Recognizing the Two Forms of Capital Instrumental to Your Business
There is a reason our economic system is called Capitalism – capital is one of the pre-requisites for surviving in the system. There are two forms of capital that, while related, are different things.
The first form is “outside capital” such as borrowed money or money put into the company by investors. The second form is “capital as business equity” or net worth. Whether you are a commercial business, non-profit or social enterprise, getting a handle of both forms of capital is vital.
For “outside capital” the business focus is on controlling its use and cost. This implies building your balance sheet to qualify for rock-bottom interest rates and the best terms.
For “capital as business equity” the focus is on discipline to direct a certain portion of cash flows to build capital (net worth) in general and working capital in specifics.
When managing a company’s money (finances), an eye must be kept on building and maintaining equity (capital) and the use/cost of outside capital.
The first form is “outside capital” such as borrowed money or money put into the company by investors. The second form is “capital as business equity” or net worth. Whether you are a commercial business, non-profit or social enterprise, getting a handle of both forms of capital is vital.
For “outside capital” the business focus is on controlling its use and cost. This implies building your balance sheet to qualify for rock-bottom interest rates and the best terms.
For “capital as business equity” the focus is on discipline to direct a certain portion of cash flows to build capital (net worth) in general and working capital in specifics.
When managing a company’s money (finances), an eye must be kept on building and maintaining equity (capital) and the use/cost of outside capital.
Outside Capital
The business person - upon deciding to start a business or take leadership of a business – must make clear in their mind the perspectives of which side of “outside capital” you are on.
For the provider of outside capital (lender or investor) the perspective is to always take out more than what you have put in. For private (non-bank) investors, the thought process is often one of varying degrees of how many feathers can you pluck from the chicken (business) without compromising the chicken.
For the business owner, the perspective is making sure you need the outside capital, controlling its costs and at what point the outside capital goes away (paying off the debt or buying out the investor).
Access to outside capital has, in some quarters, euphorically been viewed as a pathway to the stardom in the business realms. The pathway to stardom in business is actually something else. It is creating a business model in which the cost of goods, production and service are less than the price point of what customers (in sufficient volume) will buy.
It would be great if an enterprise could - from start to maturity - self-fund itself strictly from cash flows. However, there are simply times when the use of outside capital makes sense. It is the wise business person that knows when, how to control costs, and not lose sight of building the business balance sheet in a way that qualifies them for the best interest rates and terms.
A simple rule of thumb, when it comes to using outside capital, is to spend two hours figuring out how to make money without the use of outside capital for every hour spent figuring out how to qualify for and acquire outside capital.
Often times an enterprise is faced with having to make a choice. Do I go through the pain and insecurity of having a banker interrogate my finances for a business loan or do I take on an outside investor/partner?
Borrowing money from a bank (or other institutional lender such as a credit union) may require more hoops to jump through, but may have long-term advantages. For example, a bank loan for $1 million at 5 percent has a sunset on it. When it’s paid, the interest stops. An investor that wants a 10 percent return on their investment can go on for a lifetime – not totally unlike taxes.
It is up to the entrepreneur to ensure the blood, sweat and tears of founders, employees, key suppliers and even that of outside investors are not compromised by an overextension of the use of outside capital.
When too many outside investors are feeding off the business, investors can become their own worst enemy. It is not uncommon that one investor (or lender) may seek to dominate the cash being taken out from the business ahead of another investor. Heaven help the business caught in the middle.
For the provider of outside capital (lender or investor) the perspective is to always take out more than what you have put in. For private (non-bank) investors, the thought process is often one of varying degrees of how many feathers can you pluck from the chicken (business) without compromising the chicken.
For the business owner, the perspective is making sure you need the outside capital, controlling its costs and at what point the outside capital goes away (paying off the debt or buying out the investor).
Access to outside capital has, in some quarters, euphorically been viewed as a pathway to the stardom in the business realms. The pathway to stardom in business is actually something else. It is creating a business model in which the cost of goods, production and service are less than the price point of what customers (in sufficient volume) will buy.
It would be great if an enterprise could - from start to maturity - self-fund itself strictly from cash flows. However, there are simply times when the use of outside capital makes sense. It is the wise business person that knows when, how to control costs, and not lose sight of building the business balance sheet in a way that qualifies them for the best interest rates and terms.
A simple rule of thumb, when it comes to using outside capital, is to spend two hours figuring out how to make money without the use of outside capital for every hour spent figuring out how to qualify for and acquire outside capital.
Often times an enterprise is faced with having to make a choice. Do I go through the pain and insecurity of having a banker interrogate my finances for a business loan or do I take on an outside investor/partner?
Borrowing money from a bank (or other institutional lender such as a credit union) may require more hoops to jump through, but may have long-term advantages. For example, a bank loan for $1 million at 5 percent has a sunset on it. When it’s paid, the interest stops. An investor that wants a 10 percent return on their investment can go on for a lifetime – not totally unlike taxes.
It is up to the entrepreneur to ensure the blood, sweat and tears of founders, employees, key suppliers and even that of outside investors are not compromised by an overextension of the use of outside capital.
When too many outside investors are feeding off the business, investors can become their own worst enemy. It is not uncommon that one investor (or lender) may seek to dominate the cash being taken out from the business ahead of another investor. Heaven help the business caught in the middle.
Capital as Business Equity
Capital as business equity means the same as net worth. In other words, a business’ capital, equity and net worth are all one and the same.
Having an adequate level of capital (a balance sheet in which debts are not excessive relative to assets) has real world implications on cash flows, the smoothness of operations and ability to weather economic swings.
It is easy to get caught up in seeing the business as a source of cash withdrawals to surround oneself with the trimmings of personal wealth. While it may sound quaint, starving the goose that lays the golden eggs is not good financial management.
Business success is more assured if the business assets are materially unencumbered and there is working capital to facilitate smooth operations. The business that has a strong stock of its own capital is always at the front of the line when it comes to “outside capital” at the lowest cost and best terms.
Make no mistake that collateral is important to lenders. If a business doesn’t have adequate levels of capital (net worth) it may well not have the collateral needed to put a deal together. This does not mean the company should go out and buy assets just to have collateral. It means that working assets are shielded from having too many debt claims against them.
When collateral is insufficiently available, small businesses are often directed into an SBA (Small Business Administration) loan. So what does an SBA loan say about the business? It says the business is undercapitalized, doesn’t have enough collateral and may well not qualify for more credit if an unanticipated situation arises.
From a banker’s perspective, the balance sheet is the snapshot of your business at any given point in time. Adequate levels of equity (capital) are what give the balance sheet the right proportions bankers (and other lenders are looking for) – the right proportions of equity in general and working capital in specifics.
Net worth (capital) is more than a number or ratio gauging financial strength. Adequate net worth (capital) strongly supports the company “machine” in producing cash flows and staying in business.
Adequate capital (net worth) is one of the first lines of defense in controlling the cost of outside capital and protecting the business owner from losing control of their company.
Every business is a living enterprise with customers, suppliers and employees. Having unencumbered tools (facilities, equipment, working capital) to allow everyone to succeed, dramatically increases the likelihood of adequate cash flows and thereby success.
Having an adequate level of capital (a balance sheet in which debts are not excessive relative to assets) has real world implications on cash flows, the smoothness of operations and ability to weather economic swings.
It is easy to get caught up in seeing the business as a source of cash withdrawals to surround oneself with the trimmings of personal wealth. While it may sound quaint, starving the goose that lays the golden eggs is not good financial management.
Business success is more assured if the business assets are materially unencumbered and there is working capital to facilitate smooth operations. The business that has a strong stock of its own capital is always at the front of the line when it comes to “outside capital” at the lowest cost and best terms.
Make no mistake that collateral is important to lenders. If a business doesn’t have adequate levels of capital (net worth) it may well not have the collateral needed to put a deal together. This does not mean the company should go out and buy assets just to have collateral. It means that working assets are shielded from having too many debt claims against them.
When collateral is insufficiently available, small businesses are often directed into an SBA (Small Business Administration) loan. So what does an SBA loan say about the business? It says the business is undercapitalized, doesn’t have enough collateral and may well not qualify for more credit if an unanticipated situation arises.
From a banker’s perspective, the balance sheet is the snapshot of your business at any given point in time. Adequate levels of equity (capital) are what give the balance sheet the right proportions bankers (and other lenders are looking for) – the right proportions of equity in general and working capital in specifics.
Net worth (capital) is more than a number or ratio gauging financial strength. Adequate net worth (capital) strongly supports the company “machine” in producing cash flows and staying in business.
Adequate capital (net worth) is one of the first lines of defense in controlling the cost of outside capital and protecting the business owner from losing control of their company.
Every business is a living enterprise with customers, suppliers and employees. Having unencumbered tools (facilities, equipment, working capital) to allow everyone to succeed, dramatically increases the likelihood of adequate cash flows and thereby success.
The Most Successful Capitalists Have Capital and Control Capital
The first order for any enterprise leader it to get a handle on building equity (capital) and controlling the use and cost of outside capital. To do this requires conscious management.
In business, lacking control and awareness of “capital as business equity” and “outside capital” is like what happens to an inflated balloon when you let it go. It darts all over and you have little control over what it does or where it lands. Said in another way, the air in the balloon would be cash flow. The balloon runs amok because there is no control, guidance or strategy in managing the business’ money (finances).
After having hundreds of millions of dollars of credit requests pass over my desk as a banker and consulting numerous stressed enterprises, one thing is for sure: The condition of the balance sheet, which includes the level of capital (net worth) and working capital (liquidity) reveals almost immediately the extent to which management exerts control and guidance over its finances.
Too often business balance sheets simply reflect a chaotic scramble to access outside capital to offset a material lack of internal financial controls.
It’s not enough to generate cash flows; it’s what you do with the money that passes through the business relative to capital that is a pre-requisite.
In business, lacking control and awareness of “capital as business equity” and “outside capital” is like what happens to an inflated balloon when you let it go. It darts all over and you have little control over what it does or where it lands. Said in another way, the air in the balloon would be cash flow. The balloon runs amok because there is no control, guidance or strategy in managing the business’ money (finances).
After having hundreds of millions of dollars of credit requests pass over my desk as a banker and consulting numerous stressed enterprises, one thing is for sure: The condition of the balance sheet, which includes the level of capital (net worth) and working capital (liquidity) reveals almost immediately the extent to which management exerts control and guidance over its finances.
Too often business balance sheets simply reflect a chaotic scramble to access outside capital to offset a material lack of internal financial controls.
It’s not enough to generate cash flows; it’s what you do with the money that passes through the business relative to capital that is a pre-requisite.
At Business Logic, we have engineered decades of experience with “outside capital” and “capital as business equity” into our capital management products: The Business Pulse Manager and the Business loan Assistant.
By Benjamin Gisin
Professional life includes 20 years banking and 20 years consulting financially distressed enterprises. Experience from the perspective of a banker and then as a borrower advocate provided insights applicable to a broad range of economic players. Ben can be contacted at businesslogicusa.com on the contact us page.
Professional life includes 20 years banking and 20 years consulting financially distressed enterprises. Experience from the perspective of a banker and then as a borrower advocate provided insights applicable to a broad range of economic players. Ben can be contacted at businesslogicusa.com on the contact us page.