Usually, patience is prudence. But in some important instances, inaction can be a growth and value killer. Entrepreneurs that are running high growth companies have a lot of incentive to hold off for as long as possible when it comes to raising additional equity. If for no other reason, to simply build more value before marking the company’s value again. Or said another way, buying time to achieve more operating milestones to support the sale of more equity at the highest possible price.
When it comes to working capital, however, the incentives are exactly the opposite. Securing the working capital necessary to support growth is a task that should be done yesterday - always. This is not the time to be gun shy. The cost of inaction is too significant.
Quite remarkably we do often see, however, a number of entrepreneurs sometimes becoming a little confused on this topic when the working capital is only available at “non-bank” prices (i.e. higher price points that are on offer from accounts receivable financing companies and assets based lenders for example). The thinking seems to be that it is preferred to wait until the company can qualify for conventional bank financing. The problem with this approach is that it may take a long time – especially in this banking environment – and begs the question “What is the plan in the meantime?”
The answer cannot be (or should not be) to do nothing. The cost to shareholders is simply too great. Take a look at this analysis and the chart below.
The chart is intended to help make clear the impact of shareholder friendly decision making when it comes to working capital and the time to implement it. In our example, we have taken three prototypical high growth companies each currently at a $3 million revenue run rate and realizing a 45% (left bar), 50% (middle bar) and 55% (right bar) gross margins, respectively (see other assumed profile details below).
The values are simply the annual net profit that is lost each year in this example due to insufficient working capital – even if that working capital were only available at a higher than traditional cost - 1.5% per month is assumed in the example. When orders are missed, delayed or partially filled because of lack of working capital those opportunities are often lost forever.
Nearly ~$250,000 in lost profits each year is significant by any measure – but especially in the context of a $3 million revenue company. What would the value of that be using a reasonable multiple? $2.5 million! Maybe more?
So why do otherwise highly intelligent and accomplished entrepreneurs persist with this circumstance? There is of course several shades of thinking that go into the answer, but the essence seems to be that many entrepreneurs aren’t financial experts and are instinctively skeptical of things about which they know less. The best entrepreneurs seek advice from financial experts they trust – and sometimes this helps – but surprisingly the so called “financial experts” frequently misjudge this topic themselves. This is probably because those “experts” are themselves less familiar with alternative financing options – perhaps lacking the tools to properly analyze anything beyond traditional bank financing and equity.
An effective fix to this problem – including the tool to measure it - can simply be a second scenario to your current forecast. If the existing forecast is what a company expects to achieve, the second scenario is exactly the same, except that infinite access to working capital is assumed.
With this difference established, simply add the higher cost of working capital finance to your second scenario and see which scenario produces greater revenues and free cash flow (although the latter is not necessarily the primary value driver in the near term). Then, choose that option.
Your shareholders – not least you - will thank you.
Analysis assumptions include $3 million current revenue run rate, 45% to 55% gross margins, incremental revenue growth rate opportunity of 20%, 60 days sales outstanding and incremental working capital financing costs of 0.85% per month.