Finance | "Finance" Archive

The costs of growth capital

by Joe Dague
for Virginia Business
December 2006

Decades of American entrepreneurship have attracted an increasingly broad range of individuals and institutions seeking investment opportunities. While the prevalence of growth capital in today's financial markets creates opportunity for business owners, selecting the best arrangements can make a significant difference to the future health of the enterprise. Understanding the goals and habits of capital providers is crucial to making an informed choice.

Using equity as currency for growth
Unproven ideas are difficult to finance for two main reasons: the lack of a fiscal track record makes valuing the company difficult or impossible, and the capital required to test the validity of a business idea tends to be too small to attract most institutional investors. These difficulties frequently force true startup companies to find creative sources of capital. "Angel Investor" funds will sometimes finance startups, primarily in high-tech areas where intellectual capital can attract investments even before an idea has been put into practice. More commonly, entrepreneurs use their own savings and borrowings or those of family and friends to finance early asset purchases and operational activity.

Once an entrepreneur has established a track record, more capital becomes available, even if the business is not yet profitable. Venture capital and private equity funds may be willing to finance the growth of a promising enterprise, particularly if the fund managers are familiar with the industry of the company. These firms typically invest without expecting regular repayments, as they generally hope to buy rights to a company's stock.

This type of financing has several obvious benefits. Receiving capital at an early stage can allow for a faster expansion of the business, which may be crucial in a high-growth industry or market. Because the investment does not take the form of a loan, interest payments are not required, and the principal investment may never need to be repaid. For a company early in its growth cycle, this type of arrangement may be necessary.

Accepting capital on this basis does contain some subtle costs. If an entrepreneur is expecting the total value of the company to increase dramatically, surrendering future equity may sacrifice some of the wealth that the enterprise will create. Additionally, the original owner often surrenders strategic control, and the outside investor may decide to move in other business directions, or even to replace the original stewards of the company with outside managers.

Using current payments to preserve wealth
A company that generates more than enough cash to finance its current expenses is no longer dependent on outsiders for survival, and can borrow against its excess cash flow by paying a current return in the form of interest, principal repayment, or special dividends. While these returns are more expensive in the short term, the investor must then accept a lesser portion of equity. The original owners then retain more control over the company, and sacrifice less wealth in the long run.

Neighborhood banks are the most common capital providers in this space. Banks do not accept equity as payment, instead requiring principal and interest. A bank will also be more explicit in evaluating the assets of the business; because the bank owns no equity, it receives first rights to all assets if a company goes out of business, and depends on asset liquidation for its returns.

Mezzanine capital has become an increasingly popular option for enterprises that lack the balance sheet strength to receive bank financing. Mezzanine lenders demand principal and interest payments, but also require a modest equity payment, typically in the form of warrants to purchase stock at a later date. This arrangement allows an entrepreneur to finance growth without sacrificing the strategic control or equity dilution that other types of funds may require.

The capital financing arrangement of a growing enterprise is a crucial part of developing a business plan, and the decision may govern how quickly the company will grow and who will ultimately own and control it. Entrepreneurs who consider these factors fully and carefully will be in a strong position to reach terms beneficial to themselves and investors alike.