Tips For Bringing Capital into Your Business
Why Do We Need Capital?
There are two reasons for raising capital. One reason is to fund growth, and that could be capital used for things that move over time and things that don’t change over time. Things that change over time would be things like accounts receivable. As you grow, your accounts receivable increase; therefore, you need cash to finance your customers. You’re lending money to your customers in the form of accounts receivable. You need to get the money from somewhere. If you’re growing fast, you’ve got this incredible cash need, and you have people that owe you money, then you owe people money. And those offsets well. But typically, there’s not enough of a spread. The spread is too far for one to pay for the other. You’ll always need to be raising capital incrementally to fund growth.
Another reason for raising capital will be inventory. If you have inventory in your business, you might need capital to fund your inventory as you grow. That is fundamentally something that moves. Then the last one would be equipment and money, such as machines, buildings, and stuff that doesn’t move. It’s long-lived, and you’ll need it to grow your business. But it’s not something that flexes up and down based on how the company is doing.
So let’s talk about personal guarantees. This is one of the enormous deltas between an SBA and a non-SBA loan. When you go for a relatively unsecured loan, they’ll generally do it on multiples of cash flow. Now they’d love to have security. Like if you don’t pay us, we will take your building.
If you don’t pay us, we take your inventory, which they don’t like much. But let’s say they do it on cash flow. Look, you’re making a million dollars a year; we’ll loan you 2 million against that. That’s a pretty typical loan. Generally, a bank will require you to do business with them if you’re going to get a loan. Then we want to see all your cash moving in and out of the account.
So let’s go to covenants because that will be a crucial point in the negotiation. When you start talking to the bank, they’re going to ask if you do it on a cash flow basis, so they’re willing to loan you an amount based on the multiple cash flow, with no security. In other words, they’re going to make sure you stay healthy so you can pay them back.
The other element that you can get from a bank is what they call an ABL, which is an asset-based line.
Asset-based lines are secured, so the interest rate is lower. If things go south, you can claim the asset that secures the loan that it’s asset-based. Typically they’ll only lend a percentage of the value of the asset. The two are structural debt and asset baselines. You have to look hard at the seasonality and cyclicality of the business. When you think about what’s the proper debt structure for you. Suppose you are in oil and gas, technology, or things direct to consumers where Q4 is the Christmas season and is always the biggest. You want to keep that debt level at your Q1. The Q2 number is not your Q4 number. You let the ABL flow load up during the busy period and then float back down when you get out of the busy period.
That’s the perfect use of structural debt and an ABL sitting on top of it to deal with your cyclicality. The idea of a mezzanine is the debt stack or the secured creditors first, then the bank debt, and the unsecured creditors. So they’re risky. If things go wrong, they’re third in line to many other people, including the employees who are first in bankruptcy. Employees, then secured, then unsecured, and these guys might be third. They have no security. So their interest rate is going to be high.
Another class of rapid advance-type players will lend you money in a day or two. They generally look at cash flow and primarily focus on unbankable companies. They would lend you $40,000. And you would need to pay them back $80,000 over an unspecified period. What they do is they are going to put a new credit card system in, and for every credit card swipe you take, they are going to take 10% of it to pay down your loan.
If you have a bank, you’re going to have to report quarterly, and you’re going to have to have excellent tidy financials. You have to sit down with them every so often and tell them how your business is doing. The good news is they’re not on your board. They won’t be on your board because that would conflict with them, but you will have to answer them. So you now have a partner in the business even though it’s debt.
Friends and family
One last element in raising capital is the option to go to friends and family. If I need 100, 200, or $300,000 and have a rich uncle, I can borrow the money from my rich uncle. I will be able to offer my rich uncle an interest rate that is very attractive to me, but there are lower limits on how much you can charge for interest, and they’re called the applicable fund rates, AFR. Currently, the applicable fund rate for a short-term loan is 0.2% interest. You could charge as low as 0.2% interest for an in and out loan, middle term, 1% long term, or 2%. So you can borrow from friends and family for super cheap if you can get it and not violate the law.
Equity is people investing in your business, owning a percentage of your company. In the early days of your firm, you use seed capital, friends and family, most likely wealthy family members. You generally don’t have highly sophisticated investors. So you can have very light constrictions on yourself when raising capital from friends and family, and they’ll give you the money because they like you, believe in you, and believe in what you’re doing. They’re not going to be looking for control provisions or board seats. They want you to do great, make a lot of money, and make some for them. So friends and family are one thing you can go to, but the next level is high net worth. You can raise a million to $2 million at a high net worth when you’re doing your early rounds. That’s about the limit you can get to unless you’ve got somebody affluent, generally even at 2 million; it’s a club, four people chipping in half a million or a million dollars. You’ll be lucky to find somebody willing to stroke a $2 million check on a risky or early-stage proposition. The thing to remember is there are no 5 million investors (or at least very few).
Why bring capital into your business?
What if you want to be raising capital for your business for growth and raise $5 million, but there are no 5 million dollar investors. Ultra-high net worth will tap out at one or two million, maybe three on the outside. Professional money funds only get around 10. A few will do lower, but there’s a lot of overhead and time, and to do this deal, they don’t want to put a small amount of money to work. They want to put up a more significant amount of money. So it is rare to find a fund that will make a $5 equity investment for growth. The other thing you’ll see typically is a preferred liquidation preference. What this means is when we sell the company, I get my cash out first, and then I participate like usual. So let’s say I sold 10% of the company to my preferred investor for a million dollars, and we sell the company for 20 million. They get their million dollars off the top on day one, there’s now 19 million left, and they get their 10% of the company. They get 10% of the 19 million as well. So they get 1.9 plus a million, 2.9 million on their million-dollar return. A one-time liquidation preference is a little uncommon. Most of the time, they’re going to negotiate for higher than one. A 1.5 liquidation preference or a two times liquidation preference is more common. So what that means in my example, we sold by putting in a million, and I own 10%. We sold the company for 20 million. I’ve got a two-times liquidation preference. So I get $2 million off the table. There is $18 left for everybody else. I get 10% of the $18 for another $1.8 million. So I make 3.8 million on the exit.