It’s not uncommon for business owners experiencing a cash flow crisis to determine that bringing in a partner or equity investor, such as a venture capitalist or angel investor, will solve all of their problems. Unfortunately, during my 28 years in the alternative trade finance industry, I have seen many businesses fail because of this type of thinking.
Specifically, these owners did not understand the difference between equity financing and working capital. I’ve seen good, profitable businesses explode due to cash flow problems, and entrepreneurs lose ownership and control of their businesses before they had a chance to succeed. Many of these complaints could have been avoided if the owners had opened their minds and taken the time to seriously analyze everybody the financing options that are available to them.
Often what these companies really need is simply a boost or access to more working capital. “There’s a big difference between raising working capital and bringing in an equity partner,” says Davis Vaitkunas, an investment banker and president of Bond Capital in Vancouver, BC.
“While homeowners suffering from cash flow problems may think their only solution is a large injection of cash from an equity investor, that could be the worst thing to do,” says Vaitkunas. “In fact, the math will show that the owner who finances 100 percent of his working capital with stock gets a lower return on the owner’s stock.”
Working Capital vs. capital financing
At this point it may be useful to clarify some terms. For starters, “working capital” is the money used to pay your business bills until cash from sales (or accounts receivable) is received. Terms of sale vary between industries, but typically a business can expect to wait 30-60 days for payment. Therefore, as a general rule, your business should retain twice your monthly sales in the form of working capital. You can increase the amount of working capital available by retaining earnings, improving vendor credit, or using alternative financing vehicles.
Meanwhile, “equity financing” is the money a company acquires by selling some of the shares owned by the company. In many cases, this may also mean relinquishing control over some or all of the major business decisions. This can be a good thing if the investor brings a unique experience or synergy to the relationship. However, the terms of a capital investment can be complicated, so it is important to fully understand them and to have good legal advice. Think of it as a business marriage.
According to Vaitkunas, “Companies should use capital to finance long-term assets and working capital to finance short-term assets. You want to apply the matching principle and match the length of life of the asset to the length of the life of the liability.” “. A long-term asset takes more than a 12-month business cycle to pay for itself, while a short-term asset will typically pay for itself in less than 12 months.
When to dilute equity
“Fairness is a precious commodity,” emphasizes Vaitkunas. “It should only be sold when there is no other option. The equity partner should bring experience and/or contacts that cannot be found elsewhere.” The best strategy is to secure equity financing at a time when you can negotiate and preferably dictate some of the terms. Ideally, absolute control should remain with the owner.
Timing is everything when it comes to equity financing, Vaitkunas continues. “Sometimes it’s better to just take your time and wait for the best value proposition. While you wait, you can grow within your means by using short-term liabilities.”
It’s generally not a good idea to seek capital when a business is new, struggling to make a profit, or experiencing a setback. Unfortunately, this is exactly the time many business owners start thinking they need to “find an investor.” This process can be time consuming and energy consuming, which is taken away from the business, and this can have a compounding and aggravating effect on existing problems.
As a general rule, equity partners should only be sought after a company has a proven track record of sales and profitability and there is an identifiable and specific need for the money. So it is important to show how an injection of capital will lead to even higher profits and higher sales. A business that has a proven level of profitability, some historical sales growth, and even more potential for future sales growth is a much more attractive investment to potential capital partners.
Working Capital Financing
The shortage of working capital is a short-term problem that can be financed with senior debt or mezzanine debt. As an alternative, short-term financing is also available through factoring or A/R financing providers who seek certain accounts receivable and inventory assets as collateral. A combination of these types of alternative strategies can increase available working capital to the point where the need for an equity partner is no longer needed.
So how do you decide which financing tool to use for the job? “If you’re tempted to consider an injection of capital to solve growth problems, you also need to consider the potential partnership risk down the road and the real cost that capital may incur in the future,” says Vaitkunas. The best working capital solution may be an accounts receivable line of credit, which costs less than equity and introduces no partnership risk.
The bottom line:There are many alternative options available for companies that need an infusion of cash in addition to hiring a partner or shareholder. It is important for all business owners to know and understand all the options before making such an important decision. Knowing all the available options, and understanding when it is best to use which, could prevent many complaints and difficulties for many business owners.
