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A Good Funding Deal Is One That Ends Well

The capital injection from equity investors can help growth, but will you have the cash to buy them out later?

A Good Funding Deal Is One That Ends Well

With the gazillions of financing options available to fund your business growth, unfortunately, many entrepreneurs focus too much on what they can get and the interest cost. Although these are critical factors, not enough attention is given to how to end the financing relationship.

It’s all about liquidity.

To be fair, this isn’t a typical issue with “regular” debt funding, like mortgages or vehicle finance, because repayment of the capital raised is a key feature that’s front and centre in the deal’s terms. It’s much more of a concern with equity-based funding.

Equity finance is usually how venture capitalists invest. The VC will inject capital and take ordinary shares in exchange. Then they’ll want to 10X the business value and cash-out 7 years later with a tidy ROI.

If you’re dealing with savvy investors like VCs and, if they’re ethical, they’ll guide you through planning for their exit. This would be part of the deal and negotiated before they invest.

Except, working with VCs and similarly clever investors is something few entrepreneurs experience. Most entrepreneurs are our common garden variety, funded by family, friends and other fools.

More often than I’d like to admit, I’ve seen businesses without even a shareholders’ agreement, let alone a resolution or other written record of the shares being issued.

It’s specifically these situations that can ruin friendships.

But it’s probably not the picture you’re thinking: family and friends put in capital --> a calamity strikes --> the business folds --> family feud ensues.

Obviously, when a business is forced to liquidate, it’s unlikely anything is left to pay shareholders after creditors, staff and SARS have taken their dues. Whether shares are documented or not is moot. Everyone is unhappy. The only problem here is the lost capital.

So, no, it’s not that scenario, either.

I’m talking about successful businesses. Funding a business that becomes successful can also lead to a stalemate of “lost” capital. Picture the company that took on an equity partner and now, a few years later, that partner wants to exit. Problem is, the original owner can’t afford to buy them out.

Perversely, the growth plan worked out and the business is successful, just . . . it’s not successful enough.

Because the business has grown successfully, it’s also grown in value. By our anecdotal experience with our clients, even a marginally more successful business can exponentially multiply the value of the business. But that's not the real catch.

The real issue is the lack of free cash flow.

As a business grows, you'll see on the balance sheet a nice little item called retained earnings steadily grow in value year on year. Wonderful, we think! Only, that retained earnings value seldom represents bags of cash lying around. Regardless of how well a business grows, most owners will struggle to also grow the free cash. In fact, idle cash lying around is cash not being used to scale the business further and faster.

In other words, if you've successfully grown your business with an equity partner's capital, it will usually take a whole lot more than what was invested to buy them out.

You could take out a loan, but can you afford it? How might servicing new or additional capital and interest re-payments stunt your operating cash flow? Do you have “free” assets that aren’t already tied up as collateral for other debt? While VCs like to cash-out through a later and bigger funding round, is that what you want, to further dilute your equity stake with yet more shareholders?

It’s not enough to have a shareholders’ agreement governing how partners exit. You need an exit plan that includes building a reserve so you’re not stuck swapping one partner or “creditor” for another.

If you do this, you’ll be well on your way to building a business that also grows your owner wealth.