Recipe For A Capital Cake

Much of the classic thinking about financial structuring was developed for large, stable businesses, particularly quoted ones. It tends to draw heavily on historical track record and stock volatility in determining the cost of capital.

That thinking has little place in helping a young company, where the uncertainty is such that informed guesswork and compromises are the order of the day. This article will examine some of the ground rules and then look at practical examples.

The starting point is to establish how much capital is required and for what purpose. This may sound obvious; but the younger the business, the higher the level of uncertainty and the more difficult the funding requirement is to estimate.

 

We can start in the classic business planning sense by considering the market and the likely level of sales, work back through variable costs of sales to fixed-cost requirements. This builds up a picture of the overall cash requirement, for what purposes it will be required and how its shape changes over time. These cash flows can then be tested by working a series of what if scenarios and examining the impact on the funding requirement.

The key principle in funding is matching the provision of capital must mirror the purpose for which it is being used. Put simply, you would not wish to finance a large factory development with three-year money nor a personal computer with a 25-year mortgage.

Most businesses have a more or less permanent requirement for capital, best funded by equity and retained earnings, some longer-dated requirements best matched by term debt and some fluctuating requirements most easily funded by overdraft.

Business owners are concerned to keep the cost of capital to a minimum. The principal choice is between debt and equity (discussed in detail in Part 3), although in practice the cost can be altered by mixing the two in varying quantities.

To recap briefly. Debt is cheap, usually costing 1 per cent to 3 per cent over the banks cost of capital. Though cheap, it also has teeth and the old adage