CAPITALIZATION AND
FUNDING
WHITE PAPER
Chris Jones - Texas Security Bank, Executive Vice President, Chief Lending Ocer
All it Takes is Money.
Supercharged, Scalable Businesses Begin with
Proper Capitalization and Funding
The U.S. based system of capitalism sets the environment where almost anyone with a great
idea can create a business that will serve the needs of customers. This requires 1) a product or
service that customers want or that lls a need (Product), 2) the ability to produce and deliver the
product or service at a cost that will allow for a prot margin (Economic Feasibility) 3) the ability
to communicate the benets of the product or service to potential customers (Marketing), and 4)
the nancial means to get the product or service developed and into the market, communicated
to clients and for the ongoing sustainability of operations (Capitalization and Funding).
Today we will be addressing Capitalization and Funding for businesses in various life cycles
and situations. Ensuring that your company is properly funded helps insure the viability and
scalability of the business. A company that is starved for funding may not be able to take
advantage of opportunities that are readily present, while a properly funded company will have
many more opportunities for growth and success.
The Home Caddy Company
Let’s assume we have a great idea for a product that will bring organization to a garage tool bench or a laundry room, called
the Home Caddy. Let’s imagine that it’s a plastic molded crate, with individual storage compartments, that can be attached
to a wall hanger, and moved around on wheels. Our business plan contemplates that our primary sales channel will be
through our website, initially but later may include selling through small retailers and eventually through big box retailers.
Two simple questions at this point.
1) What will it cost to produce the product?
2) What do we think we can sell it for?
Let’s assume that our research tells us that we can have the product manufactured by a third
party for $2.00 each (minimum order of 10,000), and that we can retail through our website for
$5.00. So, it appears we may have a viable idea. Now we need to spend the following to get the
operation up and running:
OK Now what? We will refer back the Home Caddy Company example as we work through this
topic on Capitalization and Funding.
START UP COSTS
Product design and development
Website Design and optimization for ecommerce
Initial Inventory Purchase
Rent for small warehouse and shipping center (x 6 months)
Employees (marketing, shipping, accounting) (x 6 months)
TOTAL
$50,000
$50,000
$20,000
$12,000
$45,000
$177,000
Every year in the U.S., somewhere around 500,000 new businesses are started. Its not hard to
imagine the enthusiasm, determination and optimism that each founder poured into the creation
of their business. Unfortunately, only about 1/3 of these companies will survive through 10 years.
More than 1/2 will be gone in 5 years.
Business failures can be caused by a variety of factors including but not limited to a poorly
developed business plan, improper pricing or margins, competition, hiring the wrong team
and client concentrations. However, approximately 29% of business failures happen because
the company simply runs out of cash. Why is that? It could be because the business was under-
capitalized and relied too heavily on debt. It could be because of poor cash ow and working
capital management. Or, it could be that the company had so much opportunity, that the sales
growth outstripped the ability of the company’s resources to buy inventory, manage receivables,
and personnel.
Planning ahead for funding, whether for initial startup capital,
working capital growth or acquisitions,
is one of the key responsibilities for a business owner.
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
SURVIVAL/FAILURE
78.5%
67.2%
59.4%
Survival Rate
Years of Operation
Average New Business Survival Rate
53.3%
48.2%
44.1%
40.8%
38.1%
35.7%
33.5%
Plan Ahead – Before Funding Request
When raising capital or applying for debt, there are several very important points of preparation that must be made,
prior to approaching a capital or debt source. It’s necessary to be able to clearly explain what the company does
and how, and to anticipate questions that will be on the minds of the debt/equity sources.
• Sound, achievable business plan – easily understandable explanation of what the
business does and how it operates – differentiators – advantages - opportunities
• Management Team – depth/expertise/succession
• Good,accurate,timelynancialstatements – understand and show how you use them
• Projections – 1 year and a 3 to 5 year long term horizon. Where is
the business going and what’s needed to get there?
• Cash Forecasts – weekly/monthly
• One-page management report – show the key metrics that you watch in driving the business
• Personal Credit Score and Online Reputation – protect both – these will be an
important part of due diligence for debt/capital sources – expect background searches
and questions on credit report blemishes – full disclosure early is important
Business Funding
Now we will turn our attention to the characteristics of several different types of business funding. As we go
through these, we will begin to match up funding sources to the causes of funding needs along with the costs.
BANK
ABL
FACTORING
SUB DEBT
EQUITY
Equity: First In - Last Out
Equity typically forms the foundation of funding for most businesses. It is usually provided rst and can come from
the business owner or other investors. The money invested is at risk and meant to absorb any losses generated by
the business rst, before lenders and debt holders. Equity is considered the primary and permanent capital for the
business.
Lets’ go back to our Home Caddy Company. We had calculated start up costs of roughly $177,000
to get through the rst six months of start up and operations. Typically, this would be funded by
equity from the business owner and/or other investors, who believe in the product and business
plan enough to put the money at risk. If the idea works the investors could reap huge returns, if
the business fails, the investors could experience a total loss.
Equity is usually the rst money in to fund start up or early stage operations. Where a lender
would want to see a proven repayment capacity rst, equity funds the idea with little to no
certainty of repayment based on past performance. Below are some of the typical lifecycle type
events that would usually require equity as their primary funding source:
• Start up or Early Stage Funding – before a proven track record has been established
• Unproven concept of business model
• No historical track records
• New product development
• Acquisition (can sometimes be coupled with debt)
• Funding anticipated operating losses
• Transitional/Distressed situations
Because of the risk involved with being an equity investor, its is the type of funding that is the
most expensive. Investors taking risks where their entire investment could be lost may require
returns of 20% to 40%.
Sources of Equity
The sources available to provide Equity for a business can fall in to two general classications; those where the
business owner maintains control of all decision-making, and those where decision-making control is ceded or
shared with an investor.
The amount of initial investment and retention of prots by the company is a very important
part of fueling the ongoing growth and scalability of the company. However, if the owner’s
resources are limited and/or the retention of prots is not providing enough funding for the
growth opportunities available to the business, the owner may need to seek outside sources for
equity. Many times, there is a conict with business owners weighing the benets of reducing
taxable income (by aggressive expensing and bonusing) versus making and retaining prots in
the business. For a growth company, the retention of prots provides a measure of stable growth
capital and may postpose the need to raise outside capital.
Angel Investors
Angel Investors are usually high net worth individuals or groups of high net worth individuals
who are interested in making equity investments with their own funds into operating companies.
Sometimes they can also bring industry or operational knowledge in addition to funding, as they
tend to be current or former business owner/operators themselves.
Small Business Investment Companies
Small Business Investment Companies (SBIC’s) are private equity funds that are leveraged with
money borrowed from the SBA. They are set up for the purpose of making investments in small
businesses to facilitate growth, expansion or acquisitions. The investments can take the form of
Equity or Subordinated Debt or sometimes both. Once an investment is made, representatives
of the SBIC will typically take a seat on the company’s board and will begin to help hone the
company’s strategies. An SBIC will want to see an increase in the value of the company, and
hence its investment and will want to realize that gain in 5 to 7 years through sale of the
company or a buyout of its position by the other owner or another investor.
Within Owner Control
• Owner’s investment in the business
• Earnings generated and retained by the company
• Friends and Family
Outside Owner Control
• Angel Investors
• Small Business Investment
• Private Equity Fund
• Venture Capital Fund
Private Equity and Venture Capital
Private Equity and Venture Capital funds come in many shapes and sizes. Capital to be invested
in portfolio companies can be raised from institutional rms (pensions, insurance companies
etc.), private investors or family ofces. Venture Capital is most often seen in startup or early
stage companies, while Private Equity more often plays a role in more established companies.
However, there are varying niches of each depending on the charter and direction of the fund.
When a company ‘brings in equity” from an outside source, it is selling an ownership interest in
the company and its future prots. This should be weighed very carefully by the business owner.
This selling of equity to bring in funds to the company has advantages and disadvantages.
Some of the advantages include:
• Longer term capital without scheduled payments
• Underwriting based more on projections than historical performance
• Investors may bring expertise, support and governance
• Investors may bring a wider strategic view of industry and opportunities
Some of the disadvantages of bringing in equity partners may include:
• Accountability to others, shared decision making (you now have a boss)
• Higher return expectations (18% to 30% or more)
• Share a larger portion of the company’s prots
• Investor legal rights
While selling a portion of equity may have many immediate and long-term benets, the process
should be entered into carefully. One of the most important steps would be to agree on a fair
valuation of the stock being sold. With closely held companies this can be a challenge. Agreeing
on a fair process for valuation early in the process may help the two sides to come to a better
agreement on value.
Subordinated Debt
Subordinated Debt, sometimes referred to as Mezzanine Debt is a loan to the company that lls
a gap between what a senior lender, like a bank, can provide and the funding provided by equity.
Referred to as Junior Capital, this is a loan that usually requires interest to be paid periodically,
with the principal balance due in full within 3 to 7 years. It is referred to as subordinated or
junior, because its rights to repayment are inferior or subordinated to a senior lender and it
usually has no claim to collateral. It is however in line for payment before equity repayment.
Because this is typically unsecured and subordinate to a senior lender, the underwriting by
Subordinated Debt providers focuses almost exclusively on the cash ow history of the company.
They are looking for consistent historical performance in cash ows, sufcient to ultimately
provide repayment of this instrument.
Subordinated debt is most often used to ll the gap of nancing when the nancing need goes
beyond collateral values, sometime referred to as “Airball” nancing. It is often used to assist in
acquisition nancing where there is a signicant about of goodwill or intangible assets.
Subordinated debt typically carries an interest rate that can range between 12-18%. Sometimes
the interest may be separated into a current pay amount and a portion that is accrued for
payment in the future or at maturity. It may also carry warrants, which give the holder of the
debt the right to a future purchase of the company’s stock at a designated strike price, within
a certain time frame. Assuming the value of the company rises during the term of the debt, the
value of the warrants may add a signicant amount of additional return to the debt holder, as well
as create additional cost or equity dilution (more shares issued) to the company.
As with understanding equity valuations when contemplating an equity investment, it is very
important, to understand a warrant component of a subordinated debt issuance.
Providers of subordinated debt include funds formed exclusively for this type of lending, angel
investors, equity or SBIC funds. Also, many times with a sale of a company, the seller of the
company will nance a portion of the sale by taking back a note for a portion of the sale price. If
there is a senior lender, like a bank or the SBA, it is required that the seller note be subordinated
to the senior lender.
Accounts Receivable Factoring
Accounts Receivable Factoring is a form of working capital nancing in which a company sells
its Accounts Receivable at a discount for cash now. It is a way for a company to signicantly
accelerate its cash cycle, rather than waiting 30-90 days for collection of its A/R.
Back to our Home Caddy Company. As the company begins its transition from online sales
to selling to big box retailers, its cash cycle will change signicantly. With online sales, the
company is receiving payment at the time of sale, before the product is even shipped. That cash
can then be immediately deployed for additional inventory purchases, payroll and the like. Once
the company begins making sales to retailers, it will take much longer to return its investment in
inventory back to cash. With the retailers, the company will sell in larger shipments (increased
inventory investment) and then will have to provide payment terms to the retailer anywhere
from 30 days to 90 days. This means the company may have cash invested in the inventory
shipment for up to 120 days overall before converting back to cash. Strong growth in revenues,
but signicant strains on cash ow.
Since the company still does not yet have a track record of 1–2 years, it will be hard to borrow
working capital from a bank. However, this could be very suitable for A/R factoring. Here is how it
works.
Once the sale to the retailer is shipped and invoiced, Home Caddy can sell that invoice to
a factoring company for 98 or 99 cents on the dollar, meaning the invoice is purchased at
a discount of 1–2% for each 30 days the invoice is outstanding. This creates an immediate
collection of most of the cash owed to Home Caddy which can then be redeployed into additional
inventory for the next shipment. Otherwise the company would have to wait 60 days for
collection before it could pay for the next order.
Because factoring companies place most of their credit underwriting emphasis on the account
debtor (the retailer that owes the invoice), the operating history and condition of the selling
company (Home Caddy) is not as important. The factor will ensure it gets paid for the invoice
by notifying the account debtor of the sale of the invoice, directing payment directly to the
factoring company, verifying documentation such as purchase order, proof of shipment/delivery
and by calling on collection status.
Even though it seems that 1–2% discount is nominal compared to the cash immediacy it creates,
the company needs to understand when this is converted to a comparable interest rate, a 2%
discount equals a 24% to 28% interest rate, depending on the amount of reserve that may be held
back.
Factoring can be an expensive form of nancing and also intrusive into Home Caddy’s
relationship with its client. If used for a short period of time until bank nancing is available,
however, it can be very helpful to early stage companies that nd themselves in distressed
situations when bank nancing is unavailable.
Asset Based Lenders
Asset Based Lending (ABL) is a specialized form of business nancing that leans to higher risk
companies. This type of nancing begins with a strong focus on collateral values and a smaller
focus on earnings and cash ow, although that is not ignored. This approach assumes that its
primary repayment source may ultimately be a liquidation of collateral. For this reason, the ABL
is very thorough in its valuation of collateral assets, whether A/R and Inventory or equipment
and sometimes may include real estate. On and ongoing basis the ABL will require consistent
and frequent reporting from the company on collateral assets, so that they stay within their
acceptable margins on collateral assets. ABL can supply both working capital nancing as well
as other asset nancing such as equipment purchases. An ABL can tolerate higher leverage and
weaker earnings from the company as long as they are secure in the collateral values. This type of
nancing can be suitable to a company in high growth or expansion mode, deteriorating earnings
or distressed situations. Borrowing rates will be higher that bank nancing but typically lower
than equity, subordinated debt or factoring.
After Home Caddy establishes a track record of operations but before it is bankable, it may
consider moving to an ABL in order to get additional funding on its inventory investment. Where
a factoring company will only advance on A/R, an ABL will usually advance funds on both A/R
and inventory. The ABL would require an analysis of the Home Caddy inventory to determine its
liquidation value and would set its advance rate on inventory accordingly. By moving to an ABL
from factoring, Home Caddy would most likely achieve a lower borrowing cost and additional
funding for growth. Its reporting requirements to the ABL would likely increase as well.
Commercial Banks
Of all the forms of nancing discussed so far, most will be far more expensive than bank nancing if it is available to a
company. Because banks lend money at very thin spreads over its cost of funds (equity and deposits), they just cannot
afford losses and so must be assured of repayment of its loans. Bank’s lending decisions will focus on multiple paths to
repayment, demonstrated below:
Primary Repayment Source – the business must show a history of operations and cash
ow sufcient to repay its loan. Could the company repay this loan from the cash ow it has
historically generated?
Secondary Repayment Source – usually collateral – if the primary repayment source
deteriorates or fails, can the collateral be liquidated at a value sufcient to repay the loan?
Tertiary Repayment Source – guarantor liquidity or income from other sources – Do the
owners of the company have other assets or income that could help repay the loan if the primary
and secondary sources are not sufcient for full repayment?
The bank will take an in depth look at the management of the company and look at past
economic cycles to gauge the team’s ability to manage through a down cycle. The bank may also
try to determine if there are other lenders such as Factoring Companies or Asset Based Lenders
that could move the relationship in the case of deterioration of the company’s repayment
capacity.
Because of the repayment certainty required by banks, the borrowing needs
best suited to bank nancing are:
• Funding for incremental operating growth
• Funding for A/R and inventory growth to support sales
• Equipment and Building acquisition
• Company acquisition
• Must have proven historical cash ow and collateral
Every bank has its particular areas of interest and focus. Some banks focus on real estate
investments and development, some focus on consumer lending for homes and cars, and other
have a more commercial and business focus. It is important for a business owner to know and
understand the area of focus and comfort for the banks they are working with. A real estate
development focused bank will not be a good resource for working capital or business acquisition
nancing.
After Home Caddy establishes a two-year history of protable operations, it would be well
suited to move its lending relationship to a bank in order to signicantly lower its borrowing
costs as well as to create the most exibility in funding for future growth. The company may be
on a similar borrowing formula as with the ABL but lower costs, fewer reporting requirements
and audits will make it worthwhile. The bank can also help with other aspects of Home Caddy’s
business such as cash management, credit card processing, corporate purchasing cards and many
other services that help the company’s operation.
Conclusion
Businesses are fortunate to have access to so many varied capital and funding sources to assist
with starting, growing, and operating. Having an awareness of the various sources and how they
match up to certain causes and needs, will help the business owner make decisions on the best t
for funding based on their unique circumstances.
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