While the aim for many businesses is to move out of the start-up and into the growth stage, without adequate cash flow, your business’s growth may stall. Dennis Mattiske takes us through the ins and outs of some alternative methods of funding your business growth.
When seeking to finance their growth, businesses should consider alternatives to the more common option of a bank loan or the expensive choice of going public.
Banks usually have a conservative view on risk and security and therefore may be hesitant to fund a business with a particularly fast rate of growth.
A public listing may be expensive, and only suit a limited number of businesses that have specific criteria.
Some of the alternatives for fast-growing businesses to consider include venture capital, business angels, and joint ventures.
Venture capital can be a good way for growing businesses to access equity capital at various stages of their life cycle. While it means a business owner must surrender some ownership, it can have the major benefit of giving the business access to valuable management expertise.
Venture capital investors require a good history of profitability and strong, demonstrable prospects for growth. They also require disciplines such as business plans, formality in management, and a good management team.
Such arrangements may be suitable for businesses of almost any size, with investments ranging from as low as $500,000 up to $100 million or more.
The costs associated with this type of funding can be complex, but include an introduction fee or equivalent, a fee for the extensive legal and accounting due diligence (increasing with the complexity and size of the business), and the profits foregone. For instance, a larger business requiring $10 million funding could well have costs in the order of five to nine percent, depending on the complexity.
This approach usually brings stringent compliance and reporting requirements. For example, most businesses will need to undergo some form of due diligence review by the venture capitalist or its appointed advisors. In addition, during the term of the venture capital investment, the results and performance of the company will be subject to regular and intense scrutiny by the investor.
Some business owners not used to such regular reviews will find, at least initially, that reporting periods and deadlines seem onerous. However, owners should remember that such reporting also brings benefits through improved analysis of the company’s performance.
A venture capital investment is typically only for a limited time, usually between two and seven years. The investor will have formulated an exit strategy prior to investing in a company that will form part of any shareholder agreement. Examples of exit strategies are a management buy-back of the venture capital investor’s equity, a public listing, or a trade sale.
Private Venture Capital
The term ‘business angel’ covers private venture capital, that is funding provided by an independent third party, usually an individual who has surplus funds and wants to invest in a business with good growth opportunities and a corresponding good return on the investment.
There are a variety of firms that offer a matching service for businesses requiring capital and investors with funds. Indeed, there are more investors with funds than businesses ready for investment.
An investor will need to be shown a realistic business plan, ideally a good track record, and strong evidence of prospects for acceptable growth. In a younger business without a track record, some sort of ‘wow’ factor must exist to excite interest in the investment. Business angel funding usually involves smaller but fast-growing businesses that need immediate access to capital. The arrangement generally involves a percentage of ownership going to the investor, and either their personal involvement, or involvement of their appointed adviser, in the management of the business.
As with joint ventures, some form of exit strategy will need to be developed, for example a requirement for share buy-back. 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 that are necessary to satisfy the investor. There is also the ‘cost’ of the investor sharing in the profit that previously all went to the original owners.
Sometimes there is an opportunity for two businesses to merge through a joint venture, therefore creating funding for growth.
Generally speaking, it is only suitable in instances where the sum of the two businesses creates better growth prospects, and eliminates a degree of business risk that would otherwise limit the businesses on their own. For example, if both businesses are relatively young with similar growth and capital requirements, coming together in a joint venture won’t necessarily help with growth. Indeed, the merged business may be an even bigger business risk. However, if by merging they effectively eliminate a significant competitor, this will make them more attractive for traditional funding and other forms of finance including venture capital and business angels.
Joint ventures are more usually undertaken between a more mature business and a smaller, but perhaps more entrepreneurial, business. In these circumstances, there can be a significant advantage to both businesses. For instance, the mature business may have a surplus of funds that can be directed towards the growing business and benefit that business, while the mature business will benefit by the influx of enthusiasm from the fast-growing business and the high returns that should be associated with it.
There can often be significant cost savings in removing the duplication of all facets of the business, including production where applicable, selling and supply chains and administration.
However, business owners should be aware of the potential major downside with joint ventures. Like any partnership, whether business or personal, joint ventures require compatibility of those involved and a strong correlation in the business cultures. Where a business has been run by a dominant individual, with a great deal of personal involvement and only limited management resources, care should be taken with compatibility.
If both businesses have developed management teams and a formal management approach, there are usually less problems.
With joint ventures, agreement must be reached on the relative values of the businesses and reflected in the ongoing arrangement. Any joint venture arrangement should ensure that there are no onerous taxation consequences of the formation of the joint venture.
Dennis Mattiske is a partner with accountants and business and financial advisers HLB Mann Judd.