Top 5 Considerations in Choosing a Capital Source

Top 5 Considerations in Choosing a Capital Source

You’ve recently met with your management team, and have decided to capitalize on recent success by moving forward on a major expenditure. You’ll be building a new facility, expanding a market, investing in an acquisition, or some other growth strategy. Now you have to determine how to pay for it.

The good news: assuming you are profitable and/or have a great business plan, there exists a supply of firms looking to provide debt or equity capital to companies like yours. How can you focus your search for that new financial partner?

Let’s start with your commercial banker. Approximately 70% of small and mid-size businesses turn to their commercial banker for funding. Good idea? Sometimes. The bank can certainly offer competitive interest costs, but they usually come with restrictive terms. They also may not be able to offer all the capital that you need. A good start, but probably not a complete package.

An independent investment banker will suggest that you turn to what you might consider “non-traditional” sources of financing. These can include sources of both equity and debt, and are almost always funded by private investors. Don’t be alarmed — in most cases, these are sophisticated sources of capital that are looking to make investments in good companies like yours. They’re an extension of the banking market, and can provide far more than your hometown banker.

How do you make sense of the options? Here are the initial considerations that we consider when selecting potential sources of capital for our clients.

  • Structure: Are you looking for debt or equity? Often, investors specialize in one or the other, and some investors offer both. How you’re willing to structure your financing will play a central role in whom you approach. Debt has the advantage of avoiding dilution of your ownership stake (and those of your existing equity investors), but comes with principal payments and interest expense. Remember that your ability to attract a debt investor depends on your ability to pay interest and principal.
  • Price: Of course, minimizing the cost of capital is a top concern. Costs of debt are apparent: interest and fees are plainly disclosed in term sheets. But remember that required principal payments can restrict your pool of capital, and if your growth plan requires more money than is available after debt service, the debt could result in an opportunity cost if it’s restricting your growth. The cost of equity is a bit more complicated and depends, in part, on how much in future profit you’ll give up to the new investors.
  • Focus: An investor’s expertise in your industry is important, especially if you plan to maximize the relationship by using the firm’s expertise in executing your business plan. We have seen investors provide operational expertise, knowledge of financial controls, and new sales opportunities. The value of your new capital can be enhanced by these non-financial benefits.
  • Control: Many capital sources follow the strategy of only investing in companies in which they can take a controlling interest. If your strategy is to seek an amount of capital that represents a minority stake in your business, you must confine your search for equity to firms that prefer minority, non-control investments.
  • Culture: Finally, the cultural fit between your company and the capital source is of utmost importance. While often overlooked, this aspect of your financial relationship can significantly affect your ability to execute your growth strategy. Will the financial partner require significant oversight and/or reporting, or only periodic phone calls? Is the intensity of the potential relationship appropriate for you and your colleagues? Do you anticipate a collegial relationship, or an adversarial one? All these aspects should be considered.

Mid-market business owners sometimes overlook the importance and complexity of selecting a capital source. It is at least as important as choosing your business partners, and critical to the execution of your growth strategy.