Happy New Year! Welcome to a fresh start, a clean slate, 365 days of possibilities.
Whether you are in a new business, doing familiar business a new way or simply picking up where you left off on December 31, the start of a new year provides an opportunity to reset. I encourage my friends and clients to begin each new year like they just bought their business from the previous owners (i.e., last year’s less seasoned, less informed, less good “you”) and to immediately embark on making that business better.
After all, you don’t typically buy a business to keep it exactly the same. You buy a business because you have a vision for unlocking its potential – you have a vision for making the business better.
Here are a few practical tips to get started:
- Spend the first working hours of 2023 envisioning the business that you would be thrilled to have. What does that look like? What are the components of that business? Which of those components do you have? Which do you need? What help do you need to get them?
- Now assess your current business. How does it differ from the business that you envisioned? What should you start doing or do more of? What should you stop doing or do less of?
- Now make a “first 100 days plan”. If you bought your business today, what would you do or change in the first 100 days to make it like the business you envisioned?
- Look at your organizational structure, your organizational chart. Do you have the right people for the business you are building?
- Look at your compensation system. Does your compensation system incent the behaviors that you need from key players?
- Look at your employment agreements, policies and procedures. Is your business protected? Are your employment agreements enforceable? Are your pay practices compliant with applicable law?
- Look at your financial structure. Do you have the right mix of equity and debt? Do you have enough cash or access to cash? What if your business tripled? What if your business was cut in half?
- Look at your security. Is your data secure? Is your employees’ data secure? Is your clients’ data secure? Are you adequately backed up? Is your backup secure?
- Look at your business insurance. Do you have the right coverage, in the right amounts, for the business in which you are actually engaged?
- Look at your location. Are you in the right physical location? Can you attract great employees who can afford to get to work, park (or use public transit) and be productive? Can your clients find you? If you don’t like your answers, how much longer do you have on that lease? Where should you go?
- Look at your online footprint. Are you making an impression? Is it an impression that you are proud to have? Does it attract the kind of business that you want?
- Look at your supplier/vendor relationships. Can your suppliers reliably meet your demand? What if your business tripled? Do you have a backup plan? What if your business was cut in half? How quickly could you scale back?
- Look at your client relationships. When was the last time that you met with each one? Which ones want to do more business with? Which ones are in jeopardy?
The list of questions could go on, but you get the point. It is a valuable exercise to examine your business as if you just bought it, and to develop a “first 100 days plan” for unlocking its potential.
How Do I Fund My Vision to Make the Business Better?
Most of us do not get paid in advance for the benefit that we promise to provide to our customers. At the same time, our employees, contractors, vendors, suppliers and business partners generally are not willing to wait for their payment until we get paid by our customers. That means, as business operators, we must generally pay for our inputs before we sell our outputs. To do that we need money; that’s why “cash is king.” That axiom is truer than ever in times of growth or expansion.
If money is the answer, or at least an answer, then where to get it, how much to get and how to use it are the questions. The right kind of money is the right answer, but the wrong kind of money can be a disastrously wrong answer.
Not all Money is Equal
Consider various types of money. Some types are designed to compensate for greater risk, like an equity investment; some are designed to compensate for a specific kind of risk, like a bridge loan; and some are designed to be cost-effective when risks are lower, like a loan secured by valuable real property.
Selecting the right growth capital for your business depends on many factors:
- How deep your “j curve” is or how long until your investment becomes profitable, or at least revenue-positive, will often instruct the amount of money you need and how long you need it.
- How long before a shifting economy or a competitor makes your idea or plan irrelevant can instruct how quickly you need to implement your growth plan (and therefore the rate of deployment of capital).
- How much time you have if you get off schedule can instruct your appetite for riskiness of capital.
- Market conditions and other conditions outside your control can instruct what is even available.
Many business owners in need of growth capital think first or only of equity. The appeal of equity is that, often, an equity investment:
- It is the most patient, in that it may not have a specified repayment schedule or repayment period.
- May not have an associated stated interest rate.
In that case, the absence of mandatory interest payments is appealing.
Finding equity can be difficult, however. Equity investors often have minimum amounts of capital they want to invest, require high returns, want control of the business (which can be a non-starter for many business owners) and are looking for a time horizon after which they can expect or require a liquidity event, usually the sale of the business.
The capital provided by an equity investor is likely patient and may free the business from the cashflow concerns of debt payments. But finding the right amount of equity and the terms that are mutually agreeable is generally hard, and equity investments are frequently far more expensive than debt in terms of the amount of money that is returned to equity investors (and thus unavailable to founders) upon a liquidity event.
Mezzanine financing may be available for high-growth companies and companies that have outgrown their bank’s capacity to provide financing. Bank financing is often appropriate for smoothing out irregular revenue cycles or funding long-term capital investments. But bank financing may go only so far, and the company might need capital to go further. Mezzanine financing comes behind bank financing to provide what’s required, but it fits between bank financing and equity, hence the name mezzanine.
In a mezzanine finance arrangement, the mezzanine lender likely takes as security for repayment of its debt the owners’ ownership interests in the business. The owners remain owners of the business, but the business itself is pledged against the debt. Mezzanine financing may be the right tool if the business is in a phase of high growth and has reached a point at which bank financing is inadequate to achieve growth objectives, but owners don’t want to sell equity. If the company repays the mezzanine debt, then the owners may find that the debt was less expensive than a sale of equity would have been. If the company is unable to repay the debt and the mezzanine lender forecloses on the debt, then the debt will have proven to be more expensive than equity.
A secured-term loan, well collateralized by reliable assets such as real property, generally carries a comparatively favorable interest rate and predictable, level repayment terms because the reliable collateral provides comfort to the lender. With a term loan, the company’s assets are generally pledged as collateral, and owners should be wary of guarding those assets against unknown risks. As with mezzanine debt, if the company repays the debt, then the debt will have been less expensive than a sale of equity, almost certainly. If the company is unable to repay the debt and the lender forecloses on the assets, then the debt will have proven to be more expensive than equity, and the owners will have retained ownership of a company without assets.
A term loan may not be practical or even available until the company has accumulated considerable value in its assets and real property, or the debt is used to acquire new valuable assets. When available, however, the term loan can provide liquidity to add predictability and help navigate known near-term risks to business growth.
A bridge loan – or a hard-money loan –generally requires higher interest and has steep penalties if not repaid in a short time. This is by design. Bridge loans are designed to incent quick repayment. Over a longer term, the high interest and short repayment period of a bridge loan can absolutely choke a business, but in the near term may provide liquidity to get out of a tight financial spot.
Line of Credit
A bank line of credit is generally the least expensive and most flexible form of debt financing. There’s an old adage that says, “Banks lend money to businesses that don’t need it.” Remember, however, that banks are not venture capitalists. If a business is looking for an equity partner, it should not look to a bank.
Bank lines of credit generally provide liquidity capital on a short-term basis, and can be drawn and repaid to smooth out irregular cash flow cycles. Lines of credit can be used to finance timing differences between the borrower’s payment of expenses and collection of accounts receivable.
A rule of thumb for the size of a bank line of credit is often one month’s revenue, however, some banks look at the difference between its borrower’s collection period on accounts receivable (AR) versus the timing of payables payments. If the company’s AR collection is 45 days on average but payables are due every 30 days, it will likely need about 15 days of sales as a credit line. A company with $10 million in revenue sells about $27,000 per day, or just over $400,000 in an average 15-day period. Circumstances may be different for companies that carry inventory in addition to AR.
Lines of credit are typically smaller amounts than term loans but are generally secured by all assets of the business. Because of that, if the company repays the debt, then the debt will have been less expensive than a sale of equity, almost certainly. If the company is unable to repay the debt and the lender forecloses on the assets, then the debt will have proven to be more expensive than equity, and the owners will have retained ownership of a company without assets.
The Right Combination and Strategy
A business should have a realistic plan for combining equity, mezz debt, secured loans and lines of credit to achieve its growth objectives, but should be aware of different combinations and specialty lending products in case the plan doesn’t work out. Realistic forecasting and planning can help the company both obtain and manage its growth capital and achieve its objectives.
Jeff Cunningham is a partner at Parker Poe and represents closely held businesses, emerging businesses, and established companies. He has experience across many industries, including manufacturing and distribution, business and professional services, construction, and technology.