BIZ BITS: Growth Funding - Picking the Right Club for the Shot
Miller & Martin PLLC Blog | August 16, 2018
Author: Jeffrey Cunningham
In this blog post, Bill McDermott (Founder & CEO of McDermott Financial Solutions in Atlanta) and Miller & Martin attorney Jeff Cunningham explore the differences between types/sources of capital, and comment on which types or sources of capital are best suited to different purposes.
I was talking with my friend, Shawn, a few days ago about growth capital. He made some comment to the effect of “I would just go the bank and get some money,” and I was struck by his statement. I told him that it’s just not that simple, that banks like to lend on value, not potential, and for that reason, funding from banks, if available at all, may choke a business instead of fueling growth. He stopped me there and said, “That has to be your next blog post.”
I quickly reached out to Bill McDermott, experienced banker turned business finance consultant, and proposed that we write something together. To my delight (and relief), Bill quickly agreed.
Picking the Right Club for the Shot
I love a good aphorism. When Shawn brought up the subject of growth capital, one of my favorite aphorisms came to mind:
Pick the right club for the shot.
Picking the right club for the shot is critical in golf and picking the right funding for your business is critical for success. Not, just any club, but the right club.
If the source of capital is like your driver, it can go a long way, but the degree of accuracy can vary greatly. If the capital is like your putter, it will not move you very far, but it will not risk going as far off course. This article explores various sources of growth capital, positive and negative attributes of each, and seeks to offer some insight into which type or source of capital is best suited for your growth situation. A future article will explore growth capital from the perspective of funds providers.
Money is Fuel for Business Growth
Most of us do not get paid in advance for the work that we are going to do or the benefit we are going to provide to our customers. At the same time, our employees, contractors, vendors, suppliers, and business partners generally are not willing to wait for their payment until we get paid by our customers. That means that, as business operators, we must generally pay for our inputs before we sell our outputs. To do that we need money. That axiom is more true than ever in times of growth or expansion. Money is the answer (maybe). Where to get it, and how much to get are the questions. The right kind of money is the right answer, but the wrong kind of money is the wrong answer.
The Golf Club Analogy
Consider the various types of money, some is designed to compensate for greater risk, like an equity investment; some is designed to compensate for a specific kind of risk, like a bridge loan; and some is designed to be cost effective, when risks are lower, like a loan secured by valuable real property. In golf, club selection is influenced by similar factors: how far you have to go to reach the hole, the degree of precision required at the time, course conditions, lie, and your tolerance for hitting a bad shot. While the driver has the greatest potential to move the ball down the course as quickly as possible, it really works best off the tee, and is worthless in the sand. The right combination of power clubs early on enables you to cover more ground faster; you can always fine-tune your approach closer to the hole.
Selecting the right growth capital for your business is like selecting the right club for your golf shot. You have to factor in the distance to your objective (how much money you need), the number of strokes available or allotted to achieve that objective (how long you have to achieve your goal on schedule), the opportunity to recover from an imprecise shot (how much time you have if you get off schedule), and your lie (market conditions and other conditions outside your control).
A driver is flashy, and experienced golfers can use them to hit long, impressive shots. An inexperienced golfer, however, might hit a driver shot into the woods or the lake. Moreover, a driver is really not even a viable choice from unfavorable conditions (sand or rough). Finding and using equity is just as hard.
Finding equity can be difficult (like hitting a driver). Those providing equity have minimum amounts of capital they want to invest, require high returns, they can typically want control of the business which can be a non starter for many business owners and are looking for a time horizon where there is a liquidity event, usually the sale of the business. The capital provided by an equity investor should be able to go a long way, but finding the right amount of equity and the terms that are mutually agreeable is generally hard.
A mid-iron is often the club that follows the driver, or on some holes replaces the driver. The mid iron is a distance iron, to lend a bit of control while giving up a bit of distance.
Mezzanine financing is available for those who are high growth companies and have outgrown their bank’s capacity to provide financing. The bank financing will go only so far, much like the short iron and the company needs capital to go further. Mezzanine financing comes behind the bank financing to provide what’s required but it fits between bank financing and equity, hence the name mezzanine. If your business is in high growth and you’re reaching the point where your bank financing is maxed out, but you don’t want to go thru an equity raise, this might be the shot to hit.
A short-iron is the right club for your approach to the hole. The short-iron has enough loft to bypass the sand traps and bunkers surrounding the green, as well as the unpredictable fringe separating the green from the fairway.
A secured term loan, well collateralized by reliable assets, like real property, is like a short-iron. A term loan generally carries a comparatively favorable interest rate and predictable, level repayment terms because the reliable collateral provides comfort to the lender. Because you are pledging your assets as collateral, however, you should be wary of guarding those assets against unknown risks.
Just as the short-iron is not practical or even available until you are close to the green, the term loan may not be practical or even available until you have accumulated considerable value in your assets and real property. When available, however, the term loan can provide liquidity to help you navigate known near-term risks to your business growth.
A specialty club is like a lob wedge or sand wedge, something to get you out of a jam. The specialty clubs are generally shorter and often less accurate than short irons, but are effective for getting out of bad situations. A golfer may not plan to use a specialty club, but when he finds himself in a bad situation, he is glad that he has one available. The specialty club allows him to quickly react to a negative situation, put it behind him, and get back to playing a measured, proactive game.
A bridge loan may be like a specialty club. Bridge loans generally require higher interest and have steep penalties if not repaid in a short time. This is by design. Bridge loans are designed to incent quick repayment. Over a longer term, a bridge loan can absolutely choke a business, but in the near term may provide liquidity to get out of a tight financial spot.
In that sense, the putter is like a secured line of credit from a traditional bank. There’s an old adage that, “banks lend money to businesses that don’t need it.” Remember, however, that banks are not venture capitalists. If a business is looking for an equity partner, it should not look to a bank. Bank lines of credit generally provide liquidity capital on a short term, tap-in basis, much like your putter is needed for short shots. Lines of credit finance timing differences between the borrower’s payment of expenses and collection of accounts receivable. The rule of thumb for a bank line of credit is usually one month’s revenue, however some banks look at the difference between it’s borrower’s collection period on AR vs the timing of payables payments. If your AR collection is 45 days on average, but your payables are due every 30 days, you’ll likely need about 15 days of sales for your credit line. A company with $10 million in revenue sells about $27,000 per day, or just over $400,000 for 15 days. Your circumstances may be different if you carry inventory in addition to AR.
Playing the Hole
A good golfer will have a strategy for a hole before teeing off. He or she may plan to start with a driver, hit a mid-iron from the fairway to the green, and then putt in for a birdie. If all goes according to plan, those are the only three clubs he or she needs, but if he or she hits a bad shot, the short irons and specialty clubs are available to get out of a tight spot.
So goes growth capital. A business should have a realistic plan for combining equity, mezz debt, secured loans, and lines of credit to achieve its growth objectives, but should be aware of different combinations and specialty lending products in case the plan doesn’t work out. In the end, the right combination of clubs, and the right combination of capital, will get it home.