Risk and the Costs of Financial Capital

By Sam Norwood June 3, 2014

Bank debt is very likely your cheapest source of financial capital. Ownership equity,
despite having no contractual requirement to pay interest or dividends, is certainly
yourmost costly. Why is this?
When a bank makes a loan to a company, the bank takes little risk. Banks are regulated
with a view toward protecting the depositors. For starters, a banks lending officer and
credit review committee must be persuaded that the company will have sufficient profit
and cash flow to cover the interest charges on the loan (normally 3 or more times the
interest the expected interest expense) plus the ability to repay the loan. Only if they are
satisfied on these points will the bank go to the next step of considering collateral and
personal guarantees of the owners (joint and several. When the loan is made, there
probably will also be covenants restricting things like compensation and dividends to the
owners and thresholds of ratios that will serve as red flags, and could trigger the calling
of the loan, if broken. The bank will also be senior to all other creditors in the event of
bankruptcy. In effect, the bank simply does not take risks, and because of the low risk,
its charges for loans will be the lowest you can expect to get.
At the other end of the risk spectrum is owner equity. As an owner, you have no
contractual protections (beyond limited liability) and no guarantees of any income from
interest or dividends. You are at the bottom of the totem pole regarding recovery of your
investment in the event the business fails. If the company is privately owned, you, as an
owner, have little chance of being able to sell your position. That is, unlike being a
stockholder in a public company, there is no market for your ownership position. Your
only hope for some kind of financial compensation is that some day, perhaps in the
distant future, the company might get acquired or go public. Well, it is also possible that
at some point, when the company slows it growth sufficiently (to a crawl) it might be in a
position to start issuing dividends. But, the future is uncertain for an equity owner. The
road to success is a long one and is littered with the corpses companies that simply did
not make it. Factually, the vast majority of companies do not survive to the point of
reaching critical mass and self-sufficiency.
So, as an owner/investor, how much ultimate compensation is enough to entice you to
take the risks and remain illiquid for an unknown period of time? Lets say the bank
charges 6% for its very secure loan. And, history tells us that we can anticipate about
10% total return annually, on average, by investing in the biggest public companies. If
we invest in smaller public companies we would reasonably expect, on average, around
13%, a higher return to compensate us for the higher risk we take by investing in
smaller, less established, companies. If we consider investing in some of the smallest
public companies, with annual sales of, say, $25 million, we would rationally do so only
if our expected total return were over 13%, probably in the range of 15% to 20%. That
is, in the absence of a dividend, we would expect the value of our investment in a very
small public company to grow at a rate of 15% to 20% per year while we own it.
Now consider being an owner of a small company that is not publicly-traded. There is
no market to sell into if you decide you want out. How much more compensation would
you need to entice you into such an opportunity as an owner? The answer, widely
accepted by the IRS for valuation purposes, is about a 30%premium over what you
would require for an investment in a publicly traded company. For example, if you would
expect an 18% ROI for a similar company that is publicly traded, you would need 23%
from a private company to fully reflect the risk and inflexibility of illiquidity for your
investment.
Effectively, the cost of equity capital is what investors expect to receive, over time, to
compensate them in a competitive market for the risks they take as equity investors.
This is why equity capital is the most costly form of capital.
Most entrepreneurs are shocked when the first start seeking equity investors when they
hear their first proposal. They have to be willing to give up a shocking amount of their
ownership in order to get co-investors. For a relatively new venture, figure that the early
investors will have to visualize around a 30% ROI to be willing to go in. This is
a real quantification of the risks involved in the early stages of even the greatest-
sounding idea. You do not want to give away equity ownership for good reasons,
including the fact that if the business succeeds, the equity owners, including you, stand
to gain wealth in proportion to the risks that have been taken by all who invest with no
contractual expectation of financial reward or even beng paid back. This is the financial
lure of entrepreneurial onvesting.
The costs of other forms of financial capital fall somewhere between bank debt and
straight equity. The list of possibilities is as large as the imaginations of those involved.
Samuel W. Norwood III
2014

Accounts Receivable Factoring: Its More Than Just the Money
By Tracy Eden August 3, 2009
The concept of core competency refers to the things done by a business that lie at the
heart of its ability to manufacture a product or deliver a service. They are strengths
relative to other organizations that are not easily imitated and that can be leveraged
across different products and markets.

From a management standpoint, employees should spend as much time as possible
working on tasks that contribute directly to the businesss core competencies, and as
little time as possible working on tasks that dont. Since managing accounts receivable
isnt a core competency for most companies, many rely on accounts receivable
factoring companies to handle their accounts receivable functions.
Going Beyond Collections

An Oakville, Ontario distributor of photo luminescent material used in exit signs and
safety equipment began factoring their accounts receivable in 2008 in order to improve
their cash flow. It soon discovered that factoring services offer additional benefits as
well.
This takes the onus off of our employees to manage accounts receivable, says the
companys CEO. It allows them to spend more time focusing on more important issues,
while our factoring service handles all the fine details of our accounts receivable
management and keeps everyone on the same page.

In short, factoring services allow the CEO to concentrate on what he does best: growing
and developing his business.

This particular distributor was referred to a factoring service by its primary bank. Since
were an emerging company with a new technology, were not considered traditional, so
banks can be a little hesitant until weve proven ourselves, says the CEO. However, the
company was incurring heavy expenses on large volumes of raw materials, and the
lengthy payment terms of its customers was creating a significant cash flow crunch.

We work with municipalities, universities, schools, hospitals and Fortune 500
companies, explains the CEO. They sometimes take a long time to pay. Because of
the significant dollars involved, it made sense for us to take the small hit from factoring
in order to keep the cash flowing.

The Importance of Vendor Assurance

Another potential benefit of factoring services is whats sometimes referred to as
vendor assurance. In this companys case, its supplier was being asked to produce
large quantities, but was a little uncomfortable since they were dealing with a relatively
new company. Through its factoring services Vendor Assurance program, the supplier
was persuaded to provide the product on open account terms.

This provides a safety net to our key supplier by increasing their confidence, says the
CEO. Vendor Assurance was instrumental in helping establish credit in the first place
and increasing our credit as suppliers gain a greater degree of confidence in us.

The CEO also likes the fact that his customers are not aware that their invoices are
being financeda feature known as non-notification. Checks are made out to the
company and payments are mailed to a generic post office box. When the accounts
receivable clerk from his factoring service calls, he or she identifies him or herself as
being with the CEOs own accounts receivable department.

Due to fast growth, the companys needs are constantly evolving, notes the CEO, which
makes receiving fast and responsive service critical. I have recommended factoring
services to other companies and will continue to do so. Factoring can be a valuable
service to small and emerging companies that have strong potential.

Managing capital is different than managing cash
By Jim Blasingame March 12, 2012


There are many tasks every small business owner must handle personally, but none is
more CEO-specific than allocation of capital. Because the only thing more precious to a
small business than capital is time.

Cash management is also a CEO-critical task, but operating cash is not capital. Cash is
for expenses and is measured daily, weekly, and monthly. Capital is for investment and,
as such, is measured in years; possibly even generations.

Below are three classic capital expenditure categories.

Replacement and upgrade
This is not repair (thats an expense funded by operating cash flow), its a bigger
commitment, most often caused when repair is no longer an option, or by obsolescence.

Innovation
Exciting innovations in digital devices and programs are at once creating opportunity
and causing disruption. Small business CEOs have to mete out precious capital for
innovation in a way that maximizes opportunity and minimizes disruption. This is a
tough job because 21st century innovation weaves a fine seam between the leading
edge and the bleeding edge.

Growth opportunity
Should your market footprint be expanded with an acquisition or new branch, or should
an investment be made to build-out more online capability? Should investment be made
in support of a new product direction, or in a digital inventory management system
connected to the supply chain?

What to invest capital in and when to do it is different for every business. But what is
not unique is making sure cash and capital are applied properly. Here are three classic
best practices:

Dont use operating cash to pay for something that has a life of more than a year.

Leaving profits in the business produces retained earnings as reserves to be used for
capital investment.

A bank loan can augment retained earnings when the timeline of an opportunity or
unfortunate capital-eating event doesnt match your internal funding ability.
And remember, bankers love it when you have retained earnings skin in the game.

As we move from economic recovery to expansion, there will more and more decisions
associated with growth opportunities. Having a capital plan that combines proper
allocation of cash, retained earnings, and banking resources will go a long way toward
helping you stay relevant to customers, maintain a competitive advantage, and be more
profitable.