Growth is a driving imperative for most businesses, and regardless of whether a company is early-stage or late-stage, it will probably need capital to reach its full potential. Early-stage companies’ capital-intensive needs typically stem from their rapid growth and expansion, whereas more mature businesses may be pursuing growth by investing in infrastructure, acquisitions, information systems, and personnel.
Capital markets are the strongest we’ve seen in at least seven years. In 2014 we saw a record pace in transactions, and private equity and mezzanine debt funds forecast that pace will continue. All this is to say that the capital environment is ripe for companies looking to grow: Funds are flush with capital, have a desire to back successful entrepreneurs, and are willing to make minority position investments—which have generally been a less attractive option for investors (since they can’t effectively control the company’s operations or finances). As the United States continues to recover from its economic slump, businesses that are doing well are seeing very high valuations, largely due to the competition among capital sources to own a piece of their success.
How might this capital market environment play into your company’s growth plan? And what kinds of capital sources and strategies are available to you as you bring those plans to fruition? Let’s look at some of the available sources for capital and what you can do to prepare to execute a capital strategy.
Types of Capital
There are many different sources of capital, and they’re typically broken into two broad categories:
- Senior capital or secured lenders. These sources can take many forms (including banks, commercial lenders, asset-based lenders, term lenders, and others), and rather than buy equity in the company, they take a lien on the company’s assets.
- Junior capital. These capital sources, which include private equity firms and mezzanine debt funds, are subordinate to secured or senior lenders. In the event the company is liquidated, the secured lenders are paid in full first; the junior creditors and equity holders take what’s left of the company’s asset value in the liquidation. Unlike senior lenders, junior capital sources often have partial ownership of the company’s equity (though they may hold liens as well).
How much any particular source of capital will cost your company can vary depending on the state of the capital markets at the time, how quickly you’re growing, and the degree of perceived risk you present. Approaching many different capital sources creates more competition, decreasing the overall cost of capital and improving the terms of the financing you may be able to get.
For a company with slow, steady growth—say, 3 to 5 percent per year—senior lenders may be enough, and these are sources your company can likely approach on its own and negotiate good terms. If, on the other hand, your company’s growing much more rapidly and unpredictably—say, by 25 percent a year or more—a better idea is to work with an investment bank to approach capital sources, compare deals, and negotiate terms.
In the early stages of a company’s life cycle, making the jump from a small to a midsize company often requires a large infusion of capital. You’ll need to invest in infrastructure, personnel, and inventory, and you’ll need to finance the company’s growing accounts receivable base. Additionally, you may need or wish to buy out certain shareholders.
Take, for example, a growing small business funded by loans from family and friends. To maintain the company’s momentum, its owners would need more capital to fund infrastructure costs, hire new personnel, and bridge the gap between the procurement of goods and services and the time the company actually receives payment for those items from its customers.
While it’s possible for the company’s bank to provide this type of financing as a senior lender, this isn’t always the most feasible option. As the company’s orders increase and its up-front capital needs become greater, the bank may be willing to provide a loan only against a percentage of the company’s collateral. When a company is growing rapidly, it’s unlikely the bank’s credit facility will keep up with the company’s needs. At this point, the company’s faced with a decision: to limit its growth to what the bank is willing to finance or to look to external sources of growth capital, such as junior capital, to maintain its momentum.
Regardless of how you intend to invest growth capital or which capital sources you approach, you’ll first need to determine how much capital you need to meet your growth goals. The following questions will help you decide how much and what kinds of capital will benefit your company most:
- What are the historical and projected rates of sales growth? Is your growth slow and steady or rapid and unpredictable? This will help you determine whether a senior lender can meet your needs or whether you need to seek junior capital as well.
- What are the historical and projected gross and operating margins? Simply put, how profitable is your company? Higher-margin businesses attract a lot of attention from all types of capital sources. If your margins are low, decreasing, or even negative, you’ll have some options—but only among specific types of capital sources.
- What is the company’s current and scheduled debt service based on existing debt? Consider what portion of your cash flow is going to debt service. Then determine how much more can you afford to take on before you lose your financial flexibility.
- What is the projected cash flow of the business and how much debt can be serviced? Debt is a terrific way to finance a business—as long as your company can repay it. Say your incoming cash flow significantly decreases: With less cash flow, will you be able to keep up with your debt service schedule? If not, the equity required to recapitalize an upside-down balance sheet is very dilutive to shareholders.
- What is the growth potential of the business if it was properly capitalized? If your company received the amount of capital it needed to execute on its growth strategy, you’d expect the company’s value and cash flow (and therefore its ability to service debt) to increase. This potential could outweigh any potential debt or dilution.
Whereas growth capital typically applies to early-stage, rapidly growing companies, expansion or recapitalization capital is appropriate for larger, more established businesses. These companies may be seeking capital for infrastructure investment across many facilities, new information systems, hiring management or personnel, or expanding to an overseas market. In addition, the owners of these companies may need capital for personal purposes, such as a partial or complete buyout of other shareholders.
Though the process of raising expansion capital closely resembles the process of raising growth capital, companies at this stage will often be looking to different kinds of capital sources. Some capital sources that won’t go near a start-up or early-stage company whose growth is unpredictable will be motivated to provide capital to later-stage businesses at a much better cost, since it’s perceived as a less risky investment.
Before pursuing expansion capital or recapitalization:
- Hire an investment banker to perform due diligence and valuation analysis on your company.
- Prepare financial projections that map out the impact of future growth initiatives on financial results.
- Understand whether the proceeds of a recapitalization will be exclusive to the shareholders, exclusive to the company, or allocated between them based on a certain percentage.
- Have your investment banker provide a list of capital sources that have invested in your industry and might be willing to work with you.
Say your company wants to accelerate its growth beyond its organic strategic plan. An acquisition can fulfill a need for product development, service expertise, manufacturing, marketing, or achieve some other strategic goal, such as geographic expansion. Acquisitions can provide a more immediate return on investment by bringing existing sales, assets, infrastructure, and management.
When considering an acquisition, you’ll need to evaluate whether an acquisition is in fact the option that provides the best value. In some cases, an acquisition may meet your company’s objectives, while in other cases the opposite may be true.
Before pursuing an acquisition strategy, take the following steps:
- Understand your strategic goals. This first step is critical: Be clear in what you’re looking to achieve and why. Your management team needs to be fully on board with the strategy and understand exactly what characteristics would make an acquisition successful.
- Identify, contact, and gauge interest from acquisition targets that would advance your strategic objectives. Here, you may want to engage an investment bank to identify acquisition candidates that fulfill your objectives, contact them, and initiate exploratory discussions.
- Perform operational, accounting, financial, and legal due diligence. Thorough due diligence will help you understand if a company is an attractive target and better equip you for negotiations.
- Conduct valuation analysis. Obtain clarity on the fair value of a company by carefully assessing the target business and its ability to facilitate your company’s strategic objectives (as well as the likelihood it will do so).
- Negotiate price and structure of the deal. Once you’ve determined a valuation and structure, you and your advisors will prepare a letter of intent. This will trigger negotiations of price, structure, and other terms. Once the letter of intent is signed, your team can commence formal due diligence on the target. Your goal will be to either confirm your interest in the target or pass on the opportunity. During this period it will be important and worthwhile to have conversations with key employees, vendors, and customers.
- Arrange financing (if needed). If you can’t buy the company outright with cash on your balance sheet, you may look to growth capital to partially finance the deal.
- Finalize and close the transaction. Maintaining momentum is important. Completing a transaction efficiently and quickly can help reduce operational disruptions to both parties, maintain confidentiality, and keep transaction costs under control.
Merger and acquisition transactions can vary greatly in scope and complexity, so it’s important to have a team of experienced professionals assist with aspects such as tax analysis and earnings quality assessments.
Regardless of whether you intend to grow your company by raising growth or expansion capital or by pursuing an acquisition, the bottom line is to be prepared. Make sure your house is order, both financially and operationally, so that once you begin the process, you can complete it successfully.
On the most basic level, make sure your strategy has the full support of your company’s shareholders and management team. Second, keep in mind that any capital or M&A transaction requires a tremendous amount of information. Sophisticated accounting and accurate financial information are critical to getting the best value from your capital sources.
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Raising capital is a critical step in allowing your company to continue growing, and to do it effectively, you’ll want to assemble a team of investment banking, accounting, and legal advisors who can guide your business in the right direction. With their help, you’ll gain a clear picture of your options for financing your company’s growth and how to best structure a transaction. For more information, contact your Moss Adams Capital advisor.