Steady cashflow is very important for a small business attempting to grow. So who has it, and how do you get it? The answers will vary considerably depending on a number of factors including the stage of growth, how much funding is required and how well the business is structured.
Throughout the business lifecycle: concept, start-up, growth and value/exit, every business needs sufficient funds to support the operations and achieve the next set of objectives. Some businesses fund themselves out of operating cashflow, others by enticing equity participation, still others through loans, finance leases and debt funding. The type and amount of funding required, available and attainable are critical issues for most business. The trouble is, most small business owners have little or no concept of the potential sources of funding, or importantly, how to structure the capital and debt structure of the business.
Almost every business starts with an idea, a concept, a new way of doing things. Growing in this early stage involves turning that idea or concept into reality. Doing so requires funding in some form. Most commonly, business owners fund the concept stage out of their own pocket, from savings or by mortgaging their home or other property. As a result, funds are typically scarce and it is difficult to justify spending even a small proportion of the available funds on concept testing and development. An overwhelming proportion of business owners tend to jump straight into the business and, in doing so, place the entire future of their business at risk. Concept testing is a critical stage of any business’ growth and should not be compromised.
Ensuring adequate funding is typically a case of what you can beg, borrow or “steal”. Seek out family and friends or take out personal loans. However, be aware that these funding methods rarely provide the entire amount required. Your own funds need to be invested too and if external capital is involved, be very clear with a shareholder agreement in some form as many future disputes can be avoided.
The start-up phase involves physically bringing the business to life. For some businesses this involves expensive fit-outs and specialist equipment, others need vehicles and office space while others only require a webpage and home office.
The selected business model will affect capital financing decisions. High profile retail businesses will cost significantly more than a mobile or a work-from-home business. Very few businesses start out 100 percent debt-funded, instead relying on contributed capital from founders (savings, house mortgage or personal loan).
It is easy to estimate the set-up and fit-out costs required to establish a business. Therefore, it is easy to establish the amount of finance required. Estimating the level of working capital required to fund the business is a completely different question.
Working capital is the money used to fund the ongoing operations of the business. It includes funds invested in stock, outstanding debtors, cash at bank and other operating functions of the business. Operating losses often result during this period and must be funded out of working capital. Estimating working capital requirements demands robust analysis and assumptions about the size of the loss the period over which it will continue.
During the ramp up “cash is king”. Accurate cash forecasting is critical to minimise the borrowings required. Active cashflow management and forecasting are often overlooked. Active cashflow management means continual; weekly or even daily during early growth. Most business owners do not understand how to prepare simple cashflow projections or, even worse, don’t have the discipline to do so. “Pay now, worry later” is a dangerous mentality during start-up and the cause of many business failures. Businesses at this stage of growth rarely have the back end systems necessary to produce quality and timely management reports, an essential element in strong cashflow management. Investment in reporting and management systems is critical to support the business in the medium-to-long term.
It is also critical that the choice of any accountant or bookkeeper is an informed decision. Speak to their other clients of a larger size to see how well the basic compliance accounting has been managed. There are a staggering number of bookkeepers or accountants that have contributed to major cashflow blowouts due to poor practices that the founder or business owner was rightfully relying on.
Business growth involves considerable investment in a combination of systems, procedures, personnel, plant, equipment, information technology or even competitor acquisition. Businesses considering serious growth are typically well established with strong market and brand presence.
Obtaining funding for business growth is easier for established businesses. Financiers are more prepared to provide debt funding for expansion or acquisition to businesses with consistent profitability. Numerous factors effect the additional working capital required for growth and a businesses ability to fund financing costs i.e. make repayments. In addition to capital spending, the following should be considered when preparing a business for serious growth.
Working Capital v Capital Spending
The difference between working capital for growth and spending for growth is important. Spending for growth is the investment amount required to purchase new plant, expand distribution networks, improve infrastructure and take over other businesses. Capital spending is easy to predict and budget for. Additional working capital for growth is harder to estimate and requires more complex analysis. Working capital for growth is the additional capital required to fund the normal operations of the business. For example, assume average debtors are $100,000 and during the next year sales double. It is reasonable to assume debtors will increase to $200,000. The business requires an additional $100,000 working capital to fund this debtor’s increase.
Stock management is critical during the growth phase. Businesses must manage desire to be stocked ahead of the growth curve versus over ordering and committing to suppliers.
Supplier relationships are vital. Talk with them about growth aspirations and share forecasts to make them understand how your growth will benefit their business. Suppliers that understand their customer’s growth plans are more likely to provide support and favourable terms of trade.
Debtor and Creditor Management
Be vigilant with people who owe you money. Invest in an accounts receivable resource as soon the business can justify it. View every dollar owed to you, which is outside your trading terms, as a dollar that has been stolen. Be prepared to choose which notoriously late-paying customers you are no longer prepared to work with. Communication with customers is the key to good debtor management; never underestimate the value of calling and asking “is there any reason you have not paid?”. Good customers will not take offence to this question.
Always pay your suppliers as you wish to be paid. Using suppliers as short-term financiers is poor business practice and a sign of a business in financial stress. Paying on time will be rewarded with better prices, service and support in the long term.
Corporate governance is an important consideration when financing a growing business. Good corporate governance increases the businesses ability to borrow and reduces the risk of default. A board of management should be charged with attaining and managing the businesses finances. Ensure board members are suitably experienced with the level and complexity of financing required.
Professional advisors should take a key role in a growing business. Lawyers, accountants and importantly bankers may need to change as the business outgrows their expertise. Critically evaluate their skill set and be prepared to move on from loyal and trusted advisors who are no longer able to support the evolving business needs. Credible advisors help shape outsiders view of the businesses professionalism and success. Ask the bank which external advisors they recommend to assist with the next phase of growth. The questions should also be asked of the people within the bank.
Leasing & Debt Structures
This is an area where the diversification of financial instruments available in the past 10 years has increased significantly. There is still a tendency by small business owners to approach this area in a fairly unsophisticated manner, which usually leads to excessive personal guarantees, higher rates or not obtaining the finance at all. The bank has a role to play but there are also specialist leasing organisations and brokers that know far more about how best to structure your arrangements. Respect the role the bank has to play but also ensure you have spoken to other parties that know this area well.
Mature businesses are able to pick and choose from a number of capital raising sources. Debt and equity funding provide opportunities to continue growth, often through acquisition. Private equity businesses are more likely to take interest in an established business rather than a start-up.
The value phase requires business owners to decide on the future of the business and their role within it. The business founder may use this phase to crystallise their business asset value and exit the business. A private equity partner provides the opportunity for the owner to step out of the business. This often includes an incentive-based remuneration model over a number of years or some type of earn out. The founder uses this period to progressively step out of the business and hand over control.
Loyal employees or family members are a potential source of business purchasers. Their intricate business operations knowledge makes for an easy transition. Employees are less likely to have the cash or ability to fully leverage the business purchase. Alternate arrangements, including vendor finance and earn our agreements can be used to finance the transaction.
A public float should only be considered after becoming fully informed of the costs involved. It is wrong to assume a public float is the best way to maximise businesses’ asset value.
Debt funding becomes more appealing as businesses mature. Mature businesses with proven profitability are lower default risks. Banks will increase the gearing ratio they are prepared to accept, making available more funds to embark on new growth projects. If the business owner has no desire to exit, debt funding provides the capital needed to continue to grow the business without forgoing any equity.
The business cycle draws funds from a wide variety of sources. In the early days it’s often a matter of wherever the money can be found. As profitability and cashflow improve, the ability to source funding becomes easier and helps fuel further growth. Private equity funding or business sale provides an avenue for the business founder to exit the business and realise the value of the asset they created.