"Simply stated, there are two sides to a business balance sheet," said Vera Muzzillo, CEO of Cleveland-based Proforma. I've asked for a brief explanation of capital, a CliffsNotes version of years' worth of microeconomics training and financial experience, and Vera has obliged by breaking down the numbers in terms I can understand without an MBA. "Assets (capital) on one side and debt and equity on the other side," she continued. "Assets always equal debt plus equity."
It sounds like Business 101, an oversimplification you might find in one of those "______ for Dummies" books aimed at educating the inquisitive layperson on concepts far beyond his or her hope of understanding, and to some extent it is. But this back-to-basics approach can be helpful, especially when dealing with something like capital, a concept so simple it can be broken down into a grade-school-level equation, yet so complex that businesspeople spend years trying to master it—and often fail.
See, of all the reasons businesses fail (and there are plenty of reasons—bad location, down economy, lack of leadership, etc.), insufficient or poorly managed capital is the one that seems to appear on every financial guru's bullet-pointed "Why Businesses Fail" list. It's the second entry on the Small Business Administration's (SBA) reasons for small-business failure, and as such it's likely a major contributor to the alarmingly low success rate of startups (18 percent, according to a Harvard Business School study) and small businesses over the last few years.
In other words: If you want your business to succeed, you better know how to manage capital.
Simple Math
Naturally, Vera is telling me about automobiles. "A simple example would be a car purchase," she said. "If you buy a $30,000 car, put down $5,000 and secure a $25,000 loan, then the balance sheet would look like [this]: $30,000 (assets) = $25,000 (debt) + $5,000 (equity)." This is not a non sequitur, and no, we haven't been sidetracked by a mutual interest in the finer points of mid-sized luxury sedans. The car-buying analogy is a small-scale example of the process by which businesses can increase capital: increasing debt, increasing equity or both.
"The most common way to increase capital with debt, for a distributor, is to seek an asset-based loan backed by a percentage of accounts-receivable and of inventory," Vera explained. "The most common way for a distributor to increase capital with equity is to put money into the business."
Greg Muzzillo, Proforma's founder, noted that of the three common types of loans—asset-based, personal guaranteed and unsecured—the former is generally preferable for distributors. Personal guaranteed loans come with too much risk for new businesses (making personal assets available as collateral is dangerous when the failure rate for startups is so high); unsecured loans are often dependent on borrower reputation and can come with higher interest rates. That's why Greg recommended asset-based loans. "The most common assets a distributor has to collateralize a loan are accounts-receivable and inventory," he said.
Greg also mentioned the options available to businesses looking to increase capital with equity. "The three most common ways for a distributor to put money into their business would be to (1) put in cash as equity, (2) put in cash as a loan, or (3) defer income and put that as a loan to the company," he explained.
From there, distributors can either invest in the ability to more quickly pay vendors (this is "usually faster than your customers will pay you," said Greg) or invest in inventory, either with physical inventory or with inventory management systems. "If our customers want us to set up an inventory management program for them, and they want us to own the inventory, we need to find a way to finance purchasing that inventory," he noted. "We will own the products on behalf of the customer, but we won't need to bill them for it until we ship it to them. This is called a bill-as-ship program."
Increasing debt and increasing equity are the most common ways to increase capital, but there are other methods. Factoring receivables (selling accounts-receivable at a discount) is one option. Selling company shares to investors is another. "There are a few sources for such investors, including friends, family, angel investors and venture capitalists," Vera said. "[But] each of these sources of equity brings its own risks."
Investments from friends and family could put relationships at risk if the business fails. Selling shares to angel investors or venture capitalists could result in a slippery slope, where an underperforming business leads to the loss of more and more shares of ownership to investors. "Additionally, even if your business is successful, angel investors and venture capitalists will demand a very high rate of return for their investment," Vera added.
Getting Creative
The basic equation for increasing capital is the same for small and large businesses alike, but there are some distinctions based on the size of the company. Small companies have access to Small Business Administration loans and other resources, while large companies will likely have a larger number of avenues by which they can increase debt or equity. "Some lenders only want to lend larger amounts of money, which rules out their working with smaller businesses," Greg said. "Larger businesses are also able to go public and raise equity from a large group of investors."
Large businesses, in particular, also can increase capital by acquiring other businesses, but companies of both sizes might look to increase capital via mergers. Both options boost overall capital by combining the debt or equity of the involved companies. "The primary reason for engaging in a merger or acquisition is to increase sales and lower the cost of doing business," Vera explained.
"Acquisitions and mergers give [businesses] the opportunity to join with another company to combine sales and lower costs by sharing offices and employees (or eliminating employees where there may be overlap), or by eliminating other expenses that are overlapped between businesses," she added. "So, in an acquisition or merger you are increasing sales, lowering costs and increasing profits."
Still, the biggest challenge most businesses will face when trying to increase capital isn't choosing the method that is most efficient, or the method most likely to work—according to Greg, the biggest challenge is finding "affordable debt or equity at agreeable terms."
So how, exactly, can businesses do that? Greg gave the example of FedEx founder Fred Smith, who talked to 13 investors before someone bit on his idea for an overnight-delivery shipping service. In other words, be persistent and get the word out when searching for investors. "It's all about shopping and sourcing," Greg said. He recommended seeking out referrals from family, friends or other sources. "Lenders tend to trust referrals from people they know, so referrals may be a more effective way to find debt or equity than cold-calling banks and other resources."
Failing that, Greg recommended one last course of action for capital-seekers. "Get creative," he said. "Consider leasing instead of buying. Consider buying used equipment instead of new. Consider being austere. It's natural for business owners to want a nice building, furniture, equipment, etc., but it's critical in the early days to conserve cash. It's better to be humble than to be broke."