Financing a business and capital structure decisions

Introduction

Estimating how much funding we need to start and if these funds can become from the government or where to get funding for a business. These decisions could be more complicated than expected. Moreover, we will analyze what sources of finance are available to an entrepreneur and what are the main source of finance with pros and cons. Finally, we will find how to deal with bad credit history and the optimum debt/equity mix for business expansion.

Table of Contents

1. Introduction
2. Optimal financial structure
   1. The lifecycle of a company
3. Debt VS Equity
4. Sources of debt financing
5. Sources of equity financing
6. Funding a business with bad credit
7. Right sources for right expansion
8. Conclusions
9. Bibliography

Optimal financial structure

Looking for the optimal financial structure is a timeless journey, its arrangement is affected by endogenous and exogenous factors that change over time. Basically, we have to hook the structure to the company lifecycle and then we have to ask ourselves whether there are any more convenient combinations in terms of value creation, ceteris paribus.

In other words, is this financial structure the best option in order to generate a sustainable growth in this specific stage?

If other combinations compromise any other agent or any other asset, then that one is the optimal financial structure achievable in that context.

The lifecycle of a company

How to fund a company according to its lifecycle stage? Below, a short list of different financial solutions for different stages (M. S. Lam & G. Vega, 2021):

• Seed or startup: financing at stage 1 usually comes from the founder’s assets (e.g. taking a 401k loan) along with the government support and/or equity crowdfunding;
• Launch and growth: bank debt is often crucial in this stage;
• Maturity: in the maturity phase, the cash flows should be stable, so the financial source is mostly internal through the retention of profits;
• Expansion or Re-Visioning: increasing the company market share needs massive investments and an external boost in terms of attracting new capital;
• Exit, Harvest or Death: financing the exit could result in several options, from the sale of existing assets to depreciations or provisions, so much depends on whether a capital gain (or loss) is feasible.

Debt VS Equity

If considering only one financial structure the best option regardless the context is a clear error, judging equity as the right source and debt as the ultimate evil is even worse.

Accounting and fiscal consequences can be put temporarily aside and concentrate on the funding as a mere business goal. In order to achieve this objective, the market provides a number of tools to the management. A tool is not good or bad in itself, while its use that makes the difference.

Funding a business is basically a matter of moving money over time. The tool that moves this money is irrelevant, what really counts is whether this movement is generating value or not. Not today, not tomorrow, rather, in a going concern perspective or in general, in a sustainable way for stakeholders (clearly, if the company is going to exit, long term doesn’t matter).

In this sense, the choice of debt or equity can be seen in whole new light. If there is a credit opportunity that allows the company a solid growth, refusing debt would be totally ineffective. Similarly, if opening the capital doors to a new investor can improve the long term performance why missing that train?

Debt and Equity have its own pros and cons, here some:

In light of this, we can manipulate the debt equity mix assessing the value generated (or gener-able): the management should prefer the source that results in better positive cash flow, bearing in mind the investment feasibility and the master roadmap.

Sources of debt financing

Debt usually come from bank loans. They can be divided into:

• Asset-backed loans: mortgages, equipment loans, inventory loans and any other loan that is secured by real assets;
• Unsecured business loans: mostly term loans, where there is no collateral.

Nevertheless, many economies are incurring in the credit crunch spiral, that damages especially small businesses. Although, there are several forms of government support (e.g. SBA loan programs), entrepreneurs could take into consideration other forms of debt financing:

• Peer-to-peer lending (P2P): where it is possible to directly deal with investors, with reasonable rates and fees. When a project is funded by the “crowd” and they do not desire to be shareholders, P2P can usually assume the form of crowdlending;
• Direct lending: where non-bank institutions trade loans over-the-counter (e.g. Schuldschein in Germany);
• SME bonds: increasing, because their issuance is easier than the going public of stocks;

• Accounts Receivables Financing (invoice financing): where the factoring can be non-recourse if the financing company became responsible for the business customers’ payments, and recourse if the financing company purchases A/R from the business, but in the case of customers’ insolvency, the business has to buy back these bad A/R;
• Merchant Cash Advance (MCA): useful for <24 months financing, the MCA consists of a loan in exchange for a % share of the businesses’ daily credit card revenue. Today, it is quite expensive in terms of opportunity costs because it is often adopted by low credit rated businesses;
• Mezzanine capital: technically it is an hybrid solution, since it is assimilated to equity in the balance sheet. However, mezzanine capital includes even an interest rate in addition to the equity based (success share) percentage.

Sources of equity financing

Once an agent brings capital in exchange of a company equity’s portion, we will move to the sphere of equity financing. Common equity funding include the following:

• Angel investors: qualified investors that buy stocks from a business under the private placement exemption;
• Venture capital firms (VCs): private equity firms that focus on early stage high potential growth companies;
• Small Business Investment Company (SBIC): SBICs provide funds to small companies, as SBA, but buying stocks;
• Crowdfunding: when the crowd finance a project in exchange of a portion of the company’s equity;
• Private equity markets: when the company is taken to public, a massive flow of equity financing will be obtained. Today, this process is more accessible than past, thanks to digitalization and new markets expressly dedicated to private equity financing, small caps, and so on.

Funding a business with bad credit

Small and medium-sized enterprises (SMEs) are a major concern for European policy-makers, as the fixed costs required to access the financial markets may be too high for SMEs. Consequentially, their financing relies mainly on bank credit (G. Oricchio et al., 2017). However, when bad credit impedes SMEs from accessing to bank credit, the entrepreneur – or simply the sole trader – is forced to follow different paths.

E-platforms (e.g. US P2P Lending Club) represent a quite new solution. Clearly, if on one side quicker procedures are available, on the other we have to deal with new money systems (i.e. with different rules than banking system). Since a few years ago, we talk about shadow banking, where Loan-to-values (LTVs), fees, warranties and so on could be differ so much than the traditional banking system.

Furthermore, it is not only a matter of disintermediation, rather today the decentralization paradigma is literally changing game rules. It is not empirically (econometrically) proven that “supply creates its own demand”. But Keynes would smile in the case of the Initial Coin Offerings (ICOs) that created a trend and hype in 2017 in Europe […], and ICOs can be seen as a crowdfunding endeavor (Kaili E., Psarrakis D. & Van Hoinaru R., 2019).

(ICOs are the Initial Public Offerings (IPOs) of the tokenomics world.)

Regardless of these innovations, if a company shows a bad credit history and if it is endemic, in those cases solvency’s concerns will be brought even to the different paths mentioned above. There are no easy markets for loans (where easy means with reasonable interest rates). Before talking about e-platforms or crowdfunding, it is fundamental to investigate why the company’s credit is still bad. Looking at the company from an external perspective through a fundamental analysis with a focus on performance and solvency analysis is crucial. Obviously, the bank performs advanced due diligence on the borrower, but a financial statements and book analysis are the fundamentals.

Mind that debt is acceptable when its comprehensive cost rate is less than the return of the investment(s) made with the loan.

Once scores have been fixed, it is possible to negotiate better loans conditions in terms of interests rates, credit limits, repayments and so on. In order to be as fast as possible removed from the “black list”, a guarantor’s support could help.

Moreover, there are a number of lenders specialized in creditworthy borrowers and businesses without an established credit history. However, mostly in connection with these new businesses, it is important to remark that a strong business model is essential to grow. For instance, if a startup is living only thanks to government grants, it is likely to go bankrupt. In other words, health: once a business’ health is restored (at least in a good part), it will be possible to explore new loan opportunities.

Right sources for right expansion

Late 50s, Modigliani and Miller found out the irrelevancy of the founding source choice – through debt or equity – in terms of capital structure and investment theory (Franco Modigliani and Merton H. Miller, 1958). Management can approve the either one because what really matters is the return rate of the investment(s) realized thanks to that source and if it is greater than the financing cost rate (including the opportunity cost).

In light of this, we can surely affirm that there is not a one way right source for every expansion path: when a company plans to expand its business, the management has to firstly check the above rate comparison.

The “right” source depends on the specific moment related to the company lifecycle: are there any government support available? Has that source some indirect or hidden benefits? Is the current capital (liabilities) structure more suitable for new equity (debt)? Does the income statement need to use the tax shield originated from the finance charges? These are just some of the crucial questions about the right funding source for a company expansion, indeed subsequently, the management has to establish a financial plan according to all these considerations.

At moderate debt levels the probability of financial distress is trivial, and therefore, the tax advantages of debt dominate. But at some point, additional borrowing causes the probability of financial distress to increase rapidly, and the potential costs of distress begin to take a substantial bite out of firm value. The theoretical optimum is reached when the present value of tax savings from further borrowing is just offset by increases in the present value of costs of distress.

Trade-off theory from Fundamentals of Corporate Finance by Brealey, Myers & Marcus, 2018

Conclusions

Sometimes one source could be preferred even with a weak mathematical reason (but with strong economic and strategically reasons). Also sometimes, it is easy to demonize debt because of its nature, while it could allow great opportunities (maintaining equity intact). Thus, it is fundamental to shift focus on sustainability over time and opportunity costs and reduce resources on the traditional debt or equity choice. Regardless of the source, if one is supported by economic robustness and that support is clearly explained by the management, shareholders will certainly appreciate.

Bibliography

BREALEY A. R., MYERS S. C., MARCUS A. J. (2018). Fundamentals of Corporate Finance. New York: McGraw-Hill Education.

KAILI E., PSARRAKIS D., VAN HOINARU R. (2019). New Models of Financing and Financial Reporting for European SMEs. A Practitioner’s View. London: Palgrave Macmillan.

MIRANDA S. LAM and VEGA G. (2021). Entrepreneurial Finance, Concepts and Cases. New York: Routledge.

ORICCHIO G., CROVETTO A., LUGARESI S., FONTANA S. (2017). SME Funding. The Role of Shadow Banking and Alternative Funding Options. London: Palgrave Macmillan.