them meaningful.
As the amount of leverage and borrower risk increases, so does the probability of securing capital.
Business Financing