Companies looking to grow and needing an infusion of capital have several options, which come with various costs and requirements.
“We look at capital on a sort of continuum, with equity perhaps being the most expensive form primarily because of its diluting impact on ownership of the company. At the other end, there’s self-generated working capital derived from profitable operations,” says Paul Gibson, senior vice president and Eastern Region market manager at Bridge Bank. “In between there are a variety of financing options to assist a growing company.”
Smart Business spoke with Gibson about where small businesses fit along the continuum and options they have available to secure working capital.
What is the least expensive option to get working capital?
There is no cheaper form of capital than self-generated profits. Apple, Inc. is an example of a company that continues to be profitable and has a huge war chest of cash available for any need. But most small and growing businesses are not capitalized like Apple and look to banks to assist in the form of senior debt. This financing is usually based on a bank’s prime lending rate as its index and has a modest margin over, or under, this index. These loans are structured, including a senior secured lien on all assets through a Uniform Commercial Code filing and frequently have financial and/or performance loan covenants. There may be a borrowing formula and an advance rate against receivables as well. There is a direct relationship between pricing and structure, as all pricing is ultimately dictated by risk. When a business can’t adhere to a traditional covenant structure, the looser structure usually translates to increased pricing.
It’s best to determine working capital and growth capital needs first when exploring financing solutions. Next, identify the various capital sources starting at the least expensive and work down until sufficient working capital is obtained. Many times it’s possible to meet all needs with senior debt, but there is a limit to how much is available and that is largely determined by the profile and complexion of the company — overall assets, liabilities, cash flow, liquidity. All of these factors help identify risk.
Many growing businesses find it difficult to obtain traditional senior debt financing because they’re focused on growth at the expense of profitability. Some banks specialize in assisting companies in this dilemma, forging strong relationships long before the mega-banks will.
What’s next if companies can’t obtain sufficient senior debt?
Another potential source of working capital is subordinated debt, also known as mezzanine debt or venture debt. Subordinated lenders do not recover their first dollar in a liquidation scenario until the senior lender has collected its last dollar. This type of financing can take many forms.
With subordinated debt there is generally less structure than with senior debt. The reduced or even lack of covenants and junior lien position contribute to increased risk. Because there’s greater risk, subordinated debt also has a higher price.
Some banks offer these instruments, but more often commercial finance companies, hedge funds and other non-bank lenders offer them. The higher rates they charge are reflective of the higher cost of their capital, usually in investor funds or a bank line.
Why is cheaper not always better?
The true cost of capital shouldn’t only be measured in simple dollars or as the spread of basis points in an interest rate. The least expensive capital isn’t always the best capital because there are more factors than just price, such as opportunity costs, ease of use, flexibility of structure and other intangible benefits. For example, a low-interest loan with a covenant package that’s too restrictive can potentially result in a business disruption when a covenant violation occurs. Balancing pricing and structure relative to individual needs is critical when evaluating multiple loan options.
Most people assume that competition is the primary driver of pricing, but it’s not. Risk determines pricing — whether it’s equity or debt — and competition further refines it. Companies should understand their risk profile. It’s a powerful tool in helping to achieve the best outcome for a business’s financing needs.
Paul Gibson is a senior vice president, Eastern Region market manager, at Bridge Bank. Reach him at (703) 481-1705 or firstname.lastname@example.org.
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