Many successful businesses ultimately reach a pivotal inflection point – the point where key growth opportunities materialize, but the company lacks the necessary capital to exploit them. Whether you have your sights set on a strategic acquisition, a broader geographic footprint, or a vertical/horizontal market expansion, funding growth can be accomplished through some combination of cash from the business, debt financing and equity infusion from outside investors.
Each financing source has its advantages and disadvantages as well as unique requirements. So it’s important to ask the right questions and assess the pros and cons in order to determine the mix that’s best for your company’s growth prospects. It’s not at all uncommon for mid-sized business owners to find that their growth ambitions are stifled because they simply don’t realize how much capital is actually available to them – and as a result, they take less risk than is optimal for their business.
Debt and equity financing, however, have very different impacts on your balance sheet, earnings, cash flow and taxes. In order to determine an appropriate capital structure for your company, you need to address a number of fundamental questions:
- What’s your growth strategy (M&A, organic growth)?
- What are your liquidity needs?
- Do you have cash flow concerns (inflated accounts receivable, seasonal fluctuations)?
- What’s the current ownership structure and succession strategy?
- How do you feel about giving up equity?
Your answers will have a significant impact on the ultimate feasibility of your growth ambitions. For example, if you’re committed to maintaining a leveraged balance sheet strategy, it’s likely that your capacity to make additional acquisitions will have to be more constrained. Similarly, your willingness or reluctance to relinquish ownership will be a key determinant as to whether an equity solution is appropriate to generate additional capital beyond the amount of debt financing available.
Achieving a competitive cost of capital
For a mid-sized company, designing and achieving an optimal capital structure is an important component to ensuring continued growth while maintaining sufficient liquidity. While the fundamental task is to make a determination between debt and equity financing—what your company’s leverage ratio should be—you’ll also want to make certain that you exercise discipline in maximizing the efficient use of available capital.
The value of your company will be driven by your ability to invest capital in a way that earns a return greater than the cost of the capital—in other words, when the return on invested capital (ROIC) exceeds the weighted average cost of capital (WACC). The more that you can invest and grow your capital at positive returns, the more value will be created.
The process of capital structure optimization helps you not only to achieve a competitive cost of capital, but greater capital efficiency which leads to an improved ROIC. It requires a detailed analysis of your future cash flows based on comprehensive projections of your investment needs, dividend policy and appropriate debt or equity structuring. As part of our commitment to meeting our clients’ needs, your SunTrust commercial banking relationship manager can assist you in evaluating your specific situation and conducting the appropriate analysis.
Should you trade-off equity for growth capital?
Because investment of equity inherently results in incremental risk, equity investors will typically seek a return that’s many multiples of the interest charged on a bank loan. The good news is that the right investor — one who not only brings capital but experience, insights and valuable connections — can be a growth catalyst for your company.
Angel investors are typically retired executives who look for opportunities to invest in growth-oriented companies. They can function as great coaches and mentors, and add significant value to your company through their business contacts and industry knowledge. Like any equity investor, however, they can be a hands-on partner and likely to want a hand in your business operations. They may have strong contrary opinions about how best to grow your company, as well as requirements for belt-tightening and process changes.
It’s important that you realize, however, that although your company is likely your most valuable asset, it’s merely one element in a portfolio of diversified investments for an equity investor. And the equity you relinquish can come at a very high price depending on the success of your company.
The least expensive route to growth
On an absolute basis, debt financing will prove significantly less costly than equity financing in most instances. And with interest rates near historic lows, it may represent your cheapest source of growth capital, especially if your company has a well-documented track record of profitability and growth. Don’t lose sight of the fact that debt financing can also be an essential precursor and “door opener” to future equity investment.
Opening the door to equity through debt financing
Many venture capital and private equity firms will mandate that a certain amount of debt financing and additional access to capital be established prior to investing in your business. This additional capital allows the equity provider to leverage their own returns by facilitating and often accelerating the company’s growth potential.
A case in point is a recent $76.5MM senior credit facility (along with a $36.5MM swap trade to better manage future interest rate risks) that SunTrust structured for a young, growth-oriented developer, acquirer, and manager of ambulatory surgery centers. Because of our active involvement in the company’s growth plans, we understood that the deal was a prerequisite for the firm to receive an additional $35.0MM capital investment from two private equity firms and worked closely with both the company and its new equity partner to structure a debt financing that will accelerate the company’s growth expectations by several years.