Description:

The company in question is just a few years old and produces a highly reliable and sophisticated  information service that it sells to select industries who stand to reap significant rewards for having timely and accurate access to the information being provided.  The addressable market for the new product is large and the company’s product uniquely addresses a largely unmet need in the market.  The company has gained considerable experience in the technology and know-how necessary to produce the high quality information it provides to its clients.  The company also has developed a strong stable of clients and is currently growing its revenues rapidly.

The company has historically been funded through a combination of owner’s equity, third party equity and some debt financing.  It recently completed a small additional third party equity raise and restructured in remaining bank debt with the aim of amortizing fully within the next year.  The company maintains approximately $750,000 in accounts receivable (its primary financial asset) and expects to grow its A/R balance commensurate with its sales going forward.  The company is profitable, but continues to have large cash flow requirements associated with investing further in its technology and expanding its distribution capabilities.

Financing Question:

How best should the business owners optimize their cost of capital while at the same time gaining access to the cash flow to make the investments necessary to accelerate its growth?

Assessment:

To find the optimal solution to this problem, it is probably best to ask (and answer) the following two questions:

1. Is the target balance sheet optimal?  If no, why?
2. Are there any important economic or financial caveats that might change the answers the questions above?

First let’s take a look the company’s “Target” balance sheet and compare it to an “Improved” balance sheet.  (Btw – we’ll answer the question of why the “Improved” balance sheet is better in the next section):

The important thing to note is the two balance sheet structures above is simply that the “Target” is 100% equity financed and the “Improved” is financed with a combination of debt and equity.

We make the assertion above that the “Target” balance sheet is not optimal and offer an “Improved” balance sheet to show one we believe is better (i.e. maintains a lower cost of capital).  Let’s take a look at the following analysis to understand why the “Improved” balance sheet is materially less expensive for the company as compared to the “Target”:

As evidenced in the income statements above, the company with the “Improved” balance sheet produces a Return on Equity that is nearly half again greater that with the “Target” balance sheet.  So at this point we know the answer to question 1, above:

1)       The “Target” balance sheet is not optimal from a cost of capital point of view and we can see this by noting the significant Return on Equity differential.

What about the answer to question 2?  We offer the following analysis and commentary to look at potential answers to this second question:

First an analysis – how much more expensive would the cost of debt financing (i.e. the interest rate) have to be for it to be an inferior solution for the company?  See the table below (please note that for example purposes, the only variable change in the table below is that of the interest rate):

As demonstrated above, the interest rate on the debt would have to be greater than 26.3% per annum for the company’s cost of capital to be equal based on the two balance sheet options evaluated in this example.   Hopefully it goes without saying that that costs of debt in excess of 26.3% would result in an inferior solution for the company.  Certainly this seems a powerful demonstration of the real costs of financing decisions.

There are clearly a number of other considerations that could affect the analyses presented in this article – but any such impact would – from a financial point of view – most likely be at the margins.  In the end, the cost rationale for making certain capital raising decisions is frequently a compelling one.  Our counsel to this prospective client – of course solely from a financial point of view – is simply this:  To raise additional capital – not necessarily only as needed – but more so as can be productively deployed – through the issuance of either debt or equity – in whichever combination produces the lowest cost of capital.  And do not delay making high return investments unless you are simply not able to access the capital necessary to make investments at a price that will generate a positive marginal return.

Description:

The company in question is a new company with an exciting new consumer product.  The addressable market for the new product is large and the company’s product addresses a largely unmet need in the market.  The business owner is highly experienced in the product segment, but for the first time is launching a branded consumer product venture.  To date, the company has been financed entirely with owner’s equity – primarily from savings and mortgaging owned commercial real estate.  The company has secured purchase orders with several large national and regional retailers and is on the cusp of significantly ramping sales and in doing so, expects to expend considerable resources on the marketing and advertising necessary to drive the product launch.

Financing Alternatives:

The business owner is currently evaluating how best to finance the next – and first considerable – growth phase of the company.  The realistic options are twofold as follows:

1. Take out an additional mortgage on his owned commercial real estate property, or,
2. Enter into a accounts receivable financing relationship

Assessment:

The mortgage option will provide the business owner a lower nominal cost of financing – probably 5-6% – since the creditworthiness and interest rate is based primarily on the considerable equity in the property.  But this type of financing should be properly understood for what it truly is – an additional equity investment in the business – not different in substance than writing a personal check.  The accounts receivable financing facility would likely have a notional cost of 8-10% plus a small per invoice service fee.  Comparing these two options on a nominal cost basis will, however, yield an answer that from a corporate finance point of view, fails to properly consider the entire cost of the equity.

The proper corporate finance analysis of this situation is perhaps further complicated by the fact that the business owner does have the resources to make an additional considerable equity investment in the company – thereby being able to directly avoid the real cost of diluting his equity and the intangible cost of having to wrestle with governance and other complications associated with having a third party equity partner.

Yet as the Nobel Economist Milton Friedman famously said “there is no free lunch” – and while properly assessing of the entire cost of this equity investment may be somewhat clouded by certain of the facts – the costs do nonetheless continue to exist – even if seemingly (although not in fact) indirectly.

The following comparison will help make this clear:

As evidenced above – and assuming there is no cost of dilution or intangible governance costs – you can see that two companies that are identical in every way – except that one is 100% equity financed and the other is financed with 50% equity and 50% debt – produce very different returns on equity – again solely due to the way they are capitalized.  The difference in the returns profile is significant – with Company B generating equity returns that are 50% better than those of Company A.  By any measure this is a marked difference.

There may be other considerations (i.e. not yet generating sufficient A/R that can be financed) for our prospective client that could tilt the equation towards the additional equity investment, but like Milton Friedman said – “there is no free lunch”!

Of course we welcome your participation.  Whether you wish to comment on a post, share an experience, pose a question or even challenge the advice offered in a post – all constructive contributions are not only welcome, but encouraged.  In short, we want to hear from you – the dynamic companies that drive economic growth – about your business challenges, experienced and needs.  You can comment on various posts, submit questions via our contact form, or call us for a private discussion.

We expect to frequently write on topics that we encounter through our work with our clients, but in all such instances will be careful to protect their privacy by refraining from the use of specific names.  We want our clients and prospective clients to rest assured that their stories and challenges are safe with us – always and without exception.

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