Bottom Line: Smart Financing--Understanding The True Cost of Capital

Posted: 04/2000

Smart Financing–Understanding
The True Cost of Capital
By Steven B. Jaffee

Your business plan shows a significant need for cash. Where do you go next to execute your strategy? Before you reach the bargaining table, prepare yourself:

Have a well-developed business plan.

It may seem obvious, but the quality of your business plan can mean the difference between timely receipt of funds and countless hours of unnecessary follow-up and frustration.

Any funding source, be it angel investor, banker or family member, is risking money on your integrity and ability to provide a return on their investment. Think about what it would take to persuade you to part with your own money. Most likely, a comprehensive plan that demonstrates why capital is necessary, how it will be utilized, and how you plan to repay the debt or offer a suitable return on the investment, is necessary to get the response you desire.

Any credible investor will expect a thorough plan. It proves you know where you’re going and that you’ve thought through what it will take to get you there.

In your plan, briefly describe your industry, your business and services, company history, marketing strategy and financial condition.

Be sure to include biographies of your company’s key personnel. Many times, this is more important than the financials. The capital provider is assessing the credibility and character of the people first. Track record is certainly considered, but as they say in any prospectus, “past performance is no indication of future results.”

Be prepared to give your credit background including tax returns, and be forthright about any personal bankruptcies, outstanding judgments or liens. In and of themselves, these don’t have to be deal breakers if you’re honest and offer complete disclosure. Having your funding source uncover these issues after a commitment letter is signed could be problematic. In general, quality wins over quantity. A well-written business plan should be thorough without being burdensome. A two-page (three pages maximum) executive summary is critical–it’s the one section where a word-for-word reading is almost guaranteed. Just remember your readers are busy people, too. Give them the information they need to make a decision, and let someone else’s tome go to the bottom of the pile!

Determine how much money you need.

Whether you’re purchasing equipment, building a network or adding sales staff to grow your business, your plan should include details about the costs and estimates of how long it will take you to recover those costs with your future revenue stream.

To determine how much you need, estimate the cash needs of the business until you reach a positive cash-flow position, then add a cushion for the unexpected. (No matter how realistic your plan, there are always unforeseen obstacles that can cause cost overruns or stall revenue growth.) To estimate your cushion, consider how difficult it would be to go back for additional funds. The more difficult you think this might be, the greater cushion you should create. In the end, your funding source should view this favorably as a sign that you’re a realistic planner, not just an optimistic dreamer.

Perform a SWOT analysis.

Understanding your strengths, weaknesses, opportunities and threats (SWOT) are keys to having a realistic and complete business plan. You’ll force yourself to recognize what’s best about your company and identify your shortcomings to be able to exploit and mitigate as appropriate.

Show your best “stuff.”

Your plan is your invitation to the bargaining table, so take the extra step and have an objective source review it for clarity, consistency, typos, etc. Don’t let your great expansion idea get smothered in a shoddy presentation. Your business plan doesn’t have to be your short suit–it can be your ace in the hole.

Understanding
the Basics

Equity. Equity is ownership of your company typically denoted in shares of common stock, entitling the holder to a portion of your company’s value upon sale of the stock or liquidation of the company. Equity can be expensive when you consider a typical return for a telecom or related company would range from 30 percent to 50 percent. Don’t be fooled by the fact that equity does not usually carry a specific interest rate or “current pay” component. Just because it doesn’t have a coupon attached doesn’t make it free. It just means you have to go through a two-step process that concludes with a sale, to calculate its cost. You’ve put a lot of sweat equity into your business. Don’t be too quick to part with the value you’ve built.

Equity comes in several different forms with which you should become familiar. Although the performance expectations may be the same, the levels of administrative overhead can vary significantly.

Venture Capital. Venture capital (VC) represents the process by which investors fund early-stage, more risk-oriented business endeavors. A venture capital funding arrangement will typically entail relinquishing some level of ownership (equity) and accepting board of directors’ oversight with a requirement for a disciplined reporting regimen. Offsetting the high risk the venture capital investor takes is the promise of a high return on the investment. In addition to a hefty return, most venture capital firms look for fairly prompt payout, preferably two to three years. Although it comes with a price, if you’re just starting your business, VC money may be the way to go.

Angel Investor. “Angel” money comes from an individual or organization that invests money in a business on an equity basis, with very few restrictions. Compared to venture capital, which usually requires board membership and ongoing participation in company management, angel funding is money given on faith, without any binding covenants.

IPO. An Initial Public Offering
(IPO) is a company’s first offering of stock to the public marketplace. For many companies, this phase marks a significant milestone where ownership changes from a few large investors to a larger base of small investors. Although the requirement for performance is constant, investor involvement becomes more distant.

Table: Target Your Funding Source

Debt. The best known and usually the most inexpensive form of capital is debt financing. Secured by a lien against company assets (tangible or intangible), loans or lines of credit are available through banks or other financial institutions and typically require principal and interest payments over a specified time period. Because of its predetermined pricing and payment schedule, your business model should be able to demonstrate how your company’s cash flow will allow for scheduled payments. Though pricing is often tied to the prime lending rate, which can vary, debt financing is the least volatile of all capital sources because of its other fixed components.

Asset Securitization. This is known as an off-balance sheet transaction, where assets or receivables are sold for a percentage of cash, typically 80 cents to 90 cents on the dollar. (Accounts receivable, which are sold, still account for the same percentage of total assets, but their liquidity has changed from long to short term.) No debt is incurred and the change in liquidity with this strategy may enable resellers to negotiate more favorable terms with their carriers.

For example, $100,000 of receivables that have a collection period of more than 90 days, can be sold to provide the reseller with $85,000 immediately. This accelerated, recurring cash flow offers resellers a strong bargaining position when negotiating carrier repayment terms.

Mezzanine. Also described as subordinated debt, this is a blend of debt and equity. Mezzanine financing is usually a term loan facility secured by company assets and includes a small equity position known as warrants, or the right to purchase common stock for a nominal price. Warrants can be exercised when the facility terminates or when the company is sold. A typical mezzanine facility will include a current interest payment of 12 percent to 15 percent per year with the rest of the total expected return of 22 percent to 25 percent coming from the value of the warrants. This usually requires warrants of 2 percent to 5 percent but actual levels will vary based on many factors. (see chart “Target Your Funding Source.”)

About Fees and Covenants

Simply stated, understand all fees and covenants. Fees will affect your all-in cost of capital, and covenants will impact your ability to access the cash you need. You may be able to secure a large commitment, but if it is restricted by covenants that are unrealistic for your business, it’s probably more trouble than it’s worth. Factors commonly addressed in covenants are debt/net worth ratio, minimum cash flow coverage ratio, current ratio and/or limits on capital expenditures. Consider these issues as well as their reasonable levels for your company, and work to structure a deal that carries the most advantages for you.

Other expenses you should anticipate paying are legal fees, (for you and your funding source), audit fees and documentation expenses. Beware of service or collateral management fees and annual or unused line fees. These are fairly common and may add cost whether or not you ever use the facility. Ask for an estimate of all customary expenses before you sign, and be sure you understand when fees apply, how they are assessed and what your actual cost will be.

Choosing a funding firm–what to look for in a financial partner.

Your funding firm should understand your industry and have a good understanding of your business plan. The more comfortable your funding source is, the more likely they are to get you the dollars and accessibility you need. You’ll spend your time more efficiently, too, when you can focus on educating your partners about the unique aspects of your company as opposed to educating them about the entire industry.

A financier focused on your industry should have a proven record and be able to provide you with references to validate their credentials. Understand the financial facility into which you’re entering and make sure it’s flexible enough to grow as your company grows. You should also have a sense for your funding source’s decision-making process. Is your primary contact the decision maker? Is there a committee? What are the steps between application and approval? Knowing who’s calling the shots and what to expect in between will help you manage your time and expectations.

Chemistry between you and your funding source is another essential element to your overall satisfaction with your financial partner. If you’re dealing with a high-profile investment banker who views your deal as low priority, you’re likely to wind up disappointed. If you’re going to pay investment banker fees, make sure you get the attention you need to get your deal done.

Buddy, have you got the time?

Once you’ve determined how much capital you need, think about how quickly you need it and how frequently you need access. Is there an opportunity cost to not being able to secure financing or access your line as needs occur? If you’re looking for financing to fund an acquisition, you’re probably on a faster track than if you were buying a new building. Be sure to consider this as you target your funding source.

One more note on timing, the best time to obtain funding is before you actually need it. This gives you the luxury of carefully building your business plan and the peace of mind it affords you–two effective stress relievers.

Sources and Uses

Understanding where your cash comes from and how you plan to use it or “sources and uses,” to use the vernacular, is another critical step to understanding your capital costs. Capital projects should be funded by a source that is comfortable with being repaid over the useful life of the asset. So if you’re considering funding your network buildout with working capital normally earmarked for payroll, don’t. Once money is spent on equipment or marketing expenses, your expectation for returns becomes more long term. You may be able to stretch your payables for a while by collecting early and paying late, but sooner or later, your carrier(s) and other vendors will wise up, and when they do, you could face a crisis if you’re not prepared.

Take the example of a wireless reseller who avoided getting a working capital facility for months by developing a relationship with a carrier rep who offered extremely liberal payment terms. One day, that rep was reassigned and the reseller was forced to bring the account current. As you can imagine, this deficit created significant limitations as this reseller considered his viable funding options!

You’re in Good Company

No matter how large or well known your company is, take solace in the fact that most companies struggle when it comes to raising capital. Your search for capital doesn’t have to lead you in circles. Choosing a partner based on price alone can really shortchange you in the long run. Taking a relationship approach that considers your financial partnership, your long- and short-term objectives, and your costs–financial and otherwise–will help you approach the process of acquiring capital with confidence.

Steven B. Jaffee is president of RFC Capital Corporation
(www.rfccapital.com). He can be reached at
[email protected].