BSM Executive Advisor
	David C. Guenthner
	dave@bsmexecutiveadvisor.com
	(402) 660-7667
	Contact Dave Today!!!

• Home
• About Dave
• Consulting
• Seminars
• Speaking
• FAQ
• Contact Dave

Capital

Click here to view acquired capital.

Capital gives life to your vision. Without capital you don't have the ability to marshal the resources required to execute your vision. Without capital you can't buy the inventory or equipment you need. Without capital you can't hire people that will be required to make your vision a reality. Without capital you can't build the infrastructure to support any growth that you achieve. Without capital, your vision is probably a hallucination.

InaCom acquired over $2 billion of capital, excluding vendor financing, to fund its growth. The sources of capital included good working capital management, equity offerings including an initial public offering(IPO)of stock , several secondary offerings of company stock, subordinated convertible debentures (interest bearing debt instruments convertible into common stock under certain scenarios), accounts receivable securitizations, floor plan lines of credit and secured working capital lines of credit.

Access to capital at a reasonable cost was critical to the growth of InaCom.

The cost of capital is directly proportional to the amount of perceived risk the provider of capital sees in the company. The higher the perceived business risk of the company is, the more costly capital will be.

Equity is the most risky and consequently the most costly form of capital. There is no guarantee that you will achieve a return on equity and you could loose your entire investment. A line of credit secured by accounts receivable is the least expensive form of capital. The risk of not recovering the principal is minimal if the accounts are current and are due from recognized, reputable companies.

Between these two risk and reward scenario's you can find preferred stock, convertible stock, inventory lines of credit, supplier credit, bonds, commercial loans and numerous other combinations of risk and reward that can be tailored to you companies specific needs. All of these forms of capital are legitimate and may be appropriate for your company based on the circumstances you are in.

The first rule of capital is always lock up access to capital before you need it. Locking up capital early allows you to get the kind of capital you need and will afford the best terms that the company can get. You always want to be in a position to say no to rates, terms and conditions that are not right. If you wait until you need the capital, the cost will go up and the terms and conditions will become much tighter. The cost of putting capital or access to capital in place early is always less than the cost increase or tightening of terms that accompanies desperation.

The amount of capital you need depends on your growth plans and the capital intensity of growth in your business. Capital intensity for growth is how much net new cash is required to achieve $1 dollar in new revenue.

	Year 1	Year 2	Growth
Revenue	$100	$125	$25
A/R and Inventory	$ 60	$ 95	$35
Accounts Payable	$ 30	$ 40	$10
Net Assets	$ 30	$ 55	$25

In the above example, each dollar of new revenue required $1.00 of net new cash ($25 growth in net assets divided by $25 growth in revenue). The cash will have to come from financing activities. Accounts receivable, inventory and accounts payable have already been considered in the equation. For each dollar of revenue growth, equity or debt of some sort will have to be put in place to pay for the growth. In the above example, $25 of new equity, debt or a combination of the two will have to be found.

You must know and understand your cash conversion cycle. The cash conversion cycle of a company is the number of days between paying for inventory and collecting the cash for the sale of the inventory.

Company A buys inventory and has to pay for it after 30 days. The company carries the inventory for 60 days before it sells the inventory. After selling the inventory it takes the company 45 days to collect the account receivable. The cash conversion cycle is 75 days (60 days in inventory less 30 days in payables plus 45 days in accounts receivable). If you buy inventory and sell it, you will need to find financing for the cost of the inventory and receivables for 75 days.

The cash required for each new dollar of revenue growth and knowing your cash conversion cycle are two things you should know before you start to grow your company. Knowing them puts you in a position of projecting how much financing you will need. Knowledge puts you in a position to look for financing from a position of strength, prospectively versus reactively. Knowledge will allow you to negotiate better rates and terms than you could get if you waited until you needed the capital and then began to ask for funding.

Management of your cash conversion cycle, inventory, accounts payable and accounts receivable, is your best and least cost avenue of procuring capital for growth.

Don't carry anymore inventory than you absolutely have to and if it starts getting old, drop the price and get rid of it. Inventory does not get better with age. Some cash from inventory is always better than no cash at all.

Manage your accounts payable. Accounts payable are free loans if you turn the inventory that supports the payable. If you have $1 million in inventory and it turns every 20 days and the vendor gives you 30 days to pay, you have an interest free capital loan of $1 million dollars from your vendor for ten days. Most vendors allow a grace period of approximately 10 days so 30 days becomes 40 days and your free financing period doubles.

Many vendors offer aggressive discounts for early payment. For instance 1% 10 net 30 says if you pay in 10 days you can reduce the payment by 1%. That 1% discount equates to 18% interest on your money ( You pay 20 days early to get 1%, there are 18 20 day periods in a year of 360 days, consequently the discount is equivalent to earning 18% interest per year). Unless your borrowing cost is more than 18% or you can get more than an 18% return on the money from an investment, pay the bill and take the discount.

Accounts receivable must be managed aggressively. Your customers won't let you increase your price to them when you want and you shouldn't have to change the payment terms under which you sold to them. Accounts receivable is the closet thing to cash and if you stay on top of A/R you can keep your borrowings to a minimum. Like inventory, accounts receivable rarely get better with age.

Bank Financing

Commercial bankers look at the world differently than businessmen look at the world. Businessmen see opportunity; bankers see risk. Bankers base their views on the premise if this thing goes wrong, how do I insure that I will recover my principal. The best way to insure the recovery of principal in liquidation is to make sure that you are over collateralized. Banks will always try and be over collateralized. That is why banks typically lend only 75% of eligible accounts receivable and 60% of inventory.

Bank or debt financing is a very attractive financing alternative. The interest rate charged on secured debt or even unsecured debt is tax deductible. 10% debt to a company, after tax, is 6% money. This is very cheap capital compared to equity that has a cost between 12% and 20% depending on the riskiness of the business. Using cheaper capital- debt- you can leverage your capital base and create a higher return on equity for your investors.

XYZ Company earns $100 a year. They have a capital base, debt and equity of $1,000. If the $1,000 is equity, their return on equity is 10%. If XYZ's capital structure was $500 equity and $500 debt, they would have a return on equity of 20%. A 20% return on equity would deliver a good share price in the public markets, certainly a better price than a 10% return…at least until the point of to much leverage is reached.

Too much leverage (debt capital) can put your business at risk if things don't go as planned. Banks are far less friendly during hard times than they are during good times. Miss your loan covenants and the bank can wind up dictating how you run your business. To much leverage or financing risk piled on top of business risk can drive your cost of equity and debt up. You must have a prudent balance of debt and equity for your business. Every business is different.

Terms and Conditions

Always read and understand the terms and conditions on the capital you are raising. Once you give something up, you will never get it back. Make sure you are getting fair value for every term and condition.

Once you agree to personal guarantees, you will always have to give a personal guarantee. Once you agree to an audit you will always have to have an audit. None of these terms are unreasonable, but terms coupled with over securitization and a high rate does not have to be accepted if you are in the capital markets before you need the capital. If you aren't and you desperately need the capital, you will get what you deserve.

Equity

The primary source for equity is your savings or personal assets. If you don't have that or you have exhausted that, you must look to outside sources for equity. The primary sources of outside equity are Venture Capital, Private Equity and Public Equity. Each has its advantages and its disadvantages. Equity is the most expensive form of financing. You give up ownership of some profits and some level of control with every sale of equity.

The sale of equity, at InaCom, was mandated by the nature of the business. We were a cash intensive distribution business. Early on, we needed $1.40 of outside cash for every dollar of new revenue we generated.

InaCom had a high level of business risk. Operating margins were very thin, less than 1%. There was very little room for error's in judgment. We were a distributor caught between very large manufacturers like IBM, Compaq, H-P and Dell and very large customers like General Motors, General Electric and Citibank to name a few. InaCom had a great deal of business risk which limited the amount of financing or debt risk we could take. We had to raise a lot of equity to maintain our leverage ratio's and still be able to grow the company.

Venture Capital (VC)

Venture capital is money available from investors who buy stakes in companies based, primarily, on their business plan or vision. The idea of venture capital is to locate companies with good ideas and a need for capital very early on in the life of the company. In the case of Valcom/InaCom, Valmont Industries was, essentially, our venture capital money.

VC's raise money in the private capital markets and are a pooled money investor. They typically raise millions or billions of dollars in a fund that will buy into 15 or 20 companies. The idea is that by spreading their risk they will get three or four home runs, a few so-so investments and a few strikeouts. The bet is the homeruns will be big enough winners to offset the losers.

The VC is looking for a major ownership position in the company. The VC is generally working on a five year investment horizon and expects a 25% plus return on his capital. The VC will be very active in your company. They will demand seats on the Board and may even control the Board. Remember, the VC's long term interest is not the viability of the company as much as it is their desire for a 25% plus return and a quick exit.

The exit strategy for a VC, historically, has been a public offering of the stock of the company in an IPO. Recently VC's have been looking to private equity as an exit strategy. The shift in strategy has been driven by the heavy weight of regulation and enforcement from the Securities and Exchange Commission.

Private Equity (PE)

Private equity is very much like a VC. The primary difference is where private equity gets involved. Private equity is interested in taking large positions in companies that have a performance history and have been in business for a number of years. They are not looking for startups, they are looking for turn around opportunities, companies that need capital to grow quickly or quick flips.

Today, private equity is focused on taking public companies private. The thought is that being public is very risky in today's regulatory and litigation environment. The PE can take the company private, cut expenses, fix any operating problems and in five years when the regulatory and litigation environment is less hostile, take the company public again at a sizeable profit.

Private equity is pooled money. The funds are typically in the billions of dollars and they buy a number of companies out of each fund. The companies are leveraged up with debt to maximize returns to the PE investor. The PE investor will charge a management fee to the companies they purchase and exercise a great deal of control over the management of the company.

Private equity is interested in their return far more than they are in the return or long term viability of your company. Leverage enhances their return. The fees they charge for management services enhance their return. The timing of an IPO and the composition of the IPO is done to maximize their return.

Public Equity

Accessing the public markets through an initial public offering, IPO, used to be the preferred mechanism for creating liquidity in a company and insuring access to capital in the future. Secondary offerings of stock or debt can be done once a company goes public. An actively traded stock provides liquidity for the stock of the investors in a company.

The Enron scandal of 2000 has made the American public capital markets a very risky place to live. In reaction to Enron, congress passed Sarbanes Oxley. The responsibility for implementation of Sarbanes Oxley was left to the Securities and Exchange Commission (S.E.C.). The S.E.C. has implemented numerous regulations that have caused a rapid escalation in the cost of compliance for publicly traded companies and for those looking to go public.

In addition to the added costs of compliance, the S.E.C. has gotten much more aggressive in investigating and pursuing alleged violators of securities regulations. The fear of litigation has probably forced more companies to go private or decide to list their companies overseas than any other event.

Going public will increase your access to capital but it will also increase your cost structure and it will expose you to more litigation risk than you have as a private company. Unless you need a lot of capital or the owner wants liquidity for his investment, going public should be the avoided at this time.

© 2007 BSM Executive Advisor, All Rights Reserved.