Short term needs are better financed by short term capital. Equity is better spent on building a business, not bridging cash flow.
Craig, the foun
der of a Bay Area mobile media start-up neatly summarises something we observe across many early stage tech businesses. ‘”We approached x bank (a well known bank in the community) to fund cash flow gaps and we were told we did not have enough collateral. We are not raising another equity round for some time and need some cash to cover us until our major invoices are paid”. Craig is not alone. Within the scary stats on the lack of SMB financing being produced by the public sector lobby groups and think tanks, technology companies are part of the under-lent.
Except that many VC backed companies either rely on their equity rounds or are able to access venture debt (where the strength of the VC opens the door to borrowing).
Chris, the CFO of a SaaS business has a slightly different story. “Our customer is supposed to pay us monthly in arrears against invoice, so we are on effectively 60 days. We’d like to explore the possibility of getting an advance against 6 months of invoices”. We talked to a bank who wanted to tie us into a 2 year contract and have our shareholders guarantee. Our shareholders are not too happy about this.”. In Chris’ case, he has enough working capital to last his 60 cycle – he wants a cost effective way (without diluting further) of using his sales to give him 6 months assured cash flow.
Corporate accounts payable cycles seem to be getting longer. Reports abound of corporates hoarding cash, and anecdotes of CFOs and treasurers looking to squeeze additional returns on their margins are commonplace. Corporates are worried about further reductions in bank lending, so hold their cash. The zealous treasurer extracts opportunity from his procurement – offering to pay suppliers in less than the agreed 90/45 days, the treasurer gets a discount. So, to get paid in less than 90 days, you as the supplier offer your customer a 2% discount on your sales. Great, its ‘standard’ and everyone’s doing it. So if we’re willing to ‘borrow’ from our customers (the irony of this never ceases to amaze me), why is paying a third party lender the same or slightly more, a problem?
Some suppliers look at this as a cost of sales. Others compute this as part of cost of capital. For those people lucky enough to dodge multiple corporate finance courses in college, I’ll spare the detail except to say that both cost of equity and cost of debt matter and entire armies of finance types in the banking, investment and business world spend a lot of time (sometimes too much) analysing this.
To SMBs, early stagers and start-ups, the cost of capital matters in a simple way: if you raise equity at a low valuation, you have a high cost of equity. If you pay too much for debt, you have a high cost of borrowing. So,rather than pay high interest on debt, is it not simpler to just use equity investment to finance your cash flow gaps/
If you have no choice, absolutely, wherever you can find the money. Equity is for building the business. Longer term debt can be used for that too. But for working capital short term cash or surplus revenues should be used.
If one can borrow, even at a slightly expensive rate (not so high that repayment burdens your business but high enough that it annoys you), it’s worth considering the following:
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equity investors look for double digit or X returns. Whether its a 25% or multiple, its more than base +2-10% many commercial lenders can charge
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debt interest can be offset against tax, equity in general, cannot;
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equity finance dilutes ownership, debt does not;
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corporate financiers will tell you that equity capital should be deployed on mid-long term projects since the benefit of these projects will can yield sufficient return;
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good borrowing can lead to better borrowing – establishing good credit history can lead to better creditworthiness, which over time, leads to lower price paid for debt. Many blue chip corporates borrow below prime or close to it;
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conventional loans need the big C (collateral). Commercial debt is often asset based (i.e. on the strength of invoices, orders or assets). A small business with invoices payable by big customers can borrow on the strength of invoices and sales without having to be constrained by lack of collateral.
I think that working capital financing costs must be looked at in the same way as early pay discounts – this is really a cost of sales. You’ve already sent an invoice and expect payment in x days. Problem is you cant wait x days. You can either dip into your equity financing for this, or find a commercial lender to bridge the gap. By borrowing commercially you are taking advantage of the tax shield while building up credit. All businesses need cash throughout their lives. Venture backed, private equity backed or listed on NASDAQ, everyone needs to fund working capital and cash gaps.
And cash comes from building up good credit and payment histories, from developing lender relationships to help fund that next big acquisition or expansion. Corporates have finance and treasury teams and relationship bankers to make this happen.