A Framework for Financing Your Ideas – March 2015

This topic involves treasury.

One thing all companies need is cash to finance their operations and growth opportunities. The most astute managements have a process which provides a platform for pro-active approaches to lenders and investors. The subsequent paragraphs describe the building blocks entrepreneurs can use to develop this very important tool.

The first step we recommend is to identify and quantify the perspective revenues the opportunity provides. Care must be taken to determine the amount and timing of the revenue. The amount should be calculated in quantifiable detail. For instance, the estimated number of units of a new product that will be sold multiplied by the unit price of each and the resultant revenue. The timing should consider when the revenue will start to be generated (i.e. 6 months after the initial investment) and when the cash is collected (i.e. 45 days after the product is shipped).

The next step entails identification of the relevant costs. Again, the amount and timing is important. The amount is driven by management’s estimate of the costs of investment, production, selling, and administration as well as taxes. Note that these costs are borne throughout the process, with the cost of investment typically coming up front and, sometimes, in subsequent funding rounds.

The third step is to determine the net cash flows resulting from the prior two steps. This exercise is merely subtracting the estimated cash costs from the estimated cash revenue for each month of the project. The resultant cash flow will determine the economic viability of the project. Once economic viability is established, the cash flow will help determine the most effective means of financing the project. The topic of economic viability is addressed separately in our April 2015 post. It would be helpful to the reader to read that post in conjunction with this post. For purposes of this post we will assume the project is economically viable, that is, profitable given its inherent risks.

Next, the CFO must identify the sources of financing to be utilized. For entrepreneurs such sources are often investors and banks. The cost of these financing sources are based on the returns they require. For banks, this is reflected in the interest rates they charge, probably mid to high single digits. Other costs of bank financing are less quantifiable, but real. These costs include a security interest in the company’s assets and detailed monthly reporting requirements.

For investors, the required annual return can be 15% annually or more. It also requires the entrepreneur to give up part of the ownership of the company. While expensive, there are also benefits. These benefits include, reducing overall leverage (banks will like this); specific knowledge and experience the investor brings to the table; and, often, more flexibility than lenders. A final source of capital is the company itself through its internal financial resources. Returns must be at least equal to those of outside investors. For the purposes of this post, we assume all three sources will be utilized.

The next step entails integrating all that has been discussed thus far. Essentially an interactive spreadsheet is utilized to relate the cash flows to the sources of financing. This ensures that lenders, investors, and the company achieve their required returns, while the firm maintains a sufficient cushion or margin of error. Thus the bank should receive its interest payments from a portion of the cash flows generated by the firm and the project. In addition, the bank should have the principal repaid. Investors should receive the agreed upon return on its investment, and the firm’s investment should receive its required return. The timing of these returns is subject to the timing of the cash flow as well as negotiation. The last factor is crucial in structuring the financing and its terms.

The use of an interactive spreadsheet allows management to consider the best, worst, and most likely scenarios. In addition, it allows management to view various scenarios related to how the timing of cash flows can be utilized to provide lenders and investors their required returns. For instance, it can answer the question – are periodic payments more feasible than back-end distributions? This exercise helps management think through all the variables that affect the outcome and gauge the risks involved. Typically, many iterations are involved. An added benefit of such an approach is its applicability to individual projects as well as the business as a whole.

A brief word about debt. Since debt financing is typically less expensive than equity financing, it is very easy to attempt to use as much debt as possible. In and of itself, this is not a bad thing. However, more debt can also mean added risk. As a result, the entrepreneur must weigh the lower cost of the additional debt versus the greater default risk that stems from higher debt levels.

We stress that this is a proactive process. This elaborate exercise should be utilized before entering serious conversations with lenders and investors. As a result, the firm will be well prepared to provide a positive, forward-looking game plan upon which lenders and investors will act. By exhibiting preparation, thoroughness, and knowledge of their markets, management increases the likelihood of positive feedback.

All companies need cash to finance their operations and growth opportunities. The most astute managements utilize a process which provides a platform for proactive approach to lenders and investors who provide funding for the enterprise and its endeavors.

Capitol CFO Solutions serves clients in Maryland Washington, D.C., and Virginia. Please contact us for a free consultation.