The 5 Types of Capital to Grow Your Business

As we talk to business owners on the phone, many of whom are looking to finance their growing operations, we’ve come to realize that the financial aspects of growth can seem complicated. Often when we take a small step back and consider how everything fits together, financing a business becomes much simpler. At the core there are only 5 ways to finance your business. Every complicated way of getting capital for your business is a variation on one of these 5 types of capital. 

Your Own Revenues

This is the most obvious type of capital, but it’s often ignored or forgotten when business owners consider growing their business. No matter what other types of capital you raise, at some point everything boils down to your own revenues. If you can’t sell enough to cover rent, payroll and other working costs then your company will go out of business once you run out of cash in the bank.

Benefits

When you build your business using your own revenues, your growth tends be sustainable and you retain ownership of the whole business. Organic growth also has a tendency to be less risky because you’re not betting on the future. You already have the capital you need to grow. Depending on your own revenues also tends to make mistakes obvious more quickly since you’ll feel the changes immediately and will likely have fewer consequences if you make the wrong decision.

Risks

Unless you have very high margins and fast revenue growth, the jumps between when you need to grow and can afford to grow can get painful. For many larger investments, like buying equipment or purchasing a large piece of real estate, using revenue growth can be entirely unmanageable. The other major risk is that by relying on revenue growth early on, even 50%+ growth rates may not be fast enough to catch the major players in your market. Growing a $1M revenue business 50% only makes it a $1.5M business. If you’re trying to beat a $100M or $500M+ business, you may need to grow at 500%+ per year for the first few years to make a dent in the market. That’s likely far faster growth than your revenues will be able to support.

Another consideration is that in some business structures, holding capital for multiple years in order to save for a large purchase can have detrimental tax consequences. In an S-corp, for example, any capital left over at the end of the year ends up becoming owner’s income, taxed at your own individual tax rate.  If you’re considering saving for a large investment, a tax rate near 35% is often significantly more expensive than a loan with 10-20% interest. And, in many cases, the interest is tax deductible.

Situation It Fits Best

Most companies use revenue growth for shorter term and smaller purchases, almost always around the regularly workings of the business. Slow organic growth – primarily in hiring or purchasing supplies for daily operations – is where simple revenue growth fits best in the spectrum of capital.

Debt

Every company has some form of debt whether it’s a credit card, a bank loan or a mortgage on a piece of property. The question isn’t whether or not you should use debt, but how you’re going to use debt to grow your business and which bets you’re willing to make using debt.

Benefits

Debt can be extremely helpful in allowing you to grow without giving away any ownership. By taking a bank loan to finance your business, you’ll pay more upfront in order to grow with much stricter conditions, but once the debt is paid off you’ll own all of the larger and more valuable business. In addition, loans are a great way to finance business improvements. By purchasing a large piece of equipment with a loan, you can get use the increased productivity to pay down the loan faster. If you can generate revenue at a faster rate, or even a nearly even rate as the interest on the loan, then the investment can end up paying for itself.

Revolving debt, like a credit card, can also be used as a great way to smooth out your working capital. If you have large swings in your accounts receivables, with contracts coming seasonally or in lumps, loans between seasons can help you cover payroll and daily expenses until the next accounts receivables are paid.

Risks

While debt does allow you to keep ownership of your company, that’s only true if the business stays afloat. Debts have to be paid back eventually and many banks require strong covenants in order to loan you money in the first place. They’ll often have access to your full financials and will be able to mandate that you do different things in your business or be in breach of contract on the loan. If your growth doesn’t match the expectations you had when you got the loan, the bank doesn’t really care. They have no ownership in your business and are thinking only of the least risky way to get a return on their capital.

In the same vein of your business being viewed as a risk rather than a growth opportunity, banks tend to look only at the risk profile of your company. The riskier you appear to be, the less likely they are to give you money. The old joke is always that banks want to give you money when you have plenty of it and won’t give you a loan when you actually need it.

Situation It Fits Best

Most companies find debt the best solution to help buy certain types of large assets, to smooth working capital and to grow faster than they could organically when the risks of failure are low.  Debt is also used to make acquisitions, especially in layers. Often businesses will get part of the debt they need from a bank, part from an asset based lender, and another part from a mezzanine lender.

Grants / Concessions

Though grants and concessions are often most applicable in the startup phase of a business, there are often tax breaks or special incentives that can continue to help the bottom line of your business.

Benefits

The benefit of most grants and tax concessions is that they don’t need to be paid back. A local government is trying to spur growth in their region or a large company is trying to grow an ecosystem around their products, so they’re trading short-term profits for your long-term allegiance. The incentives, like New York’s Tax Free Zones, are there to help bring business to town and expect nothing else.

Risks

Grants and tax benefits can help your company grow or be artificially profitable in ways that aren’t obvious until the incentives expire. The incentives also often end up funneling your company into a set of circumstances that are no longer valuable once you’ve grown beyond past the initial benefits.

Most often used

The most common scenarios are for large companies, like Microsoft, Amazon or Google, to offer incentives to smaller businesses in order to get them to use their products. Whirlpool, for example, offers co-promotion where they’ll pay for half the advertising up to a certain amount for small businesses that carry their products. Governments also offer tax breaks, free rent and other incentives to help promote certain types of businesses on a regular basis.

Public Equity

The idea of becoming a public company became pretty well understood after the IPO bubble in the late 90s, but since then the markets have cooled down a bit. Large companies are still going public and it’s still a great way to create liquidity for your business, but only a few hundred companies a year go public each year leaving the odds of public equity as a long-shot for most businesses.

Benefits

Going public can allow your business to raise significant amounts of money to use in growing your business and can raise the profile of your business. By selling shares on the open market, your valuation becomes less opaque and acquiring other companies with your stock can be much easier. Also, allowing your shares to be traded publicly also creates liquidity for all of your shareholders, including employees with small option or equity stakes. Since private companies are inherently hard to value, it’s extremely tricky for early employees to sell very small stakes in your business prior to your company being listed on a public exchange.

Risks

One major risk of  being a public company, especially when you’re still small, is that it opens you up to significant oversight. Not only is there a fair amount of extra paperwork and laws (Sarbanes-Oxley for example), the act of writing 10-Ks and quarterly reports can give information not only to your investors but to savvy competitors as well. As a public company, it’s also very easy to get caught trying to make analysts happy by chasing this quarter’s earnings targets, whether or not that is actually the best use of your company’s resources.

Most often used

While some companies IPO when they are very small, the average company going public has a multi-hundred million dollar or billion dollar valuation and high growth rates.

Private Equity

While private equity has come into the spotlight for being associated with Mitt Romney in recent years, the concept is actually a lot larger than simple ‘private equity groups.’ The concept of private equity is any equity owned by anyone privately. Most often the reference means someone who is purchasing the equity of a private company in a private transaction, which is anything from friends and family investing in your business to a venture capitalist funding a startup or a private equity group buying a large company.

Benefits

If you fund your business growth with private equity, you don’t pay back the investment over time like you would with debt. Instead, you’ve exchanged a percentage of ownership in your company  for the capital invested. And, since the investor is now a significant owner, they’ll want to be involved in the running of the business or at least be an advisor as you continue to run it. From a regulation perspective, as compared with public equity, since the transaction happens between private parties there are significantly less regulations and a lot less public disclosure.

Private equity, primarily in the form of venture capital, is a great way to fund early stage and pre-revenues businesses with great potential, high risks of failure and large capital needs. Because the investors are expecting high growth and potential failure, and are working with you as an advisor, the conditions can help you invest much faster than possible otherwise. This can actually allow you to build a business that would otherwise not be possible or get to the points of scale required to be profitable. Many startups also use equity, usually in the form of options, as a way to help recruit amazing people to work at the company. While companies are small or less profitable, augmenting pay with ownership in the business can help bridge the gap between your offer and other job offers.

Risks

While you never have to pay back the money that investors give you to grow the business, they keep the equity you gave up in exchange. Often this is a great deal in an early stage business, if you give up 20% equity for 10x or 100x growth, but if you don’t hit growth targets to get to profitability fast enough you can end up giving away most of your business to investors. Also, provisions in the contracts negotiated to exchange the equity often give investors ‘preference’ in the winding down or sale of a business – meaning they’ll get 1x or 2x their investment before anyone else gets any of the proceeds.

Most often used

Equity investments are used all the time in different stages of businesses. Some companies start with partners who have different ownership shares in the business, other companies raise money from friends and family. Private equity also enters the equation often in helping more mature businesses grow by buying a stake in the business – as small as 10% and as much as 100% – before advising and adding other resources.