Posted on: September 22nd, 2017
Growth Capital describes a form of financing that addresses the funding needs of a growing company. The concept has evolved from the private capital market and banking market.
It is a term commonly used by financiers, but not widely understood among business owners. Business owners typically refer to growth capital in more specific terms, reflective of the way they think about their business.
Growth Capital can come in any form, in any amount of either a loan or investment. As a business owner looking to see their business thrive, Growth Capital can be the water that helps you flourish.
Tip #1 – Growth Capital is financing used to scale a business.
Tip #2 – It can be used for any type of resource investment within the Company.
Growth Capital can be used to fund any funding need a company may have when they are progressing through a growth phase.
The more intense the growth phase, the greater the need for growth capital, as companies usually require substantial upfront investment to scale at rapid rate.
The common theme to Growth Capital is that it is money invested in the Company that expands the resource base of the business. Growth Capital allows the Company to grow at a faster rate.
This can include additional cash, increased working capital, and purchases of equipment or addition of more employees. Growth Capital is agnostic as to which resource within the company it is targeted to.
It can be used for virtually any pro-growth initiative. The size of the Growth Capital raise and the underlying form of the financing varies depending on the targeted growth rate and the condition of the company’s balance sheet and cash flow.
Usually, the selection of different forms of growth capital emerge from deep understanding of a growth plan, its time frame and capital requirement in addition to the plan’s risk to the overall business.
How Do I Select the Right Form of Growth Capital?
The right form of growth capital is very dependent on the specific factors of your own company and growth plan. Long term growth requires longer term, flexible forms of growth capital such as mezzanine debt or equity.
Short to intermediate term growth is more likely to be funded with a short term, less flexible bank loan.
Tip #1 – Long term, uncertain growth paths requires patient, long term capital.
Tip #2 – The riskier the growth, the more importance the patience quotient of the capital.
Discontinuous growth, that is growth in a completely new direction with new products and new markets, requires patient long-term forms of growth capital.
When a company is doing something completely new – such as developing a new technology or expanding their sales footprint in a new region, there are many unknown variables that could result in the need for more time or more money.
The development efforts may take 5 prototypes to come up with the right one. The new market entry efforts may underestimate the time it takes to find new customers and to walk them through the sales cycle.
Management may feel they have good guidance as to time and cost factors for this new exploration, but things always take longer and cost more to get to the finish line.
This lack of predictability makes this a high-risk growth plan, best funded through long term, low risk, and flexible forms of growth capital such as mezzanine loans or equity investment.
If the high risk development does not pay off, your existing business needs to be protected so that the losses do not take the company under.
This calls for growth capital that is comfortable exchanging their funding for a variable claim on the future value of your business.
With mezzanine lender or equity investors, if the growth does not materialize, they will usually get their capital back along with a modest return. They will not be in a position to take over your business, foreclose on assets, or force you to sell.
Growth capital that is continuous or flows organically from existing customers, products or markets is more likely to be funded with short term debt. This type of growth is low risk, and is generally predictable as to time and cost factors.
There is less uncertainty as to the overall execution of the growth so it can be funded with a less flexible, lower cost form of growth capital such as a bank loan or asset based loan. These types of loans require principal repayments and are secured.
If the business starts heading in the wrong direction, their remedies can be harsh as they have the power to accelerate the loan and foreclose.
The best way to visualize the difference between capitalization of high risk and low risk growth plan is through using a seesaw schematic.
The higher the risk of growth, the lower risk and more flexible the capital should be. The lower the risk of growth, the higher risk and less flexible the capital should be.
How Much Will Growth Capital Cost?
Growth capital can come in all different forms (such as debt or equity) and in all different sizes, making the cost highly variable. The size of the capital raise affects the pricing, as the amount of capital will be measured against the collateral value or equity value of your company.
If the amount you need is high relative to the collateral or equity value, you will pay more. If the amount your need is low relative to the collateral or equity value, you will pay less.
When evaluating the true cost of growth capital, you should consider the opportunity cost of not having enough money to execute your growth plan. Many businesses simply never fulfill their growth plans, because they are under capitalized.
The cost of not realizing growth potential is high as it results in lost value when the company is sold. With growth capital, the cost is best measured as the value of removing capital as a barrier to growth. With it, you can grow faster, become bigger and expand widely.
Tip #1 – Size and value of your company affect the price of the growth capital.
Tip #2 – The dollar amount needed and the time horizon for the project determines the best type of growth capital.
If the raise amount meets the growth capital provider’s structuring parameters, then you can expect to receive pricing terms that reflect the risk and the return requirements of the growth capital provider.
Growth capital cost covers a wide spectrum depending on whether it is structured as a loan or as an investment. Loans charge interest, while equity investments take mostly shares.
Each growth capital provider, be it a bank, or a mezzanine lender or a growth equity provider, has standard pricing.
Banks charge interest and upfront fees, and usually base their loan pricing at a spread to Libor or the Prime rate. Banks charge 4.5% to 5.5% on their loans to middle market companies. Mezzanine lenders, take greater risks than banks and charge 10% to 15% on their loans.
Their loans have fixed interest rates as well as a return kicker. This return kicker gives the lender participation in the exit upside at the end of the loan.
Growth Equity investors are the most expensive and take shares in companies. They usually have a 25% to 35% shareholding position.
Their share position is a function of their return requirement of 20% to 25%, and the fact they do not receive any interest payment on their money. They make all of their return upon the exit of the company.
What are the Keys to Raising Growth Capital?
Providers of growth capital have to buy into the future of your company in order to have comfort. They need to feel confident that all of the pieces of the puzzle are in place within your company–which you have the firepower to grow rapidly.
While all businesses have the potential to grow, only those that have prepared to grow and embraced the keys to grow, will succeed. The process of engaging with growth capital providers requires professionalism and carefulness.
Each growth capital provider has different preferences and requirements, which means it can be difficult to find the right balance of presentation form, growth story, and financial projection.
- Strong market research
- Clear and well-articulated company growth story
- Strong management team
- Strong financial projection model
First, you need a well-researched growth plan that clearly identifies the opening in the market, and how you can attack it. The best growth plans are based on bottoms-up research of customers, products and regions.
Secondly, you need to have a strong growth story that articulates in writing how you will do it. This needs to emphasize specific steps of tactical execution.
Your articulation of the growth story in your confidential memorandum must be clear and objective. The clearer the articulation is, the more it will resonate with your audience.
It is wise to use simple financial ratios and third party statistics to support your view. Thirdly, you need to showcase the strength of your management team in your confidential memorandum.
Management is the most important driver of the overall success of your growth plan. The growth path is not a linear one, but circuitous with dead ends and road blocks.
A good management team knows how to best navigate this circuitous path. Growth Capital providers seek great management teams to back and then empower them with capital.
Fourth, the projected financials should demonstrate growth of several orders of magnitude. The growth should show EBITDA increasing 2 to 5 times over a five year period, translating into a large exit value for the business.
Growth equity investors need this type of breakaway growth to make money, as they own only a minority portion of the shares (25%).
How Much Growth Capital Can I Raise?
The bigger the growth step, the greater the need for capital. The amount that can be raised depends on the approach of each capital provider. Banks see companies as entities with collateral value.
A bank will advance growth capital as long as there is asset collateral to secure the loan. With this approach, the Company’s asset base is the limiting factor.
If the Company is asset rich, it can qualify for a large loan. Usually, growth planning requires financing far beyond collateral value to really make a difference. That’s were cash flow based lending comes into play.
Types of Valuations
- Collateral valuation – uses collateral value to determine loan amount.
- EBITDA enterprise valuation – uses a multiple of EBITDA to determine the loan amount.
- Pre-money equity valuation- uses future growth to determine a starting equity value.
Cash flow lenders such as mezzanine lenders advance growth capital using an EBITDA multiple approach.
This is a subjective measure and is subject to optimization, giving a company far greater availability than an asset based approach. Usually, you can attract a loan equal to 3 to 4 times adjusted EBITDA.
With this approach, you get more money at the point when you need it the most, at the inception of the growth journey. With growth equity providers, technology companies can raise large sums of money without giving up control.
These investors use an approach called pre-money equity value as their baseline. Pre-money valuation is usually based on the assumption of hyper growth and eventual market leadership.
Money losing companies with transformational products usually get high valuations, giving them the ability to raise large amounts of equity at low prices.
How Will Growth Capital make my Business Stronger
Growth capital is the foundation of a healthy company. It gives your business extra financial resources to expand. There are several ways that growth capital will make your business stronger.
It will increase the size, the diversification, the strategic planning and the professionalism of your business. The size of your company is critical to long term viability and competitive responses.
Smaller companies lack the support systems to get through tough times, and have a harder time competing with big companies.
The bigger your company, the more effectively it can weather a challenging period and handle competitive market conditions.
Smaller companies are generally more regional and single product focused. This increases their fragility if products or customers change abruptly.
Benefits of Growth Capital:
- Greater Size and Scale
- Greater Diversification
- Enhanced Business & Strategic Planning
- Greater Professionalism
Through diversifying your products and your customers, you have more diversification and a greater spread of risk. Growth capital forces a company to think critically about its future and to chart out a strategic road map for expansion.
This discipline is a tremendous learning experience for a business and it helps it sharpen its ability to internally communicate and to plan.
The due diligence process that a growth capital investor subjects you to will help you evaluate your business in a new and worthwhile way.
Finally, growth involves evolving to more professional ways of doing things. This applies to organizational structures, information systems, management quality and business processes.
As part of any growth capital process, a company must be honest with itself and acknowledge its gaps and where it has room for improvement.