Return On Investment Versus Cost of Capital

The common challenge faced by business owners and entrepreneurs is how to take advantage of short opportunities that require capital.

A typical scenario would be entering a contract to deliver a good and service that you have access to but the buyer does not.

Lets make up some numbers to better illustrate.

Say you have an opportunity to supply 100 widgets to a company you’ve never done business with before for $10,000 each for a total sale price of $1,000,000.  Your cost to supply before financing costs is $600,000 so there is a potential $400,000 margin in the deal.

You have the access and ability to complete the deal and all that is required is capital.

Like most deals, there is some time requirement to deliver.  In this case, lets say its 3 months.

So all that’s missing is capital to make this highly profitable deal go and with 3 months to work with, you should have plenty of time, right?

Potentially.

You’d probably be surprised to see how many of these deals never happen or have to survive a mad scramble at the end to make them work.

Operational issues aside, the main reason for failure or distress is from the inability to secure capital for deal.  And in many cases, this failure to secure capital comes down to the mind set of the business person (or none business person in charge).

The starting assumptions of most people is that 1) money won’t be hard to find, and 2) it will come at a reasonable cost.  For these high value, unproven transactions, these assumptions are almost always wrong.

Especially when its your first time through with a transaction like this to a new customer, the goal is to get it done and make some money in the process versus trying to maximize the return.  If the deal gets done, there will potentially be future deals with the customer and potentially other customer now that there is a track record established.  If the deal doesn’t get done, it was all a waste of time as well as a liability issue if breach of contract occurred.

The capital that tends to be available for these types of transactions is opportunistic in nature and come with a high cost of use.

I’ve seen cases where the source of capital required the borrower to split the margin with them.  I’ve seen cases where the capital source wanted 3%+ for the use of the funds and a large fee on completion.

When business owner and managers hear these types of numbers, they scream foul and walk away in disgust if they’re new to this game.  And instead of getting the deal done and making some money, they tend to spend and waste their time looking for cheaper money that will save them money on the deal.

Look,  I’m all for saving money and maximizing my return on a deal.  And as far as high cost sources of financing go, I don’t like or dislike them.  This is not about what someone thinks is far or unfair.  This is what all business financing scenarios are about, and that in one word is RELEVANCE.

Business financing is always about finding the source of capital that is relevant to your specific needs and situation at a given point of time. And what is relevant is what is available to complete the transaction in the time period required.

Too many times business people shoot themselves in the foot by holding out for a better deal, for a cheaper source of capital.  If you can find one, great.  But if time is ticking and the next best option will get the deal done but grossly cut into your profits, what do you do?

I say get the deal done, make some money, and build off of your successful transaction so that the next time around you have a chance at a greater return.

But that’s just me.