When Growth Outpaces Cash – How Capital Structure Corrects It
A new vcfo client recently concluded their highest sales quarter ever but wondered why they were struggling to pay vendors. Clearly, they were growing. It was just as clear, however, that their growth was unsustainable without significant changes to bolster their underlying support mechanisms.
When growth increasingly outpaces cash, insufficient attention to your balance sheet, statement of cash flows, and capital structure will rear its ugly head more and more. Struggles with paying bills will be joined by struggles to bring on more people, acquire needed equipment, and expand capacity to meet demand. The remedy lies in clarifying the present picture and putting the best blend of capital structure components in place.
Prepare for Growth
Goals for growth should not be arbitrary. A goal to grow 15% when current operations can only sustain growth of 4% will do you no good. Sufficient stability and flexibility must be built into the balance sheet to prepare for that growth. A good first step is to evaluate the time-to-liquidity and time-to-maturity of your current assets and liabilities.
With assets, only cash is instantly liquid. Time-to-liquidity with Accounts Receivables and Inventory depends on variables such as payment terms and how quickly products are sold. Marketable securities and prepaid expenses are part of the picture too. With liabilities, look at the frequency and duration, interest rates, and payment amounts that will be required to pay off current obligations. Assessing these balance sheet elements is key to determining capacity for growth or whether a gap in your ability to fund current and planned operations is present.
Use Capital Structure to Build Growth Capacity
Building growth capacity and bridging growth gaps can be achieved with the right capital structure – the blend of debt and equity that comprises a company’s finances. The right capital structure is as unique as you and your company. It’s the one that affords you the greatest probability of achieving your business and personal goals.
On the debt side, evaluate the growth any debt would fund versus what it would take to secure and repay the obligation. Debt is an important and useful tool that comes in many forms. Traditional debt-based financial instruments include revolving lines of credit, bank loans, and mortgages. Before taking on debt, consider – What is your borrowing capacity and how are your current business practices and processes affecting it? What interest rates are attainable? How will the debt be collateralized? What terms can be negotiated?
Raising funds through the sale of equity is another avenue for funding. Giving up equity in your company can serve as a strong stimulant for investment that’s needed for growth. It can give you access to new expertise, broader resources, and even ways of diluting risk. However, giving up equity almost always also means ceding some degree of control or governance input in the company. Some equate finding the right equity partner(s) to a marriage. It’s important to find those partners whose values and objectives are congruent with yours.
The two most universal types of equity are Common stock and Preferred stock. While there are variations, Common stock typically includes voting rights while Preferred stock does not. In early pre-revenue stages when it’s difficult to value a business, companies may elect to issue Convertible Notes which are not paid back via payments and interest, but instead allow investors to convert the notes to an anticipated issuance of preferred stock or warrants at a future point. Additionally, new and innovative forms of equity investment are also gaining traction. Regenerative finance is one such example that’s sometimes referred to as “patient” capital.
An important takeaway here is to understand that a wide array of debt and equity options are available to support the growth of your business. Similarly, numerous variables go into determining what the best blend of equity and debt is for you. If you don’t have the right expertise in place to give you a solid understanding of the different options and their respective pros and cons, bringing on a fractional CFO is highly recommended.
Situate for Sustainability
Growth shouldn’t be simply seeking a higher net income number in the next quarter. Growth should be about building your business to where you want it to be and getting there via a path that protects you, your objectives, and your overall vision for the business. Adopt a long-term view of growth that fully considers your personal timelines and your company’s sustainability. Woven into an effective capital structure are answers to questions such as:
- How sustainable is the growth of the market we’re in and/or are thinking about entering?
- How qualified and reliable are our customers? How quickly do they provide payment?
- How much of our revenue is de-risked via contractual agreements and for how long?
Setting yourself up for controlled long-term growth and the outcomes you want requires you to know what is sustainable and what is speculative. In a capital structure context, an inability to make these distinctions often translates into business owners giving away part of their company or taking on significant debt obligations for something temporary, inflated, or borne of wishful thinking.
Reflecting confidence and forming ambitious goals for growth are great. However, your focus as a business owner has to be more than producing J-curve earnings. Recognize that downturns are inevitable and be prepared for them. Sound, strategic decisions and effective capital structure inject liquidity and flexibility into your balance sheet and put you in the best possible position to mitigate cash constraints and drive business growth.
Are you working to grow your business? Do you have the right capital structure in place to support it? Our experts can design a plan to support your objectives and help you set the right course. Request a Free Consultation from a vcfo expert today. We’ve partnered with more than 5,000 businesses in our 27 years and would love to put our knowledge and experience to work for you.