Beyond Numbers: The Crucial Chapter Every Entrepreneur Must Master

As a student, the 'Sources of Finance' chapter has been a perennial favorite, whether it was in my CA studies or in CFA curriculum. This seemingly straightforward topic holds the power to shape or dismantle businesses in no time.

Despite its apparent simplicity, the real-life applications of this chapter underscore its paramount importance.

Today, let's delve into the intricate world of 'Sources and Costs of Capital for a Business'–a chapter that, beyond calculations, can either fortify or dissolve a business. It may appear deceptively easy, but its real-world implications highlight its critical role.

We'll be exploring questions like:

1. What exactly are the sources and costs of capital for a business?
2. How do these factors influence a business's financing decisions?
3. What are some tangible examples of equity and debt financing,
4. and how do they leave their mark on the balance sheet and cash flow statement?

So let's start with basic question, What is Capital ?

Capital is the money or assets that a business uses to fund its operations and growth. Capital can come from various sources, such as equity, debt, or retained earnings. Each source of capital has a different cost, which reflects the risk and return expectations of the providers of capital.

The cost of capital is the minimum rate of return that a business must earn on its investments to satisfy its investors and creditors.        

The cost of capital affects the financing decisions of a business, as it determines the feasibility and profitability of different projects and opportunities. A business should only invest in projects that have a higher return than the cost of capital, otherwise it will destroy value for its shareholders.

A business should also choose the optimal mix of debt and equity that minimizes its cost of capital and maximizes its value.

Equity and debt are the two main types of external financing that a business can use to raise capital.

Equity financing involves selling shares of ownership in the business to investors, such as venture capitalists, angel investors, or the public.

• Equity financing does not require the business to pay fixed interest or principal payments, which reduces the financial risk and increases the financial flexibility of the business.
• However, equity financing also dilutes the ownership and control of the existing shareholders and requires the business to share its profits and future growth potential with the new investors.

Equity financing also tends to be more expensive than debt financing, as equity investors demand a higher return for taking on more risk.        

Some tangible examples of equity financing are:

• Issuing common or preferred shares to the public through an initial public offering (IPO) or a secondary offering,
• Selling shares to private investors, such as venture capitalists, angel investors, or corporate investors,
• Using retained earnings or accumulated profits to reinvest in the business.

Debt financing involves borrowing money from lenders, such as banks, bondholders, or suppliers. Both types of financing have advantages and disadvantages, depending on the situation and goals of the business.

• Debt financing does not dilute the ownership or control of the existing shareholders and allows the business to benefit from the tax deductibility of interest payments.

However, debt financing also increases the financial risk and the financial obligations of the business, as it has to pay fixed interest and principal payments regardless of its performance.         

Debt financing also imposes certain restrictions and covenants on the business, which may limit its operational and strategic flexibility.

Some tangible examples of debt financing are:

• Issuing bonds or debentures to the public or institutional investors,
• Obtaining bank loans or lines of credit from financial institutions,
• Using trade credit or accounts payable from suppliers or vendors,
• Leasing or renting assets or equipment from lessors or landlords.

The Impact & Cash Flow :

The impact of equity and debt financing on the balance sheet and the cash flow statement of a business depends on the amount and timing of the transactions.

Equity financing increases the equity section of the balance sheet, which represents the owners’ claim on the assets of the business. Equity financing also increases the cash inflow from financing activities on the cash flow statement, which reflects the net amount of money raised or paid to the investors.

However, equity financing does not affect the income statement, as there are no interest or principal payments required.

Debt financing increases the liabilities section of the balance sheet, which represents the creditors’ claim on the assets of the business. Debt financing also increases the cash inflow from financing activities on the cash flow statement, which reflects the net amount of money borrowed or repaid to the lenders.

However, debt financing also increases the interest expense on the income statement and the cash outflow from operating activities on the cash flow statement.

Let's understand this with a story:-

ABC Inc. (startup) is a software company that develops and sells a cloud-based platform for online education. The company was founded by three entrepreneurs who invested $100,000 of their own money as seed capital. The company has been growing rapidly and has attracted many customers and users. However, the company also faces many challenges and opportunities, such as increasing competition, expanding into new markets, developing new features, and improving customer service.

The company needs more capital to fund its growth and achieve its goals. The company has two options: equity financing or debt financing. The company decides to explore both options and compare their costs and benefits.

Equity Financing

The company approaches a venture capital firm that specializes in investing in software startups. The venture capital firm is interested in ABC Inc. and offers to invest $10 million in exchange for 20% of the company’s equity. This implies a valuation of $50 million for the company. The venture capital firm also requires a board seat and certain rights and preferences, such as anti-dilution protection, liquidation preference, and veto power over certain decisions.

The cost of equity financing for the company is the expected return that the venture capital firm requires for its investment. This depends on the risk and growth potential of the company, as well as the market conditions and the availability of alternative investments. The company estimates that the cost of equity financing is 25%, based on the industry average and the comparable transactions.

The benefits of equity financing for the company are that:-

• It does not have to pay any interest or principal payments, which reduces its financial risk and increases its financial flexibility.
• The company also gains access to the expertise and network of the venture capital firm, which may help it grow faster and overcome its challenges.
• The company also retains its full operational and strategic autonomy, as it does not have to comply with any debt covenants or restrictions.

The drawbacks of equity financing for the company are that:-

• It dilutes the ownership and control of the existing shareholders, who now own only 80% of the company.
• The company also has to share its profits and future growth potential with the new investors, who have certain rights and preferences over the existing shareholders.
• The company also faces more pressure and scrutiny from the venture capital firm, who may have different objectives and expectations than the founders.

Debt Financing

The company approaches a bank that specializes in lending to software startups. The bank is interested in ABC Inc. and offers to lend $10 million at an interest rate of 10% per annum, payable monthly. The loan has a maturity of five years and requires the company to maintain certain financial ratios and performance indicators, such as revenue growth, profitability, and cash flow. The loan is secured by the assets and receivables of the company.

The cost of debt financing for the company is the interest rate that the bank charges for the loan. This depends on the creditworthiness and financial health of the company, as well as the market conditions and the availability of alternative sources of funding. The company estimates that the cost of debt financing is 10%, based on the industry average and the comparable transactions.

The benefits of debt financing for the company are that:-

• It does not dilute the ownership or control of the existing shareholders, who still own 100% of the company.
• The company also benefits from the tax deductibility of interest payments, which lowers its effective cost of debt and increases its net income.
• The company also retains its full operational and strategic autonomy, as long as it meets its debt obligations and covenants.

The drawbacks of debt financing for the company are that:-

• It increases its financial risk and its financial obligations, as it has to pay fixed interest and principal payments regardless of its performance.
• The company also faces the risk of default and bankruptcy, if it fails to meet its debt obligations and covenants.
• The company also has to pledge its assets and receivables as collateral, which may limit its ability to use them for other purposes.

The Decision

The company compares the two options and decides to choose equity financing over debt financing. The company believes that equity financing is more suitable for its stage and situation, as it provides more capital, less risk, and more flexibility. The company also believes that the cost of equity financing is justified by the value and potential of the company, and that the benefits of partnering with the venture capital firm outweigh the drawbacks of diluting the ownership and control of the existing shareholders.

The company accepts the offer from the venture capital firm and issues 20% of its equity to the new investors. The company uses the $10 million to fund its growth and achieve its goals. The company hopes that the equity financing will help it increase its valuation and profitability, and eventually lead to a successful exit, such as an initial public offering (IPO) or a merger and acquisition (M&A).

Sources and costs of capital are important factors that influence the financing decisions of a business. Choosing the wrong sources or costs of capital can lead to value destruction, financial distress, or even bankruptcy for a business. Here are some real life cases that illustrate the consequences of wrong sources and costs of capital:

• In 2005, Toys “R” Us, the largest toy retailer in the world, was acquired by a consortium of private equity firms in a leveraged buyout. The deal was financed by $5.3 billion of debt, which increased the company’s interest expenses and reduced its cash flow. The company struggled to compete with online and discount retailers, and failed to invest in its stores and e-commerce. The company filed for bankruptcy in 2017 and liquidated its assets in 2018. The case shows how excessive debt financing can increase the financial risk and limit the operational flexibility of a business.
• In 2007, EMI, the British music company, was acquired by Terra Firma, a private equity firm, in a deal valued at ￡4.2 billion. The deal was based on optimistic assumptions about the growth and profitability of the music industry, which were soon challenged by the global financial crisis and the digital disruption. The deal also involved a high cost of equity, as Terra Firma demanded a 20% internal rate of return on its investment. The company failed to meet its financial targets and covenants, and defaulted on its debt in 2011. The case shows how unrealistic expectations and high costs of capital can lead to overvaluation and underperformance of a business.
• In 2013, J.C. Penney, the American department store chain, issued $785 million of equity to raise capital and reduce its debt. The equity issuance was a surprise to the market, as the company had previously denied any plans to raise capital. The equity issuance diluted the existing shareholders and signaled the company’s financial distress. The company’s stock price dropped by 13% on the day of the announcement, and continued to decline in the following years. The case shows how equity financing can have negative effects on the ownership and confidence of a business.

These cases demonstrate the importance of choosing the right sources and costs of capital for a business. Equity and debt financing have different advantages and disadvantages, depending on the situation and goals of the business.

• Equity financing does not require the business to pay fixed interest or principal payments, but dilutes the ownership and control of the existing shareholders.
• Debt financing does not dilute the ownership or control of the existing shareholders, but increases the financial risk and obligations of the business.

The sources and costs of capital affect the feasibility and profitability of different projects and opportunities, and the optimal mix of equity and debt that minimizes the cost of capital and maximizes the value of the business.

But, how to find and evaluate different sources of capital for your business are:

• Identify your capital needs and goals. You should have a clear idea of how much capital you need, what you will use it for, and how you will repay it. You should also have a realistic projection of your revenue, expenses, cash flow, and profitability. You should also consider your growth potential, competitive advantage, and exit strategy.
• Research and compare different sources of capital. You should explore various options of equity and debt financing, such as venture capital, angel investors, crowdfunding, bank loans, bonds, trade credit, and leasing. You should understand the advantages and disadvantages of each option, such as the cost, risk, availability, flexibility, and impact on your ownership and control. You should also check the eligibility criteria, application process, and terms and conditions of each option.
• Prepare a compelling business plan and pitch deck. You should have a well-written and well-presented document that showcases your business idea, value proposition, market opportunity, competitive analysis, financial plan, and funding request. You should also have a concise and engaging presentation that highlights your key points and captures the attention and interest of your potential investors or lenders.
• Network and build relationships with potential providers of capital. You should leverage your personal and professional contacts, such as friends, family, mentors, advisors, customers, suppliers, and industry associations, to find and connect with potential providers of capital. You should also follow up and maintain communication with your potential providers of capital, and provide them with updates and feedback.
• Negotiate and finalize the deal. You should evaluate and compare the offers and proposals from different providers of capital, and select the one that best suits your needs and goals. You should also negotiate the terms and conditions of the deal, such as the valuation, equity stake, interest rate, repayment schedule, collateral, rights and preferences, and covenants. You should also review and sign the legal documents and contracts, and comply with the due diligence and reporting requirements.

I hope you find this answer helpful. If you have any questions or comments, please feel free to reach out to me. Thank you for reading.

Source: CFA Institute, Investopedia, Wallstreetmojo, Corporatefinanceinstitute, Mckinsey.com , hbr.org .