Growing businesses take countless paths to find competitive advantage and a business model to deliver it. At some point, the time arrives to optimize financial structure to fit with the company’s operational accomplishments and its plans for the future. According to SunTrust Research of 532 business leaders, businesses that most actively planned for growth also keenly managed their debt mix with 58 percent stating that they had an extremely strong debt ratio. That means settling on an ideal capital structure with the right amount of leverage, often collateralized by real property, to help leaders find the capital they need to grow, reduce capital costs, and diversify investment portfolios.
Understanding the Benefits of Leverage
As part of lowering a business’s overall cost of capital, business leaders adjust the mix of debt and equity in proportions optimized for changes in market conditions or in the business itself. In doing so, they open a number of strategic possibilities including:
- Adding a new source of growth capital for the business. Debt is typically faster and cheaper to access than equity capital.
- Providing equity investors with a higher return on their investment. Since debt combines historically low rates and tax deductibility to reduce its cost, equity investors can benefit from the fixed costs of debt being used to concentrate higher returns towards their capital.
- Accessing owner liquidity. Owners looking to find liquidity from a portion of their equity or diversify their investments can often do so with increased leverage to free more cash from the business.
Determining Optimal Capital Mix
Many factors come into play when determining the best capital mix. Dispel the notion that there is a single static number that determines the optimal capital mix for your business. While there are industry rules of thumb, the optimal capital mix for a business is forever fluctuating based on the company’s performance and track record, its “leveragable” assets, the business cycle position and economic conditions, and current interest rates.
Coming to the best mix of debt and equity for your company at any point in time engages the best thinking of your management team, financial experts and board along with key external advisors like your accountants and bankers. Your SunTrust Relationship Manager is a great person to help you weigh the pros and cons of each type of financing and to find the right mix that fits your company, your industry and your risk profile.
Rethinking the ideal capital mix is also a great time for some debt housecleaning. Retiring loans with high interest rates or unattractive terms should be a high priority. Twenty-three percent of business leaders said they are looking to refinance in the next 12 months. You might also consolidate loans and banking relationships for simpler management.
For an example of thinking about capital mix strategically, look at a manufacturing company closing on $20 million in annual revenue that worked with SunTrust to go through a capital rebalancing process. The company faced a need for a new $3 million piece of equipment to maintain competitive parity and to address the cost and service requirements of its customers. The business leaders increased debt as a portion of the capital mix to finance the equipment, understanding that the investment in this new equipment would provide growth that would increase the value of equity and, within a few years, would bring the capital mix in line with the business’s goals.
Adding Leverage with Real Estate
There are a myriad of ways to add leverage to a capital structure, but one of the fundamental methods used by small and medium-sized businesses is through real estate financing. Growth often results in expanding facilities. SunTrust Research shows that 30 percent of business leaders are planning to expand facilities, and this is a natural way to add debt to a capital structure.
Determining whether to lease your facilities or buy them is the first decision. Evaluating how a purchase will help you control operating costs and how it will help you lock in advantageous locations are but a few of the considerations in deciding whether to buy. A full analysis of these questions includes looking at the status of current leases, lease and buy/sell market conditions for commercial space, timing pressure to move and the effect of location change on customers and employees.
If owning real estate does make sense for your business, obtaining a commercial loan on owner-occupied business property is one of the most widely-used methods to add leverage to your capital mix. Real property provides well-understood loan security for the lender, introduces an additional asset type to your company holdings and offers appreciation upside. All of these benefits accrue to the company without equity dilution.
A variation on having the business take on debt is for a business owner to do so personally. By buying real estate and leasing it back to the company, the owner naturally diversifies a concentration in company stock. When the owner transitions from the company, there will be an available income stream of lease payments along with access to real property appreciation.
Next Steps – Getting Started
Before making any changes in capital structure, step back to make sure to set any major decisions within the context of your strategic plan. When it comes to understanding capital mix and the possibilities of real estate purchases, your SunTrust Relationship Manager should be at the top of the list. Your SunTrust Relationship Manager can lend valuable insight about capital structure and help you find the best ways to use real estate to achieve your leverage goals. Along with your other advisors – CPA, lawyers, financial advisors and others – your Relationship Manager can put the debt financing in place to meet your capital mix and business goals.