Tweet

The Difference Between Venture Capital and Working Capital: Why Knowing the Difference Can Help Your Business Survive

Guest post by: Tom Klausen

Article Overview: It is not uncommon for business owners suffering through a cash flow crunch to determine that bringing on an equity partner or investor, such as a venture capitalist or angel investor, will solve all their problems. Unfortunately, many businesses have failed due to this kind of thinking. Specifically, these owners did not understand the difference between equity financing and working capital. Often, what these businesses really need is simply a boost in or access to more working capital.

The Difference Between Venture Capital and Working Capital: Why Knowing the Difference Can Help Your Business Survive

It is not uncommon for business owners suffering through a cash flow crunch to determine that bringing on an equity partner or investor, such as a venture capitalist or angel investor, will solve all their problems. Unfortunately, during my 28 years in the alternative business finance industry, I have seen many businesses fail due to this kind of thinking.

Specifically, these owners did not understand the difference between equity financing and working capital. I’ve seen good, profitable businesses blow themselves up because of cash flow problems, and entrepreneurs lose ownership and control of their companies before they had a chance to succeed. A lot of this grief could have been prevented had the owners opened their minds and taken the time to seriously look at all the financing options that are available to them.

Often, what these businesses really need is simply a boost in or access to more working capital. “There is a big difference between increasing working capital and bringing on an equity partner,” says Davis Vaitkunas, an Investment Banker and President of Bond Capital in Vancouver, BC.

“While owners suffering from cash flow problems may think their only solution is a large injection of cash from an equity investor, that could very well be the worst possible thing to do,” says Vaitkunas. “In fact, the math will demonstrate that the owner who funds 100 percent of his or her working capital with equity earns a lower return on owner’s equity.”

Working Capital vs. Equity Financing

At this point it might be helpful to clarify some terms. For starters, “working capital” is the money used to pay your business bills until the cash from sales (or accounts receivable) has actually been received. Terms for sales vary among industries, but normally a business can expect to wait somewhere between 30 and 60 days to be paid. Therefore, as a general rule, your business should retain two times its monthly sales in the form of working capital. You can increase the amount of available working capital by retaining profits, improving supplier credit, or using alternative financing vehicles.

“Equity financing,” meanwhile, is money a business acquires by selling some of the ownership shares in the business. In many cases, this can also involve giving up control in some or all of the most important business decisions. This can be a good thing if the investor brings in some unique expertise or synergy to the relationship. However, the terms of an equity investment can be complicated, so it is important to completely understand them and have good legal counsel. Think of it as a business marriage.

According to Vaitkunas, “Businesses should use equity to finance long-term assets and working capital to finance short-term assets. You want to apply the matching principle and match the length of the asset life to the length of liability life.” A long-term asset takes more than one 12-month business cycle to repay, while a short-term asset will normally be repaid in less than 12 months.

When to Dilute Equity

“Equity is a precious commodity,” Vaitkunas stresses. “It should only be sold when there is no other option. The equity partner should bring experience and/or contacts that cannot be found elsewhere.” The best strategy is to secure equity financing at a time when you can negotiate and preferably dictate some of the terms. Ideally, absolute control should remain with the owner.

Timing is everything when it comes to equity financing, Vaitkunas continues. “Sometimes it’s best to simply take your time and wait for the best value proposition. While you’re waiting, you can grow within your means using short-term liabilities.”

It’s usually not a good idea to look for equity when a business is new, struggling to earn a profit or suffering from a setback. Unfortunately this is exactly the time when many business owners start thinking they need to “find an investor.” This process can take a lot of time and consume a lot of energy, which are taken away from the business, and this can have an aggravating and compounding effect on the existing problems.

As a rule of thumb, equity partners should only be sought once a company has a proven track record of sales and profitability and there is an identifiable and specific need for the money. Then, it is important to show how an injection of capital will create even greater profits and higher sales. A business that has a proven level of profitability, some historical sales growth and even more future sales growth potential is a much more attractive investment to potential equity partners.

Financing Working Capital

Working capital shortages are a short-term problem that can be financed with senior debt or mezzanine debt. In the alternative, short-term financing is also available from factoring or A/R financing providers who look to certain accounts receivable and inventory assets as collateral. A combination of these types of alternative strategies can boost available working capital to the point where the need for an equity partner disappears.

So how do you decide which financing tool to use for the job? “If you are tempted to consider an equity injection to resolve growing pains, you must also consider possible partnership risk along the way and the true cost that equity can bring down the road,” says Vaitkunas. The best working capital solution may be an accounts receivable line of credit, which costs less than equity and does not introduce partnership risk.

The bottom line: There are many alternative options available to businesses in need of a cash infusion other than taking on a partner or shareholder. It is important for every business owner to know and understand all of the options before making such an important decision. Knowing about all the options that are available—and understanding when it’s best to use which one—could prevent a lot of grief and hardship for a lot of business owners.

Related Articles
  Venture Capital & Recessions
  The Biggest Obstacles I Had To Overcome
  The Venture Capital Capital Calamity Thing
  VENTURE CAPITAL INVESTMENT IN INDIA
  Venture Capital and Angel investors - Challenging to raise money outside of Canada
  “Tips For Entrepreneurs In Selecting A Venture Capitalist”
  Contacting The Venture Capitalist
  4 Ways to Increase Working Capital
  Working Capital Financing
  Venture Capital - Getting Ready
  Phrase du Jour: Venture Tourist
  How does my firm attract Venture Capital?
  Diligence
  The Six things you must have to buy a Franchise
  How to Pickup a Venture Capitalist
  How To Valuate Your Business
  Getting Started In Real Estate Investing
  How Do African Businesses Get Start Up Capital?
  Traditional vs. Non- Traditional Financing – What are the differences?
  Fred Wilson and the Venture Capital (Non-)Cartel

Article Tags: alternative business finance, cash flow crunch, cash flow problems, working capital
Referred by: http://www.cfgroup.net



Related Forum Posts
Del Castienne - International Business and Project Brokers - In addition to the above, Del Castienne is an international brokerage firm specializing in various entrepreneural services. Del Castienne is more than just a brokerage, as we facilitate Private International Venture Capital for Business and Projects from Commodity Speculation Transactions, MBO, MBI, M&A, Bridging Finance, Patents, Branding, JV, Corporate Advisory Services, Business Plan Development, etc.. Del Castienne is linked to 1200 private international Venture Capital consortiums and Funding Syndicates with a funding capacity of $ 115 billion and 5000 international Investment Bankers and Business & Project Brokers. This in itself should provide you with a gateway to the best source of funding in the world. Through Del Castienne any entrepreneur can have up to a potential success rate of 25% (conditions apply) with absolutely no up front costs. Del Castienne charges a maximum of 5% commission which is far below the international standard of 10% - 12% on project value. If you are tired of running back and forth with countless dissappointments, please give us an opportunity to assist you. Our minimum Venture Capital amount is $1 million and we a Commitment Letter can be provided with in 30 days after formalities are in place and your information was received.
New Small Business Topic - Hello everyone, I'm on the lookout for new topics to add to my site. We just launched a Franchising section and are planning Human Resources section. Do you have any thoughts for a new section? Here's a list of what we currently have: Angel Investors Branding Bank Loans Business Coaching Business Plan Franchises (New) Insurance Legal Marketing Public Relations Sales Small Biz Loans Venture Capital
How to valuate a business - Hi Garth - here is how we did it at Northern Crown Capital when I was helping them raise venture capital for Toronto-based entrepreneurs. Assume the start date is 2003 so 2008 projections are 5 years out: How Northern Crown Capital Valuates a Business 2008 Financial Projections Earnings Before Tax $5,865,000 Tax Rate 42% Taxes $2,463,300 Net Earnings $3,401,700 Amount Seeking to Raise Today $3,500,000 Discounted Value of Future Opportunity, 5 Years Out 2008 P/E Ratio 15 Value of Company in 2008 $51,025,500 Discount Rate Applied 30% Year 2008 $51,025,500 Year 2007 $35,717,850 Year 2006 $25,002,495 Year 2005 $17,501,747 Year 2004 $12,251,223 Value of Company at Investment in 2003 $12,251,223 Less: Investment Amount $3,500,000 Present Value $8,751,223 Discount for Risk & Private Company 40% Less: Discount for Risk & Private Company $3,500,489 Private Company Value $5,250,734 Present Value (What the Owner Keeps) $5,250,734 60.00% Financing (What the Investor Gets) $3,500,000 40.00% Total $8,750,734 100.00% I hope this helps!
I have an invention, now what do I do? - I am sure that a lot of this is covered in different topics, but as a new inventor, I have some questions. Bit of info for you, so you know where we are. 1. I have a working prototype. 2. This is a web based piece of software. 3. The software has to do with social media. (Although it is not a social site) 4. It is a tool for social media users. Cross platform, meaning, Facebook, twitter, linkedin etc.. all the major ones. 5. We have active users. This is a tested solution with real users. We did a market test and had 40-50 users signup within 1 day. We are currently not accepting new users until the beta is completed. 6. We are ready to start looking for Venture Capital or Investors. Where should we start? Patent? First to market? NDA's? Anyone have experience in this realm? What should we do first? .
Re: Kevin's Case Study #8 - How do you attract a finance expert? - These are all really great ideas. The other thought is to go back to your own friends, clients, suppliers and find out who they use. I got introduced to an amazing person, Devon Cranson at Cranson Capital, by asking around. Nothing beats a recommendation from a trusted source Jude


Share this article with your friends. Fund someone's dream.

Leave a comment below or share on the left and you'll help support entrepreneurs in Africa through our partnership with Kiva. Over $50,000 raised and counting - Please keep sharing! Learn more.

Newsletter

Get advice & tips from famous business
owners, new articles by entrepreneur
experts, my latest website updates, &
special sneak peaks at what's to come!

Name:
Email:

Popular Articles

Marketing & Sales tools – going back to basics

The Importance of Master Data Management (MDM)

RULE YOUR BUSINESS LIKE A SHINE STAR

Suggestions

Email us your ideas on how to make our
website more valuable! Thank you Sharon
from Toronto Salsa Lessons / Classes for
your suggestions to make the newsletter
look like the website and profile younger
entrepreneurs like Jennifer Lopez.