It takes money to make money and employing the right capital structure for your business goes a long way to help achieve your growth aspirations. In a competitive industry, you need to continually invest in growth. Cash is required for advertising, customer acquisition, expanding your sales team, expanding production capacity, purchasing stock, and the list goes on. If executed well, cash spent today will result in revenue growth down the track. In the interim, you may be spending more than you’re earning, generating a cash flow shortfall that needs to be covered with capital. There are various capital options available to fund these shortfalls, and employing the right capital at the right time is an important driver of success.
In the absence of generous friends and family members willing to donate funds on a ‘no strings attached’ basis, capital will generally come in the form of either debt or equity. The problem is that there are multiple options available within both the debt and equity buckets, and choosing the right option for the stage of your business is important. Which options should you consider, and when? Simply put, the stage of your business will determine which options are available, but it’s ultimately up to your company and its advisors to select the appropriate capital instrument.
As a business evolves, most companies broadly follow a similar path in terms of the capital they employ. Common options include:
Friends & Family
Once personal savings have been spent, credit cards are maxed out and capacity within mortgage accounts are exhausted, founders commonly turn to friends and family for additional cash. Any cash injection from these sources is likely to be small and will eventually need to generate a return that’s commensurate with the risk attached. However, it generally comes with rather flexible repayment terms.
Another place people turn to early on when they need cash is their bank. Unfortunately, most banks aren’t interested in lending to companies that are cash-flow negative, even if you’re electing to spend ahead of earnings for good reason. However, a bank may be able to provide your business will access to suitable finance facilities if you meet certain criteria. The extent to which a company qualifies for various facilities will ultimately depend on your ability to repay the bank for use of these facilities. Ask your local banker when it makes sense for you to employ asset, trade, stock, or invoice finance facilities throughout the cash flow cycle of your business, and what criteria you will need to meet to qualify for each. Remember, being cash flow positive is the key to utilising bank funding.
Debt is often preferable to equity as a source of finance because once the fixed payments are made, you still own the value created by the business. By contrast, equity is suitable when the risk attached to your business is too high to qualify for bank facilities (i.e. you’re cash flow negative), your bank facilities are maxed out, the cost of debt is too high, or you’re after strategic investors to help grow your business. Selling shares in your company to raise equity will involve giving up some ownership and control, but you will also gain new shareholders that can provide experience and expertise beyond their cash injection. Getting the right equity investors on board early on, and identifying when you need additional expertise (as well as cash) is one of the most important decisions that impact the long term success of a business.
There are several places you can look for investors depending on the stage of your business:
1. Close networks
Early stage companies are capital intensive and founders more often than not have to look for capital from their close networks to get a business off the ground. The advantage of investment from closely-related parties is that they often know the business well and can make decisions quickly. The disadvantage is that this group only has so much money, so you can easily tap them out. Furthermore, if the business runs into trouble, things can turn pear shaped very quickly. Countless friendships and marriages have been ruined as a result of business relationships turning sour.
2. Wider network
In the validation phase, the next source of investment is often your wider personal and professional network. If you have taken the time to build a strong network in your industry then you should only be two degrees of separation away from a range of angel investors, high-net-worth individuals, or seasoned investors. The advantage of these types of introductions is that they are still connected to you personally so can take some of what you say based on trust. They also often have deep pockets and an ability to invest larger amounts. The disadvantage is that things are starting to get serious at this point so you’re putting your reputation on the line, and taking other people’s money comes with serious responsibilities. In the long run, this group also has limited funds, so eventually your business will outgrow your wider network.
3. Outside investors
When your business is firmly established but you’re choosing to spend ahead of earnings to grow, then the next source of investment to tap will be outside investors such as private equity and venture capital investors who are new to the business. The advantage of this group is that there are lots of them out there. The somewhat ironic disadvantage is that they’re not easy to find. These investors are looking rationally for a return on their investment, so they care about deal terms and will be looking for things like independent directors and proper legal documentation to de-risk their investment as much as possible. This type of private investment can also come with highly valuable advice, mentoring and introductions because (once they’re committed) these investors are very closely aligned with your success.
Any of the above groups might be a sensible source of equity investment but finding the right group will depend on the stage of your business. The most common mistake that we see at Snowball Effect is companies who approach the wrong type of investor for their company stage and then misunderstand the inevitable rejection as a personal rejection of their idea or business.
One of the most important things to remember when striving for growth is to identify which sources of funding you need well ahead of actually needing the funding. Raising capital is hard. Seeking advice ahead of time and engaging the right professionals is crucial to ensuring your business succeeds.
Bill O'Boyle is head of growth capital at Snowball Effect.
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