Bank debt is very likely your cheapest source of financial capital. Ownership equity, despite having no contractual requirement to pay interest or dividends, is certainly yourmost costly. Why is this? When a bank makes a loan to a company, the bank takes little risk. Banks are regulated with a view toward protecting the depositors. For starters, a banks lending officer and credit review committee must be persuaded that the company will have sufficient profit and cash flow to cover the interest charges on the loan (normally 3 or more times the interest the expected interest expense) plus the ability to repay the loan. Only if they are satisfied on these points will the bank go to the next step of considering collateral and personal guarantees of the owners (joint and several. When the loan is made, there probably will also be covenants restricting things like compensation and dividends to the owners and thresholds of ratios that will serve as red flags, and could trigger the calling of the loan, if broken. The bank will also be senior to all other creditors in the event of bankruptcy. In effect, the bank simply does not take risks, and because of the low risk, its charges for loans will be the lowest you can expect to get. At the other end of the risk spectrum is owner equity. As an owner, you have no contractual protections (beyond limited liability) and no guarantees of any income from interest or dividends. You are at the bottom of the totem pole regarding recovery of your investment in the event the business fails. If the company is privately owned, you, as an owner, have little chance of being able to sell your position. That is, unlike being a stockholder in a public company, there is no market for your ownership position. Your only hope for some kind of financial compensation is that some day, perhaps in the distant future, the company might get acquired or go public. Well, it is also possible that at some point, when the company slows it growth sufficiently (to a crawl) it might be in a position to start issuing dividends. But, the future is uncertain for an equity owner. The road to success is a long one and is littered with the corpses companies that simply did not make it. Factually, the vast majority of companies do not survive to the point of reaching critical mass and self-sufficiency. So, as an owner/investor, how much ultimate compensation is enough to entice you to take the risks and remain illiquid for an unknown period of time? Lets say the bank charges 6% for its very secure loan. And, history tells us that we can anticipate about 10% total return annually, on average, by investing in the biggest public companies. If we invest in smaller public companies we would reasonably expect, on average, around 13%, a higher return to compensate us for the higher risk we take by investing in smaller, less established, companies. If we consider investing in some of the smallest public companies, with annual sales of, say, $25 million, we would rationally do so only if our expected total return were over 13%, probably in the range of 15% to 20%. That is, in the absence of a dividend, we would expect the value of our investment in a very small public company to grow at a rate of 15% to 20% per year while we own it. Now consider being an owner of a small company that is not publicly-traded. There is no market to sell into if you decide you want out. How much more compensation would you need to entice you into such an opportunity as an owner? The answer, widely accepted by the IRS for valuation purposes, is about a 30%premium over what you would require for an investment in a publicly traded company. For example, if you would expect an 18% ROI for a similar company that is publicly traded, you would need 23% from a private company to fully reflect the risk and inflexibility of illiquidity for your investment. Effectively, the cost of equity capital is what investors expect to receive, over time, to compensate them in a competitive market for the risks they take as equity investors. This is why equity capital is the most costly form of capital. Most entrepreneurs are shocked when the first start seeking equity investors when they hear their first proposal. They have to be willing to give up a shocking amount of their ownership in order to get co-investors. For a relatively new venture, figure that the early investors will have to visualize around a 30% ROI to be willing to go in. This is a real quantification of the risks involved in the early stages of even the greatest- sounding idea. You do not want to give away equity ownership for good reasons, including the fact that if the business succeeds, the equity owners, including you, stand to gain wealth in proportion to the risks that have been taken by all who invest with no contractual expectation of financial reward or even beng paid back. This is the financial lure of entrepreneurial onvesting. The costs of other forms of financial capital fall somewhere between bank debt and straight equity. The list of possibilities is as large as the imaginations of those involved. Samuel W. Norwood III 2014
Accounts Receivable Factoring: Its More Than Just the Money By Tracy Eden August 3, 2009 The concept of core competency refers to the things done by a business that lie at the heart of its ability to manufacture a product or deliver a service. They are strengths relative to other organizations that are not easily imitated and that can be leveraged across different products and markets.
From a management standpoint, employees should spend as much time as possible working on tasks that contribute directly to the businesss core competencies, and as little time as possible working on tasks that dont. Since managing accounts receivable isnt a core competency for most companies, many rely on accounts receivable factoring companies to handle their accounts receivable functions. Going Beyond Collections
An Oakville, Ontario distributor of photo luminescent material used in exit signs and safety equipment began factoring their accounts receivable in 2008 in order to improve their cash flow. It soon discovered that factoring services offer additional benefits as well. This takes the onus off of our employees to manage accounts receivable, says the companys CEO. It allows them to spend more time focusing on more important issues, while our factoring service handles all the fine details of our accounts receivable management and keeps everyone on the same page.
In short, factoring services allow the CEO to concentrate on what he does best: growing and developing his business.
This particular distributor was referred to a factoring service by its primary bank. Since were an emerging company with a new technology, were not considered traditional, so banks can be a little hesitant until weve proven ourselves, says the CEO. However, the company was incurring heavy expenses on large volumes of raw materials, and the lengthy payment terms of its customers was creating a significant cash flow crunch.
We work with municipalities, universities, schools, hospitals and Fortune 500 companies, explains the CEO. They sometimes take a long time to pay. Because of the significant dollars involved, it made sense for us to take the small hit from factoring in order to keep the cash flowing.
The Importance of Vendor Assurance
Another potential benefit of factoring services is whats sometimes referred to as vendor assurance. In this companys case, its supplier was being asked to produce large quantities, but was a little uncomfortable since they were dealing with a relatively new company. Through its factoring services Vendor Assurance program, the supplier was persuaded to provide the product on open account terms.
This provides a safety net to our key supplier by increasing their confidence, says the CEO. Vendor Assurance was instrumental in helping establish credit in the first place and increasing our credit as suppliers gain a greater degree of confidence in us.
The CEO also likes the fact that his customers are not aware that their invoices are being financeda feature known as non-notification. Checks are made out to the company and payments are mailed to a generic post office box. When the accounts receivable clerk from his factoring service calls, he or she identifies him or herself as being with the CEOs own accounts receivable department.
Due to fast growth, the companys needs are constantly evolving, notes the CEO, which makes receiving fast and responsive service critical. I have recommended factoring services to other companies and will continue to do so. Factoring can be a valuable service to small and emerging companies that have strong potential.
Managing capital is different than managing cash By Jim Blasingame March 12, 2012
There are many tasks every small business owner must handle personally, but none is more CEO-specific than allocation of capital. Because the only thing more precious to a small business than capital is time.
Cash management is also a CEO-critical task, but operating cash is not capital. Cash is for expenses and is measured daily, weekly, and monthly. Capital is for investment and, as such, is measured in years; possibly even generations.
Below are three classic capital expenditure categories.
Replacement and upgrade This is not repair (thats an expense funded by operating cash flow), its a bigger commitment, most often caused when repair is no longer an option, or by obsolescence.
Innovation Exciting innovations in digital devices and programs are at once creating opportunity and causing disruption. Small business CEOs have to mete out precious capital for innovation in a way that maximizes opportunity and minimizes disruption. This is a tough job because 21st century innovation weaves a fine seam between the leading edge and the bleeding edge.
Growth opportunity Should your market footprint be expanded with an acquisition or new branch, or should an investment be made to build-out more online capability? Should investment be made in support of a new product direction, or in a digital inventory management system connected to the supply chain?
What to invest capital in and when to do it is different for every business. But what is not unique is making sure cash and capital are applied properly. Here are three classic best practices:
Dont use operating cash to pay for something that has a life of more than a year.
Leaving profits in the business produces retained earnings as reserves to be used for capital investment.
A bank loan can augment retained earnings when the timeline of an opportunity or unfortunate capital-eating event doesnt match your internal funding ability. And remember, bankers love it when you have retained earnings skin in the game.
As we move from economic recovery to expansion, there will more and more decisions associated with growth opportunities. Having a capital plan that combines proper allocation of cash, retained earnings, and banking resources will go a long way toward helping you stay relevant to customers, maintain a competitive advantage, and be more profitable.