Since 1984

185 NORTH REDWOOD DRIVE
SUITE 160
SAN RAFAEL
CALIFORNIA
94903 USA
(800) 367-9848
 

Where to Get Needed Capital for Growth

“The faster I grow, the less cash I have!” complains the empty-pocketed business owner. “On paper, we’re really profitable, but I have trouble making payroll!” 

Why are growing companies so short of cash? The answers are simple. To handle the increased business, you must pay upfront for increased help, growing inventory, bigger space, more equipment, raw materials, products to resell, etc. You must fund these out of your bank account until you get paid for increased sales. The faster you grow, the greater the demand on your cash. 

Many small companies fail to take this into account in their growth plans. Thus, paradoxically, rapid growth can actually put them out of business!

A couple of examples:

Furniture store. Claire opened her store with about $80,000 of inventory. Sales were great, so she quickly ordered more. A year later, sales had kept climbing but she was gasping for cash. How did this happen? Her inventory level was up to $140,000, and during the slower summer season, products weren’t turning over as fast. She couldn’t pay her suppliers on time, so they started putting her on COD. Thus she couldn’t bring in needed stock for the busy holiday season. 

The lesson here: Don’t use short term financing to cover long-term needs. Instead of relying on 30-day supplier terms, she should have borrowed additional long-term capital to pay for her inventory increases. She could afford to repay that loan over several years from the cash flow generated by profitable sales.

Graphic designer. Anna’s graphic design firm kept getting bigger contracts. To do the work, she had to hire more staff and pay them. Her corporate and government clients would typically pay her in 45 to 60 days. Because she ran a small, new service firm, banks would not give her a line of credit. But she had good personal credit, so she was able to finance her growth using low-interest offers on various credit cards. Every time she’d receive an offer for a low or zero-interest account, she’d roll over an existing balance into that. This worked well, as long as she made all her payments on time. However, during a summer lull, she was late on a few payments, and the credit companies boosted her rates to the max! Despite her growing and profitable business, this huge increase in the cost of capital forced her to declare bankruptcy.

The lesson: Don’t grow faster than your access to affordable capital will allow. Anna had the double whammy of rapid growth and slow-pay clients. 

How to Capitalize Your Growth. Every viable company has a certain base of working capital. These are the funds it needs to conduct business. As you grow, you must increase your permanent working capital enough to cover the cash demands of your anticipated growth. Where does this money come from? There are four main sources:

1. Self-financing, through cash flow generated internally via profitable operation

2. Personal investment, from your savings, second mortgage, etc. (Or your trust fund or lottery winnings!)

3. Borrow the money. Bank, family, friends. Least desirable: run up your credit card balance.

4. Sell equity; bring in an investor. Angel investor, venture capitalist. 

Which is best?

It’s a trade-off. The farther down this list you go for capital...

+ + The more money that is available

+ + The faster you can grow

+ + The easier it is to take advantage of emerging opportunities in the marketplace

– – The more control you give up to others

– – The more intensity and stress you may face

Sources of Capital, Rate of Growth

SourceGrowth Benefit, Cost
Fund from profits Slower Lower risk, but you may miss window of opportunity
Borrow from bank Medium You keep control. Must prove ability to repay
Equity investor High Grow like crazy, but lose control

Self-financed growth is safe, prudent, and you retain control. But it limits the rate of your growth, so you may lose opportunities to better financed competitors. Many of us are reluctant to spend money we do not have. It’s a mindset. We are scared to go out on a limb and borrow money to invest in our own growth. It is as if we do not have confidence in our own ability to make it pay off. 

Borrowing to finance growth is usually preferable, and may be essential. A lender’s first question is always, “How will you pay this back?” If you can’t convince them, or yourself, you shouldn’t borrow. Your rate of return should be greater than the cost of capital by a large margin. 

But if you see the payback, and you want to grow, you are crazy not to borrow. There is a lot of money in the world for people capable of turning good ideas into profitable businesses. 

Borrow money when you don’t need it. Do not wait until you are desperate to go to your banker. Plan ahead for your increasing capital needs. Borrow a small sum from the bank, then pay it back. Borrow a bit more, then pay it back. Repeat this a few times, and the bank will come to you offering a larger line of credit. Take your good credit rating and shop for the kind of credit terms you need. Then when you need the money, it’s much more likely to be available to you. 

Costs of Capital Compared. Here is a list of the types of business working capital, ranked from most to least expensive:

• Getting no capital; thus missing out on a lucrative opportunity.

• Taking on a partner who makes a “sweat equity” investment. While this seems attractive to cash-strapped companies, it usually turns out to be much more expensive than just hiring the person.

• Taking on a partner or shareholder who makes a financial investment. It is better to bring in a person for synergy and needed skills, and borrow money from the bank, instead.

• Getting private placement capital, i.e., from a family member, business associate, or customer. Better to borrow the money from them rather than selling a piece of your business. 

• Factoring your accounts receivable.

• Making payments late, thus incurring interest and penalties—especially from paying taxes late.

• Running up credit card balances; using credit card cash advances.

• Failing to take trade discounts (e.g., “2% net 10”.)

• Getting an unsecured loan.

• Using personal savings (Your effective cost depends on the lost return on alternate investments.)

• Getting a secured loan, e.g., second mortgage.

• Renegotiating existing loans for a lower rate and a larger balance.

• Stretching out payables as long as possible without incurring interest or penalties.

• Invoicing in a timely fashion, and aggressively collecting overdue receivables. This is “free money.” Slow payers are using you as their banker.

• Financing growth from your cash flow. The least expensive, but the slowest. 

• Free phone forum Q&A with Mike Van Horn.
"Where to Get Needed Capital for Growth."
Limited to 10 callers. Thursday, April 26th, 8:00-9:00 a.m. PDT. Sign up by calling 415-491-1896, or e-mailing mvh@businessgroup.biz. We’ll send you the phone code.