Posts Tagged ‘debt’

In Almost All Cases, Risk and Cost Of Capital Are Closely Related

If you have ever studied the theory of finance (and managed to stay awake through it), you will have been exposed to yield curves, CAPM , risk free rate, weighted average cost of capital, term structure of interest rates, and so on.

Basically, the more risk that’s present in an application of capital, the higher the related cost of capital.

Yet, I continually see business owners that are trying to change the equation while searching for low cost capital with a high associated level of risk.

The lowest interest rates are reserved for opportunities where the lender is well secured, there is well established cash flow, excellent credit, and a reasonable amount of total debt load.

Rates for both debt and equity capital will go up as these investment characteristics become less excellent.

This is pretty straight forward stuff that most people would understand and agree with.

However, the context of society’s basic understanding on the cost of capital is based more on mortgage rates and car loans than anything else.

Business Financing can be a whole different ball game due to the higher levels of inherent risk and when we speak of risk, its risk of lender or investor loss.

From a lender or investor point of view, risk has everything to do with the liquidation pathway which stated in different terms means “how do I get my money back if things go south”.

For residential mortgages, the lender puts the house up for sale and gets the funds back in 3 to 6 months, depending on the market and the  foreclosure procedures in play.

For a commercial mortgage, the same applies, but the market can be a lot thinner in terms of buyers, and the time period for sale could turn into years which will require payment of property taxes, maintenance, utilities, etc, which all reduce the proceeds and increase the chance of loss.

Higher risk equals a higher cost of captial.

When you look at unsecured loans based on stated income and credit, the risk is again higher.  For in the event of a failure to pay, what’s the likely hood of the lender getting any money back?

Equity capital is significantly higher than debt capital in most cases due to higher risk of loss by the investor.  Equity investors will demand a wide range of returns, but the range can be as broad as 15% to 30% or even broader … depending on the risk.

Yet I’m still amazed when medium to high risk ventures are convinced they should be able to secure low risk capital.

Unproven business models and business start ups for example are not prime plus type risks.

Many times start ups and unproven ventures get upset with me when I propose relevant business financing solutions that they view to be high or even extortive.   I have had many discussions with entrepreneurs seeking 8% to 12% money for a 18% to 25% risk.  They have nothing to offer in terms of security except the future cash flow projections of their business idea or project.

I then provide the best analogy I have to try and bring them back to earth which is as follows.

A private investor will place second mortgages for 12% to 14%, fully secured by residential properly, providing a higher than normal rate of return due usually to the bad credit of the borrower.  Their relative risk is small, although they will have to be prepared to deal with some foreclosures, but the profit margin is still very good.

So if these guys can get 12% to 14% all day long secured by real estate, why would they ever invest in a venture looking for even a lower rate of interest and not offering any real security except the promise of future profits?

Some times I get through, but most times I don’t.

I guess hope does spring eternal.

Technorati Tags: Business Financing, cost of captial, debt, equity, investors, lenders

Can You List The Four Reasons Why Someone Would Need To Secure Capital?

There are 4 and only 4 reasons to secure capital for a business.  Each reason or purpose for Business Financing will impact the type of lender or investor to approach as well as the manner in which you approach them.

The 4 reasons for seeking more capital for a business are as follows:

Start Up.  At the commencement of a business entity or operation, funds may be required for working capital, fixed assets, intangible assets, leaseholds, inventory, and so on.

Growth.  An existing business looking to expand may require capital to increase its capacity as well as the working capital required to fund a larger volume of activity.

Acquisition.   When one business acquires another, it must purchase either the shares or the assets of the target business with a combination of cash and external capital from debt or equity sources.

Debt Consolidation and/or Re-organization.  In times of business downturn that create financial losses, capital must be injected into the company from debt or equity sources to cover the costs of operation and allow the company to continue.   Another scenario would be when the term structure of the debt outstanding does not match up against useful life of the assets securing it.  In these cases, a debt restructuring will take place to balance out the balance sheet. A third example would be when outstanding debt exceeds the leverage against equity allowed by the lender, requiring a debt reduction and/or an infusion of investor or shareholder equity.

Each of the reasons to Secure Capital or apply for business financing have their own lending and investing criteria.  A business manager or owner seeking incremental capital would be well advised to gain a greater understanding of what is required for each and work towards identifying lenders and/or investors that are relevant before proceeding too far with any inquires to secure business capital.

We will get into more of the specific for each of these uses of funds in future posts.

Technorati Tags: acquisition, Business Financing, debt, debt consolidation, equity, growth, investor, lender, lending, Secure Capital, start up

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.

Technorati Tags: Business Financing, capital, debt, equity, finance, loan, loans

The question of how to secure capital for your business is commonly asked and pondered by most small and medium sized business owners and managers at one time or another.

When you search the internet for the answer, you tend to get the same lame regurgitation of things like new businesses should look to friends, family, and fools for capital; existing businesses should look to banks; and that you need to consider debt financing versus equity financing that gets into the whole venture capital versus angel investor rhetoric.

Wow.  Really revolutionary and informative information.  Some even go so far as to say these are secrets if you can believe it.

Now I’m not implying that these various terms I just threw out don’t need to be explained or are not important.  No sir/madam.  I’m merely saying that all these terms with some amount of abbreviated explanation are thrown at you like a bucket of water in some weak attempt to answer the question.

Perhaps its because the generic answer set I’ve outlined is pretty basic and safe and even friendly.

But useful?

Instead of starting at the beginning, lets start at the end.  A bad ending.  Depending on whose stats you read, over 50% of businesses will fail, fold, go kaput in less than 5 years of existence.  Whether its 43.7% or 71.2% that fail in 5 years doesn’t really matter.  The point here is that its a lot and its alarmingly high.

So, why is it so high and what that got to do with securing capital?  Answer, it has everything to do with securing capital.

The internet for one is awash with people looking for money to finance their business ventures, either start up or existing, and most of the solutions that they come across are geared towards lending them money based on nothing to do with their business.

Business Financing in large part, is not based on business.  Its based on personal credit, personal net worth, liquidatable (new word) assets, third party guarantees, government grants and guarantees, etc.   This applies not just for start ups, but for existing businesses as well.

The point (yes I do have a point) here is that if you try hard enough, you can probably find someone to give you some money for what you’re trying to accomplish that you say requires capital.

But your ability to be successful is dependent on 1) having a tested business model; 2) having a tested marketing approach and position; 3) having enough necessary experience, or access to the necessary experience for the venture, and finally 4) accurately estimating the capital required to become cash flow positive (business can generate enough cash to pay bills and generate a return on the capital you secured) including a substantial contingency plan for all the things that may go wrong along the way.

If  you don’t complete the above 4 points, my first question to you would be, how do you know how much capital you really need?  My second question would be, if you don’t Secure Capital sufficient to complete whatever you’re starting (your estimate was out and now you’re short), what are you going to do?

So how to secure capital for your business starts with how much capital do you need and is that much capital going to be able to generate a return based on your plan of attack.

In most business failures, if they did the exercise first (honestly and objectively at the very beginning), they wouldn’t need to secure capital because they’d find so many holes in their own logic and planning that they’d stop and revise things until they made more sense.

I’m not saying planning is perfect, because its not.  And no amount of basic planning and analysis will stop business failure.   But I’m telling you, its not going to be anywhere near 50% either.

The final point today is that when you make the effort and figure out what business approach should work (and I do say should as planning is imperfect) and clearly outline the capital you need to secure, you will not only have an easier time securing business capital (well thought out plans have a higher probability of getting funded), but you’re also more likely to meet or exceed your profit expectations (well thought out plans have a higher probability of making money).

We’ll get into a lot more on how to secure business capital as there can be a lot to it, depending on what you’re trying to do.

But the starting point is not “where do I apply?”, or “what tricky things can I do to get an application approved?”

If you that’s where you want to start, you’re looking to become another statistic.

Technorati Tags: business, debt, equity, financing, loan, Secure Capital, small business, working capital