Raising Cash for Expansion Requires Some Calculation

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Raising Cash for Expansion Requires Some Calculation

Entrepreneur’s Notebook

by Paul Gurrola and Eric Lesin

How much outside capital would it take to grow your business by, say, 20 percent?

If you’re serious about raising debt or equity capital to grow your business in uncertain times, it’s a question you’ll need to answer. Indeed, your answer will prove crucial to any successful search for outside capital because you can’t expect anyone to back you if you yourself don’t understand what you need.

Capital is essential to the founding of every business, and equally essential to growing one. All too often, however, entrepreneurs go looking for outside capital without carefully calculating how much they need to accomplish their goals. Instead, they offer only round numbers, hoping they will prove more than adequate.

But in uncertain economic times, vague numbers don’t persuade lenders and equity investors to open their wallets. Such people want certainty, or at least some limit on uncertainty, and you take an important step in addressing this problem with a solid calculation of the capital you need and the results you expect it to achieve.

The calculation may be easier than you think, using key numbers from your financial statements and a formula developed by a leading business academic, John Colley Jr., of the University of Virginia and enhanced by Alan Patz, associate professor of management and organization at the Marshall School of Business at the University of Southern California.

The key numbers are your:

– Earnings before interest and taxes

– Interest expense

– Marginal tax rate

– Dividend rate, if any, as a percentage of EBIT

– Long-term debt to shareholder equity ratio

– Net assets

– The targeted growth rate

The formula is this:

(EBIT interest expense) x (1 – marginal tax rate) x (1 – dividend payout percentage) x (1 + long term debt divided by shareholder equity) x (1 + the targeted growth rate) (net assets x the targeted growth rate) = needed capital.

Projecting need

In essence, this formula measures your ability to leverage new retained earnings based on past performance. Note that when you subtract interest, taxes and dividends from earnings, you get retained earnings, and that when you divide long-term debt by shareholder equity, you get a measure of your leverage.

These two factors, multiplied together, measure your present ability to leverage retained earnings. The result, multiplied by your targeted growth rate, extrapolates this ability into the future.

Meanwhile, net assets multiplied by your targeted growth rate tells you how much your net assets will grow at your targeted growth rate. This number, subtracted from the earlier extrapolation of your present ability to leverage retained earnings into the future, yields the answer to the original question: How much capital do you need to achieve a specified rate of growth.

To see how it works, assume gross profit of $3 million, interest expenses of $150,000, a marginal tax rate of 40 percent, dividends of 2.5 percent, a long-term debt to shareholder equity ratio of 2, net assets of $6 million, and a targeted growth rate of 20 percent.

Plugging in these numbers, we get:

($3 million – $150,000) x (1 – .4) x (1 – .025) x (2) x (1.2) ($6 million x .2) = $2,801,400.

Some caution is necessary in using this formula because it assumes constants at every step constant interest rates, constant taxes, constant dividends, a constant long-term debt to equity ratio. It even assumes that, with additional capital, your company will continue to show the same return on assets.

In the real world of commerce, these factors change over time; a moment’s thought tells you that as your earnings go up, for example, so will your marginal tax rate, in all likelihood. And anyone who runs a growing company knows the strain that growth puts on cash flow and even on such measures of performance as your return on equity ratio.

Thus, the result you get from the calculation in our example, $2.8 million is in reality only the first step in arriving at a good answer to the original question. Getting a more refined answer requires the use of a computer spreadsheet to factor in different assumptions over a limited range, with different results in essence a range of answers from which you may choose.

Other considerations

There are many other questions to answer in planning any campaign to raise outside capital: How fast can you grow with present earnings? Can your production facilities handle fast growth? How about your distribution system? Your back-office functions? Does your management team have the experience to oversee fast growth?

These questions take time, and you know going in that you can’t really answer them with certainty. Indeed, you must regard the answers you get with the same caution with which you consider the answer to the formula above because in the hurly-burly world of commerce, only time can tell you whether you’re right.

What you do know right now is that in uncertain economic times, the outside sources of debt or equity capital you approach will regard you with a great deal of caution. They will or will not open their wallets to you based on their best estimates of your ability to carry out those plans and the more closely you know what you need in the form of capital to do so, the more likely it is that you will receive the financing you seek.

Paul Gurrola and Eric Lesin are partners at Venture Management Group in Los Angeles and can be reached [email protected] or [email protected].

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