By Brian Boorstein
Our last article explored the options available to your company if you have decided to seek outside capital. We defined the types of capital you can pursue (equity, mezzanine capital and senior debt), and left off with a discussion of some of the requirements needed to raise those types of capital.
In this article we take a closer look at the costs associated with obtaining the capital.
The costs involved include more than dollars. The higher the risk to the capital source, the longer the term of the commitment, the closer the relationship between the source of financing and your business. Assuring that there is an alignment between an equity investor’s values and the culture of your business becomes important to a successful relationship that will nurture growth in your business.
Further, ideally all funders will be committed to supporting the breadth of elements involved in developing a healthy and sustainable business, not just the financial projections. Since healthy cultures and engaged employees positively influence productivity and cash flow, shopping for funding sources that will support the overall success of your business should be part of your consideration.
Cost of Capital
As stated in Part 1 of this article, equity is the most expensive capital, followed by mezzanine and then senior debt. The cost of the various types of capital is directly related to the risk that you are asking an investor to take. A senior lender has the highest priority in the capital structure in terms of payment and liquidation. A senior lender prices that capital to reflect that position and generates its return primarily through interest payments.
A mezzanine investor has advanced capital that exceeds the asset base of the company, so the mezzanine investor will rely on the cash flow to generate its return. Thus, a mezzanine investor will receive a portion of its return along the way through interest or dividend payments, and a portion on the back end of a deal through a refinancing or sale of the company. In waiting a longer time for its return and relying on still-undetermined gains in the future, a mezzanine investor has taken on greater risk than the senior lender, and expects to earn a higher overall return.
Following the curve, the equity investor has accepted the greatest amount of risk and should expect the greatest returns. Consequently, equity is the most expensive capital to raise.
The actual cost of the various types of capital floats with changes in the capital markets. Supply and demand of capital have an effect on the relative cost of capital as well as the prospective economic climate for the time of the investment. That said, there is a normalized range of returns that the different capital types generally seem to demand. By and large, the all-in compounded return (ie, interest, dividends and equity gains) for senior debt range between 8 and 12 percent, for mezzanine capital between 12 and 20 percent, and for equity 20 percent on up.
Probability of Satisfying Expected Payments on the Capital
For the most part, the combination of your reasonable assessment of the likelihood that you can satisfy the expected payments on the capital as well as the market’s perception of that likelihood will drive your decision as to what type of capital you should try to raise. Both you and the capital markets will assess whether your company currently has the necessary pieces in place, or if there is a good chance that you can put them in place, to generate the cash flow and create the value that is required to pay for the capital.
In reality, the analysis that takes place is part quantitative and part qualitative. The quantitative analysis, while mathematical, is still somewhat subjective. The projection of future cash flows is subject to a wide variety of factors. People view raw data and forecasts in diverse ways, which leads to different conclusions about cash flow and, ultimately, risk. From a qualitative standpoint, there can be a tremendous disparity in people’s judgment of management talent and opportunities, again leading to divergence in the assessment of risk and return.
In any case, the intersection of your confidence in being able to make the expected payments on capital and the market’s confidence that you can overcome the hurdles will dictate the type of money that you can raise, not just what you want to raise.
There is no easy or single point answer to the question “What type of money should I raise?” In these articles, we have attempted to highlight the market requirements and expectations for raising equity, mezzanine capital and senior debt. By no means, however, do we want to convey the idea that the decision to raise equity, mezzanine capital or senior debt is as discreet as choosing between one security type or another. In fact, you will likely find that when you endeavor to raise outside capital, the fluidity of the capital markets will bring to bear numerous options and variations off of the basic security types.
Most often, you will find that investors will be attracted to one or more of these securities. In that case, you can choose from among your options and create a capital structure that is prudent for your business and comfortable for you in your own risk/return continuum.