Key Takeaways
- Capital allocation decisions involve funding business operations either through debt or equity (or some hybrid of these two).
- Capital allocation decisions are made to maximize return on equity (related to equity value) while value creation activities are performed to maximize return on invested capital (which is correlated with enterprise value).
- Capital allocation decisions almost always come with strings attached whether it be debt or equity since lenders and investors require a return on their respective investments. This involves obligations to stakeholders and less autonomy but can help owners to achieve their growth objectives.
Introduction
This article is Part III in a series about holistic exit planning and value creation. Part I can be found HERE and Part II can be found HERE. I noted in the original article that capital allocation decisions are primarily to the benefit of optimizing equity value (versus enterprise value or the net proceeds after transition). In business school, often times corporate finance courses go into detail about capital allocation theory. For public companies (or large private companies), optimal capital structure is an important part of their corporate finance function. However, for SMEs capital allocation is rarely optimal (nor achievable) and for many owners, not even on their radar. This article provides a high-level summary of:
- What is capital allocation?
- Why would an SME owner interested in growth with an exit in mind care about it?
- The pros and cons of various sources of funds.
What is Capital Allocation?
There are primarily two sources of funds for any business owner: debt and equity (although some instruments may be hybrids of both). Capital allocation entails how a company weights its use of debt versus equity. When most businesses start, the company is often times 100% financed through the founders’ equity. This start-up equity may be divided between multiple owners or the ownership interest of one single shareholder. Throughout the life of a company, capital allocation decisions have to be made with pros and cons to each. Much like equity, debt can be employed by a company to fuel its growth. There are various sources of debt that SME management can consider, each with their own particular strings attached. Both debt and equity can by raised from outside parties and such funds represent the use of Other People’s Money (or OPM for short). When used judiciously, OPM can help a company scale up its operations and increase an owner’s equity value, but when poorly managed, a company can be ruined and equity can fall to zero.
Why Should an SME Owner Care?
SME owners hoping to grow their business with an exit in mind should implicitly care about capital allocation decisions and the sources and uses of funds raised for a number of reasons:
- Raising money through debt or equity can help a company grow through the power of leverage. Much like real estate, where when markets are positive a leveraged investment can produce a high return on investment, using OPM can help to increase an individual owner’s return on investment (in this case, a return on equity).
- Growth is expensive and often requires investments that will produce potential returns later. For example, a growing business may have to invest in quality management and workforce to handle the necessary economic activity required to meet ownership’s objectives. In addition, investments in working capital and capital assets may be required to keep the company’s wheels turning. Other investments in infrastructure such as IT may be required. When growth is fueled through acquisitions, then debt is often times used by SME owners (unlike some public companies that may buy through share-for-share exchanges).
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Outside parties providing new debt or equity are now stakeholders in the organization and will place expectations upon the company management so they can obtain a reasonable return on investment.
All in all, it is not impossible to grow a business through only using owner founder equity, but in practice, it is quite difficult to do so especially if an owner has aspirations beyond running a lifestyle business that has multiple employees and perhaps a layer or two of management.
Common Sources of Funds for the Middle Market
Below, I have outlined the most common sources of funds available to SME owners. I have purposely ignored the “start-up” space where the role of angel investors and venture capitalists is a different one from the typical Middle Market business. This is also not meant to be an exhaustive list but rather is provided as a general overview of options available to SME owners.
Debt
Senior Debt
Most debt facilities provided by Schedule 1 banks in Canada will be considered senior debt and secured. Senior debt takes priority over other types of debt in a company such that if that company goes bankrupt, the senior debt will be paid down first before other stakeholders’ claims are addressed. Senior debt usually comes in various forms such as operating loans, terms loans, or floating rate facilities. In general, the duration of the debt instrument is usually matched up with the purpose of the loan so for example, an operating line of credit with an indefinite life is often used to fund working capital while capital asset purchases are commonly funded with term loans. Senior debt has the advantage of usually providing the most favorable interest rates but may also have stricter financial covenants than other types of financing.
Asset-based Lending
A financial institution may lend to a company based on the value of certain assets such as machinery & equipment or working capital components such as accounts receivable and/or inventory. Asset-based lending is another form of secured lending that may be useful to companies with less of a financial track record but with somewhat of an asset base that can provide collateral. Rates on asset-based lending will usually not be as low as senior secured debt but more favourable than mezzanine debt. Asset-based lending also often requires periodic reporting to the bank (often quarterly or monthly) and may also require periodic inspections or audits in the case of physical assets or inventory.
Subordinated (or Mezzanine) Debt
Subordinated or mezzanine debt is often partially or wholly unsecured and is junior in claim to more senior debt. Mezzanine debt is commonly seen in start-ups and venture-capital backed enterprises and also in the Middle Market to fuel a company’s growth. In some cases, mezzanine and senior lenders work together where the mezzanine lender provides additional add-on lending to a company (such as with a management buy-out or in an M&A transaction by assuming additional credit risk the bank is unwilling to assume. Mezzanine debt can come in many forms ranging from a pure vanilla term loan to a facility that includes equity components such as warrants and options. The main advantage of mezzanine debt is the flexibility it provides owners and the less stringent constraints on the business while the downsides are higher interest rates along with potentially equity dilutive instruments such as warrants and options attached.
Factoring
Factoring involves the sale of accounts receivable to a company who legally assumes the ownership of such receivables. To compensate for risk, the factoring company will provide the company with a certain percentage of the dollar value of accounts receivable purchased. For example, an accounts receivable balance of $1,000,000 might be sold to a factoring company for $850,000. The advantage of factoring is that it provides a company with an immediate cash infusion that may be needed to repair its working capital. The obvious negative is that factoring is one of the more expensive forms of financing. That being said, when a company is experiencing a cash crunch, factoring might be a viable option to consider to provide temporary cash flow relief.
Special Purpose Debt
Debt can be also raised for special purposes such as an acquisition, management buyout, an employee stock option program (or ESOP), or to fund specific investments in growth (costs associated with building infrastructure or expanding the management team). Such debt will have to be negotiated with a lending institute based on the business merits of the specific activity and most likely the interest rate will be higher than regular secured debt. It is not uncommon for some mix of traditional banks and alternative lenders working together to provide capital.
Preferred Equity
Preferred equity is a type of equity that often has similar qualities as debt. Preferred shares often may pay a dividend although the terms of such shares will delineate whether dividends are guaranteed. Preferred shares may also have other rights attached such as convertibility to common equity, voting rights, along with redemption or retraction options. For Middle Market companies, preferred shares are common in family businesses, although the TOSI legislation in 2018 reduced the viability of using such shares as an income splitting tool. Preferred shares are mostly used when an estate freeze has been enacted with the older generation receiving “frozen” preferred shares while the children receive growth common shares. Preferred equity has priority over common equity upon the liquidation of a corporation although it is subordinate to all forms of debt, both secured and unsecured.
Preferred equity can be also used by Middle Market companies in the case of companies engaging in structured growth or with a phased exit although this is more commonly seen with venture capital or private equity backed companies. When third parties are given preferred equity to fund growth, the main downside is the potential dilution of common equity if such shares either have convertibility features, or alternatively warrants and options attached. If dividends are guaranteed (i.e., cumulative), then much like debt, cash flow has to be set aside to service the preferred shareholders.
New Equity Investments
New equity investments refer to cash infusions from new contributions of money in exchange for newly issued common share commonly referred to as treasury shares. This can take the form in multiple ways:
- An existing shareholder invests additional money into the company in exchange for treasury shares;
- A new investor purchases a minority interest in the company by buying treasury shares; or
- A new investor purchases a majority interest in the company by buying treasury shares.
(Note that a purchase by an outsider of an existing shares does not provide the company with any extra capital as this is essentially an exchange of shareholder ownership and a personal transaction only. That being said, other issues may arise with a new shareholder on board with certain rights attached to those shares.)
For SMEs, new equity investments may be the only source of capital in periods where a company has little to no financial history (or has a perceived inability to service debt). This is most commonly seen in the start-up sphere where angel and venture capital investors are the common way to help scale up a business. For traditional Middle Market businesses, shareholder buy-ins are often seen with professional and medical practices or where new strategic partners come along who bring some specific business acumen to the table.
As we will note in the next section, however, raising equity money is not the same as borrowing debt since each has a different cost associated with it, so the decision to raise equity needs to be made with great care.
The Cost of Debt vs The Cost of Equity
Most everyone is familiar with the concept of the cost of debt: the associated interest rate on borrowings. However, equity also has a cost associated with it and, relative to debt, its cost is almost always much higher (unless we are making comparisons to credit card interest rates or payday loans). This is called the cost of equity since you are now sharing upside potential with additional shareholders—essentially splitting the pie into more pieces. This works fine if the capital from the new shareholders helps the company grow by a substantial margin, but in cases where new equity provides little to no growth, new equity only services to dilute earnings to legacy shareholders. This means that, all other things being equal, an owner should always wish to use debt to finance the company’s operations over equity infusions. While that is true, an owner may be limited in achieving this goal since the business may not be able to borrow anything from a lender due to any number of factors including a lack of company history, poor financial performance, or an unwillingness from an owner to provide a personal guarantee.
Over the life of a business, it is important to understand and manage the sources and uses of funds to improve economic returns at both the enterprise and shareholder level. If a company is growing with an exit in mind, then prudent use of debt is a potentially potent tool to help achieve a successful exit.
There is No Such Thing as Free Lunch
We’ve all heard the saying “there is no such thing as a free lunch” and capital allocation is definitely no exception to that rule. Any time a company uses OPM to grow their business, there are always strings attached since providers of capital need both a return of and a return on their investment. Debt providers will often provide conditions called covenants that must be adhered to by the company for the duration of the lending arrangement whether that be a term loan or indefinite in duration such as an operating line of credit. Covenants can squeeze businesses during rough patches but they can also provide owners with the necessary discipline to stay focused on producing returns. Some lenders may also require periodic reporting to give comfort that their loans can be serviced and paid back in a timely fashion. In a grow-and-exit scenario, an owner has specific objectives in mind over a defined time period (anywhere between two to five years or beyond), so using debt to fund some of the necessary value creation activities such as expanding management or beefing up technological infrastructure may be the preferred route so long as the company has a strong grip on its financial situation and cash flows. Debt used wisely can help a company scale up in an accelerated fashion, but poor or reckless use of funds can wipe out all the value in equity.
As noted above, the cost of equity is often greater than that of debt, so bringing on new equity from non-founders can be an expensive proposition since a slice of ownership is now being divvied up to other shareholders. This is a good idea when the new equity investors are bringing expertise to the table but in the case of passive investors, they are can essentially be very expensive loans. Luckily, with Middle Market businesses, the type of equity investors such as private equity firms, independent sponsors, or family offices, can bring expertise and business acumen to the table that may help an SME owner not only exit their business but also participate in future growth.
ROIC vs ROE
Two important metrics exist which owners should understand: return on invested capital (ROIC) and return on equity (ROE). Invested capital is value of debt and equity in a company (and can be measured either by the book value or the fair market value depending upon the purpose of the calculation). Each metric measures investment returns but ROIC measures it at the enterprise level while ROE measures it at the shareholder level. Ideally, owners want to maximize both if they can. Value creation activities that we previously discussed are aimed at optimizing enterprise value while prudent capital allocation management is aimed at optimizing equity value. In other words, value creation activities maximizes ROIC while capital allocation can help to maximize ROE. Both are important to SME owners to understand and manage if they wish to grow their companies with an exit in mind.