Risk Management Association Journal Winter 2020/Vol. 88.1
Business Capital takes a deeper look at the relationship between risk and cost of capital, and the delicate equilibrium in
creating the optimal loan structure.
Equity or Debt?
Although the actual failure rate of the average small business is unknown, business consultants generally consider 33% a close approximation and, based on SBA statistics, this failure rate goes up to 66% for companies younger than 2 years old. With these kinds of statistics, it is more than likely a business will face liquidity constraints at some point.
Small business owners may seek equity investors as an alternative to traditional borrowing. The explosion of mega-deals since 2013 pushed 2018 venture capital investment figures to record breaking amounts, with larger deal sizes but fewer companies receiving investment.
Equity is risky capital considering that, according to Harvard research (Shikhar Ghosh, WSJ 2012), 40% of venture-backed firms in the US end up in liquidation leaving their investors with nothing; NVCA puts the failure rate closer to 30%. Either way, if the business does succeed, be prepared to give up not only cash flow, but also varying degrees of decision making and control, and live within the limits of the equity.
Unlike equity investors, debt providers securitize their risk up front and lend money at rates commensurate with the perceived risk of the specific situation and transaction. Debt providers look for an established model, revenue stream, sustainable cash flow, and tangible assets and collateral (i.e., real estate, equipment, AR, etc…) as a collective basis for offering a loan.
So what’s the difference?
Perhaps a business has a valid reason behind the challenges that produced a not-so-clean balance sheet or, erratic sales and profits due to a one-time weather, economic or management disruption, or an unusual capital expenditure, for example. Hard data doesn’t give the opportunity for explanation. Based on hard data alone, a bump in the financial road can be viewed as a complete veer off course by potential lenders and result in either outright rejection, or overly painful loan terms.
Actual hard data cannot be changed; the perception of that data can be. A good financial advisor will collect and examine all of the hard credit and collateral data, but will also gain a greater level of detail and understanding of the story in each situation. Most rapidly growing or distressed business owners cannot present a squeaky-clean P&L history and balance sheet. Many of them have legitimate reasons for their financial plight. An advisor seeks to get an understanding of each particular client’s situation and, in cases where there is an explanation, there is value, and there is a clear path to profitability – will package this information together with the financial data to present a complete picture to lenders why the actual risk is much less than the perceived risk. This type of presentation can produce a positive effect.
Win-win and win for Borrowers, Lenders and the future
When the entire picture is packaged, the result for the borrower is an increase in the likelihood of accessing capital as well as financing options. The cost and terms of capital are more favorable. The financial advisor’s upfront vetting and underwriting process mitigates the risk to the lender on the back end with the 5-C’s of commercial lending: Capital, Collateral, Credit, Character and Capacity. Addressing these issues upfront maximizes the chances of predictably qualifying for the anticipated loan.
The better the process and strategizing prior to a capital infusion, the more likely it is that a business will succeed and that lenders will be repaid. If a business should fail, the process scrutinized that owner and business upfront based on, not only the attributes related to actual risk – capital, collateral and credit – but also on the unquantifiable attributes of character and capacity. Factors both tangible and intangible were weighed and the borrower was determined to have integrity and feel moral obligation to repay the loan, not take undue risk, and have the ability to execute on the business plan for the mutual benefit of the borrower and lender.
Finding Equilibrium in Financing
Every business needs a solid financial foundation of both equity and debt capital to support the owner’s business plans. Business conditions are fluid and can rapidly change necessitating an alteration in the capital structure to finance new funding requirements which can result in a change in the overall cost of capital based on the overall risks to the business. Successful proprietors recognize the need to adapt to new business conditions in order to maximize growth in revenues and earnings and secure financial structure which enable them to compete in the marketplace.
Chuck Doyle (firstname.lastname@example.org) is the Managing Director of Business Capital (BizCap ®), a leading debt advisory firm founded in 2002. He has over 25 years of experience structuring senior debt and growth capital financing for lower and middle market companies. BizCap has secured over $3.5B in credit for clients across a broad range of industries, geographies and financial structures who require a unique, timely and tailored financing structure to address their particular needs, especially in special situations.