Managing your company’s capital structure is arguably one of your most important functions. Managing a careful balance between equity and debt that a business uses to finance its day-to-day operations, assets and future growth is vital. Normal cash flows can’t always fund significant growth opportunities. One must aggressively take advantage of opportunities when they arise. Here are five steps to get started.
Understand the levers for optimal capital structure. Additional capital is periodically needed to expand one’s business in order to invest in new markets, people, technology and/or equipment. As you need more capital, you must figure which lever to pull, equity or debt, with the objective of maximizing the company’s market value short-term and long-term.
Equity is invested capital and comes in two forms, common and preferred stock. Selfishly, existing investors are often reluctant to raise more equity as it will dilute their shares. But savvy owners know that dilution can be offset by creating material value – rising tides raise all boats. Preferred stock does not usually give shareholders voting rights, while common stock does. Preferred stock often pays fixed dividends with the potential to appreciate in value. And, if a company’s assets are liquidated, the preferred stock is redeemed before common stock is, giving preferred a better chance of getting at least some of their money back.
Debt has its own financial benefits and comes in many forms. Debt is often considered ‘cheaper’ than equity, because it doesn’t dilute your ownership. When employed at the right levels, it represents a sensible way to provide capital for the financial future of your business. In addition to traditional lines-of-credit and cash flow loans, you should explore other options that may be more financially advantageous, including asset-based loans (equipment, inventory and receivables financing), subordinated, mezzanine and convertible debt.
Get the right leverage. Astute debt is good, increasing financial resources for growth and expansion. But too much debt can result in high interest costs, and creditors may restrict a company’s freedom of action via covenants. Popular measures of leverage are debt to equity and debt to income, which measures what portion of your monthly cash flow serves your debt. The ‘right’ leverage varies by industry and individual company characteristics. You should consider the leverage at your competitors when deciding what is right for your company.
Bring in expertise as needed. Analysis and metrics tracking are necessary tools and should also enable you to negotiate with your lenders and investors. It’s important to get advice from your accountant or financial advisor to make sure you are making an informed and objective decision.
About the Author
Tom McDermott is a managing director at Cambridge Wilkinson, an investment banking services firm.
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