Bruce Werner specializes in governance, strategy, finance and M&A. Author & Experienced Outside Director. Kona Advisors LLC.
Most private companies don’t spend much time thinking about their capital structure. A few people own the business, and they typically have a relationship with a commercial bank that works well for them. This usually includes a line of credit, equipment financing and perhaps a mortgage. When times are tough, the owners put more money into the business if and when they must.
This works well for a lifestyle business, but not as well for a growing business. A service business may not need much capital to fund growth, since a line of credit will float receivables, and there is no inventory to hold.
But if you have inventory and receivables and rely on fixed assets, you likely need more permanent capital to finance growth. That usually means an equity infusion, which will dilute your ownership.
The sum of debt and equity is your capital structure. How do you optimize it to fund growth at the lowest cost with the least dilution?
Debt is cheaper than equity due to its tax deductibility and lack of dilution, but it does increase your risk. But it is not all about cost.
Here are questions you should ask yourself before deciding what is best for your business:
Long-Term Objectives
Are you a long-term owner, or is your plan to hit a number and sell? If you plan to own the business for at least five years, you may want more of a relationship-driven than transaction-driven capital source. Longer horizons mean more ups and downs. Who is likely to be more helpful if you need a favor?
Banks and investors have specific strategies for how they like to deploy their money. You need to be looking at the part of the market that is best aligned with your objectives.
Who do you want as your partners?
Whether it is debt or equity, you are taking on partners. What rights are you willing to give them? How much time do you want to spend reporting and answering questions? What say do they have in running the business? If the relationship sours, how do you get rid of them?
Here’s a common scenario: In private companies, there are often two partners. Years later, one passes away, and the spouse owns the equity. This gives you a new partner whom you did not agree to have. You need a mechanism to address this, and this decision should be agreed upon when the original partnership is formed.
These are the issues with partners. You need to think about where you can compromise and what are dealbreakers for you.
What do your partners have to offer?
Money is a commodity; you can get it from many sources. What are the new partners bringing to the table besides money? Do they bring customer relationships that save you a few years of marketing? Can they turn on new suppliers to help launch new product lines? Can they turbocharge your product portfolio?
If they are bringing more than money, there may be a reason to consider an equity investment. If they are only bringing money, then a debt instrument may be more appropriate.
Costs And Returns
An optimal capital structure will maximize the value of your business with the lowest cost of capital. This reduces your risk and ensures the business can meet its obligations.
The average return for the S&P 500 for the last 100 years is thought to be about 10% per year, including dividends and growth. As a private company owner, you should be earning more from your business than the public markets to compensate you for the lack of liquidity and the highly concentrated position. However, this does not include the value of pride of ownership, and perhaps family legacy, that you may have by owning your business.
Risk Tolerance
Risk can be measured in many ways, but the best way is “Can you sleep at night?” If not, you should consider making a few adjustments.
Lenders will measure the margin of safety to get their money back. Variations in cash flow and loan-to-value ratios are critical to understand. Before taking on partners, you should run sensitivity analyses to understand what happens in a down market. Can you service your debts if revenues drop 10%? 20%? And for how long?
Think about what has happened to the great brick-and-mortar retail businesses of the past as the internet has changed how consumers shop.
Flexibility As Markets Change
Your markets and industry will change over time, and you will need to change your product portfolio, marketing strategy, sales tactics and operations to adapt to these changes.
You should use sensitivity analyses to think about how your capital structure may need to change to adapt to your changing markets. If you need more equity, should it be common or preferred? Is a mezzanine or junior debt instrument a better compromise for your needs?
You want your capital structure to fund growth with a margin of safety, at a low cost, while not constraining what you do with the business. By having access to more parts of the capital markets, there might just be a better way forward.
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