When a business or its owner can’t finance the next big step to expansion, what is the best option and what will the owner sacrifice and gain? Dennis Mattiske looks at various types of financing and what investors can expect in return.
As a business expands it inevitably needs more financing to support increases in inventory and debtors (working capital). Expansion can also lead to a need for more equipment, larger premises, and to increased overheads. And businesses must innovate to research changes to products when they reach the end of their life cycle, and to research new products and markets.
If sales growth is achieved by reducing margins without a planned strategy (which includes planning for funding), financing growth may lead to the beginning of the end for the business. Reduced margins and increased overheads can lead to disaster.
And so, you need to work out if growth is sustainable. An increase in working capital is generally in proportion to sales growth and fluctuates up (and down) accordingly. Funding for investment in working capital can be tailored to match those fluctuations. However, the need for more equipment and larger premises comes in steps, and a decision to increase either of these is difficult because sales growth might not continue. Elementary planning involving market research, product analysis, competitor analysis and so on, will provide support for the decision.
Be aware of how much funding is required. The amount of working capital needed to support sales increases is a function of the annual stock turn of the business and the number of days outstanding for debtors. Increases are generally in proportion to sales. Deciding how much is required is governed by the degree of difficulty in predicting the increases in sales levels. However, funding for equipment, premises and innovation is project specific. Many sources of funding can be considered, and a combination might be the best approach.
Finance Sources
The cheapest source of finance is increased credit from suppliers. If sufficient goodwill has been established with suppliers they will sometimes grant special credit terms as it can be in their best interest to assist in increasing sales of their products.
Current profits can be a source of funding growth, especially constrained growth. Tax obligations must be considered, especially in infant businesses with high rates of growth.
Retained profits in the business or other owner’s funds are a ready source of finance. However, a proper balance of using this source of funding with outside funding is important. A business owner should require a significantly higher return on capital invested in the business (15 to 20 percent currently) than that required by a bank or traditional financier (currently seven to eight percent), and so it should be cheaper to finance through loan funds from an outside source. A basic level of owner investment will be required by the financier.
Banks have a range of funding products to suit different circumstances. A basic overdraft is relatively expensive (with interest and charges) and is appropriate for shorter-term growth fluctuations, but is inappropriate for permanent increases in working capital, plant, equipment, or premises. It could also be appropriate for short-term projects on innovation but wouldn’t be appropriate for businesses wanting permanent increases in R&D.
There are other products, such as debtor funding, but traditional bank loans are the cheapest for more permanent funding. For plant and equipment financing, there are the normal lease/buy decisions, sometimes driven by taxation outcomes.
In larger businesses if security for finance is beyond the resources of the business owner there are further options, such as business angels, venture capital or from listing on a stock exchange.
The two significant downsides to these types of finance are cost and relinquishing a degree of ownership. But in the right circumstances the upside can also be significant, providing opportunity for growth and profitability that would be impossible to achieve from personal funding. Another plus can be access to external expertise.
Private Venture Capital
The term business angel has evolved to cover private venture capital—funding provided by an independent third party, usually an individual who has surplus funds and wants to invest in a business that has opportunity for growth and will bring a corresponding good return on the investment.
There are a variety of firms in Australia that match businesses requiring capital, with investors with capital. Indeed, there are more investors with funds than businesses ready for investment. An investor will require a readily communicated business plan, ideally a good track record and strong evidence of prospects for good growth. In a younger business without a track record there must be some sort of ‘wow’ factor to excite interest in the investment. The investor will require a percentage of ownership and either personal involvement (or involvement of an appointed adviser) in the management of the business. There will also be a requirement for share buy-back or some other form of exit strategy. The percentage of ownership required will depend on the strength of the business, its value and the amount of funds available for investment.
The cost of this sort of funding can include an introduction fee (usually negotiable), and a share in the costs of the legal and accounting due diligence necessary to satisfy the investor. There is also the cost of the investor sharing in the profit that previously went to the original owners.
There are other independent corporate advisory firms with access to institutionalised private equity that usually provide access to a complete buy-out strategy. This can include a continuation of some form of ownership but often to a fairly small extent.
Venture Capital
Further up the scale there are various companies that specialise in providing venture capital. There are large companies such as CHAMP and ABN Amro Morgans dealing with investments of $15 million and above, and smaller companies dealing with lesser investments. Some of these do have specialities such as technology, while others steer clear of technology businesses altogether (especially technology businesses without a history of good results).
Usually venture capital investors require a good history of profitability and strong, demonstrable prospects for growth. Business plans, a formal management structure and a good management team, are also imperatives. The level of the investment is partly a function of the perceived risk and would be more than 50 percent. Funding can result in a return of some capital to the owner.
The costs associated with this type of funding can be complex but include the equivalent of an introduction fee, a fee for the often more extensive legal and accounting due diligence (which increases with the complexity and size of the business), and then the profits foregone. For a large business requiring $10 million funding, the costs would be in the order of five to nine percent, depending on the complexity.
Stock Exchange Listing
Businesses looking to fund growth by listing on a stock exchange have the option to use the main exchange, the Australian Stock Exchange (ASX) or two smaller regional exchanges, the Newcastle Stock Exchange (NSX) and the Bendigo Stock Exchange (BSX). The cost of a listing is lower for the regional exchanges but they don’t have the market interest of the ASX, nor the increase in company profile enjoyed by ASX listings.
In 2005, 118 small companies raised $1.1 billion in funding on the ASX with an average market capitalisation of $24 million. The average funding raised was $9.5
million.
There are added costs for stock exchange listings, including the cost of the prospectus, expert reports, underwriting, and the imposition of the formality involved in listing requirements. Costs would be a minimum of $500,000 but would generally start upwards of $800,000.
While the costs associated with the introduction of any sort of outside investor—whether a private investor, venture capitalist, or the public—are high, there can be very significant rewards. Overall there is the otherwise unattainable increase in profitability and a commensurate increase in value. This can stem from involvement in much larger markets such as those in Asia, or the significant increase in product range or market penetration afforded by the increased funding and profile.
* Dennis Mattiske is a partner with accountants and business and financial advisers HLB Mann Judd Sydney.
