A deeper look at the relationship between risk and cost of capital, and the delicate equilibrium in creating the optimal loan structure.

Equity or Debt?
Although the actual failure rate of the average small business is unknown, business consultants generally consider 33% a close approximation and, based on Small Business Administration statistics, this failure rate goes up to 66% for companies younger than 2 years old. With these kinds of statistics, it is more than likely a business will face liquidity constraints at some point– even if this is due to the flipside of success, hyper-growth or scaling the business.

So is it better to seek equity or a non-dilutive debt-based capital option? Obviously, that answer depends on the specifics. Each individual situation and option carry varying types of risk for the business owner.

Equity Investors
Generally speaking, opting to give up a stake in the business – to a private equity investor, venture capitalist, angel investor, friends, family or fools – is not for the faint of heart. Like most marriages, the beginning is fantastic and like most divorces, the breaking-up can be painful. Investors are taking a big risk and want to be compensated accordingly. Seeking equity investors requires having a well-written business plan, solid financial projections and, in the modern era, even a checkable digital footprint - along with a lot of confidence to convince investors to give you their money. In return, they will expect a piece of your pie and/or returns in excess of 20%, in most cases much higher. Debt providers will also expect repayment at an agreed future point in time that could either be opportune for all parties or possibly detrimental to both the borrower and lender.

Doesn’t scare you? Consider that, according to Harvard research (Shikhar Ghosh, WSJ 2012), 75% of venture-backed firms in the U.S. have never provided returns to investors and, in fact, 40% end up in liquidation leaving their investors with nothing. If the business does succeed, be prepared to give up not only cash flow, but also varying degrees of decision making and control, and live within the limits of the equity or loan agreement.

Debt Providers
Unlike equity investors, debt providers securitize their risk up front and lend money to companies at rates that are commensurate with the perceived risk of the specific situation and transaction. It is important to note that all debt providers fully intend to get their capital back and may go to extreme measures to do so including loan documentation that provides for the appointment of a receiver. Money has to be paid back within a designated amount of time and with interest. A non-dilutive approach to accessing capital requires a greater focus on cash flow and payments due, regardless of success or failure. Debt providers look for an established model, revenue stream, sustainable cash flow, and tangible assets and collateral (i.e. real estate, equipment, AR, etc…) as a collective basis for offering a loan.

On the upside, with a debt provider, it won’t be necessary to share company profits, give away ownership percentage, or deal with someone who wants to make different strategic decisions on the direction of the company. Be it equity or debt, receivers are tasked with preserving the value for all stakeholders involved as well as the court.

Non-Dilutive Capital Options
Let’s take a look at the primary kinds of debt providers to Small and Mid-Size Businesses (“SMB’s”). We will list these in order of most to least risk averse, which directly correlates to lowest to highest cost of capital.

1. Banks typically offer the lowest cost of capital, but are also the most conservative, lending primarily to the most creditworthy businesses. Traditionally, banks view small business as the riskiest, based on their historical rates of failure mentioned earlier. Banks are also limited by regulation, so cannot be as flexible or creative in providing financing solutions as they must protect their depositors from unnecessary credit risk.
    

2. Finance Companies and /or Asset based lenders are typically formula based senior debt providers and lend on a percentage of collateral value, i.e. A/R, inventory, machinery & equipment, real estate, trademarks, intellectual property and even goodwill. Unlike banks, they are not controlled by federal regulation, but are credit constrained mainly by customer leverage. They offer a higher cost of capital and assume the risk of asset prices softening – which is likely to happen during the next recession.
   
   Risk in this type of financing is mitigated with the (most often) first position securitization of collateral and assets which can – and will – be liquidated to recoup any financial losses in the event of a business failure or loan default.
    

3. Mezzanine / Sub-Debt Lenders provide capital in a subordinate - and therefore more risky - position to the senior debt mentioned above. This sub-debt is, however, senior to equity in its liquidation preference (in bankruptcy). It is a credit product that sits between equity and senior debt on the capital stack. In case of “fire,” equity gets burned first and that is why credit providers will look to see a sufficient amount that can be torched before it reaches debt in that capital stack. That risk is proportional to reward; upside potential is most substantial for investors. Sub-debt lenders demand a higher return for their capital commensurate with their 2nd position lien rights and often totally unsecured status. They focus on providing capital for profitable companies and seldom, if ever, provide junior capital for distressed businesses.
   
   The benefits of the second and third financing types listed above are in the structure. Because alternative lenders usually are not bound by federal regulations and government oversight, financing solutions can be “out-of-the-box,” or more creative, to meet the needs and challenges of each borrower. The drawback vs. more traditional institutional lenders, such as the first option above, is in the cost of capital. Usually – though not always – the money will be more expensive. Again, the cost is related to the actual risk to the lender in each situation.
    

4. Merchant Cash Advance Lenders are nonbank lenders that thrive on subprime candidates. As these types of borrowers usually have a poor credit history and nowhere else to turn, the risk to the lender is most high and therefore so is the cost of capital - sometimes in excess of 50%. These lenders advance cash quickly in return for a share of future sales, extracted from the borrower’s credit card receipts or ACH, a digital transfer of funds directly out of the borrower’s bank account, on a daily, weekly or monthly basis. It is one of most expensive forms of financing and only for those with no other options.
   
   In the recent boom of the digital age, another “alternative to alternative” lender type has cropped up, the Technology Based or Online Alternative Lender. Online platforms have led to rapid escalation of new entrants into small business lending. While this may give greater options to businesses that won’t qualify for a traditional bank or institutional loan – or perhaps even a “traditional alternative” loan, this path requires more diligence in researching potential lenders, reputations and products. These lenders provide an efficient on-line platform to a variety of lenders but, one should remain mindful, that these lenders are diligent and disciplined providers of credit.
   
   It is critical that business owners fully vet and understand the implications of these last two types of financing. While there are legitimate, reputable lenders in this group, some are just sharks out to take advantage of desperate business owners. They will charge a fee just to “qualify” for a loan and to have access to their lenders. Also, most of these types of last-ditch options come with unreasonable interest rates and terms.
   
   All of this can be confusing to troubled business owners. There are benefits to hiring a financial advisor instead of tackling the process alone.
   
   With so much at stake and so many possibilities to weed through, it is often helpful to engage an objective third party financial advisor to run the process. This can help to ensure an informed, competitive process; due diligence upfront to produce more, better and vetted offers. This enables clients to negotiate from a position of strength and results in the best structure and optimal cost of capital for each particular business situation.

Stabilizing Actual vs. Perceived Risk
There is no doubt of the relationship between risk and cost of capital. It is a balancing act for lenders and borrowers alike. How that risk is calculated, verified and plugged into the equation is a critical piece in determining the final structure and cost of a credit facility. On both sides of the deal, teams of credit experts, accountants and lawyers pore over the financial and business data on a very granular level; valuation teams assess and verify assets. New technology tools give access to almost real-time data flow, concurrently compressing and expanding the due diligence cycle, making this evaluation process faster and more accurate. The outcome still comes down to risk – both actual and perceived.

So what’s the difference?
Actual data does not always tell the whole story. Perhaps a business has a valid reason behind the challenges that produced a not-so-clean balance sheet or, erratic sales and profits due to a one-time weather, economic or management disruption, or an unusual capital expenditure, for example. Hard data doesn’t give the opportunity for explanation. Based on hard data alone, a bump in the financial road can be viewed as a complete veer off course by potential lenders and result in either outright rejection, or overly painful loan terms. Actual hard data cannot be changed; the perception of that data can be.

A good financial advisor will certainly collect and examine all of the hard credit and collateral data, but will also gain a greater level of detail and understanding for the story in each situation. Most rapidly growing or distressed business owners cannot present a squeaky clean P&L history and balance sheet. Many of them have legitimate reasons for their financial plight. An advisor seeks to get an understanding of each particular client’s situation. In cases where there is an explanation, value, and a clear path to profitability, an advisor can package this information together with the financial data to present a complete picture to lenders why the actual risk is much less than the perceived risk. This type of presentation can produce a positive effect.

Win-win and win for Borrowers, Lenders and the Future
When the entire picture is packaged, the result for the borrower is an increase in the likelihood of accessing capital as well as financing options. The cost and terms of capital are more favorable. A financial advisor’s vetting and underwriting upfront mitigates the risk to the lender on the back end by addressing the 5-C’s of commercial lending. There are the quantifiable predictors of actual risk - Capital, Collateral, Credit; and the more intangibles - Character and Capacity. The latter two relate to perceived risk and evaluating the likelihood the borrower will feel a moral obligation to repay the loan and not take undue risk. A well-scrutinized process maximizes the borrower’s chances of predictably qualifying for a loan, future business success and the lender getting repaid. A fully vetted client and financial strategy reduces the probability of courts and receivers dealing with undervalued assets, false securitization or litigation issues in the event of a business failure.

Finding Equilibrium in Financing
Every business needs a solid financial foundation of both equity and debt capital to support a sound strategy. Business conditions are fluid and can rapidly change, necessitating an alteration in the capital structure to finance new funding requirements. The result can be a shift in the overall cost of capital based on overall risks to the business. Successful proprietors recognize the need to constantly adapt to new business conditions and maintain financial equilibrium to maximize growth in revenues and earnings. Securing the best and most balanced capital structure is critical to successfully compete in the marketplace.

It Takes a Team
At the end of the day, futures are won and lost taking risk. A critical element to success is eliminating as much of that risk as possible. In the case of a capital raise, it’s wise to get the best possible advice. This is a process that doesn’t happen often in the life of a business and can take anywhere from 30 days to over a year. If, in that time, company executives are taking their eye off the ball by talking and negotiating with lenders, they are not running the business or focused on revenue generating activities. A team of outside experts can augment the staff, juggle all of the moving pieces to drive the best cost of capital, create the optimal loan structure and customize a total solution that meets specific business objectives.

Whatever the outcome, for every business, a mitigated financial risk and a well-balanced capital structure maximizes and preserves value for all stakeholders.

*Chuck Doyle is the Managing Director of the San Francisco office of Business Capital, a commercial finance and restructuring firm founded in 2002, www.bizcap.com. He can be found at cdoyle@bizcap.com