Grants are the rarest and least important source. They probably should not even be mentioned except that they are extremely useful to entrepreneurs who go after and succeed in getting them . They usually come from government, corporate, industry, or charity sources and are either recognitions of past achievements or are seed or sustaining funds for some socially, economically, or technically beneficial endeavor.

Depending on the stage of development the business is in, perhaps the most important form of grants is for workforce training and education, usually of disadvantaged, or displaced workers. The best advice on grants is: if you are lucky enough to get one, thank your benefactors profusely, but do not base your company=s future on receiving handouts.

Grants, especially those administered by agencies of the federal government, are to be used for a specific purpose and very rarely involve actual cash. It is more likely that, as in the case of Dwayne Fosseen, whose company, Mirenco, of Radcliffe, Iowa, received a grant from the Department of Energy, services in kind. Mirenco got a fully-tested, manufacturable prototype from DOE engineers.

Debt is the most widely used external source of capital. The three main sources of debt, commercial mortgages, commercial and industrial bank loans and trade debt, account for more than 90% of all identifiable sources of funds. Since the other sources of finance (private placements, business angels, venture capital funds, initial public offerings, Regulation A offerings and intrastate and interstate public offerings) may also have a debt component, the actual number is probably much closer to 98% of total small business financing.

The situation is much changed for large companies. They tend to rely far more on equity for capital. The actual ratio of long term debt to total capital varies between industries, but debt rarely accounts for more than 50% of total capital. In most cases, long term debt accounts for less than 20% of a company=s total capital.

Why is it that small companies rely on debt and larger companies on equity? Is there some intrinsic difference between a large company and a smaller one that makes debt preferable in one case and equity in another? Clearly, the corner gas station is not an embryonic Exxon and the local hardware store is a long way from becoming Sears Roebuck and Co. But, do those facts indicate that small companies must be limited to debt in seeking finance?

Asked another way, is the ideal capital structure for a small company appreciably different than that of a large company? Unfortunately, no one knows what the ideal capital structure for a typical small company should be since there is really no such thing as a typical small company. The ideal capital structure for a given company will have to be determined at each stage of the company=s development.

Capital stretchers, rather than sources of capital is joint venturing, cross-marketing, strategic alliances, etc., in which expertise, equipment, facilities, manpower and equipment may be shared by entities engaged in some mutually advantageous undertaking. For instance, brand new equipment or software may be provided to a promising startup as a beta test. The idea being that the manufacturer wants to know if his ideas are right for the startup's market. Clay Womack managed to get IBM to provide him with Lotus Notes applications, servers and support because IBM wanted to know how its products would perform in that environment. Dell Computers also provided hardware for the same reasons. Not only was Womack the first into an area which has become the huge online stock trading market, but he was able to convince IBM and Dell that he could provide useful information.

Capital: Should You Buy or Rent?

The basic rule for start-up companies, never buy what you can rent, is generally not true when it comes to cash. It is impossible to say how many small companies have remained small because they rented their cash through debt rather than bought it through equity. Since equity financing is an almost infinitesimal slice of the small business capital formation pie chart, the answer maybe, "a significant number."

The logic is inescapable. If a company needs all the capital it can get its hands on, then the interest and principal payments it must make to service its debt have to come from the vital stream.

There would be no questions about the wisdom of using equity rather than debt to finance growing companies if it weren't for conventional wisdom which holds that "equity is the most expensive form of capital."

Assume a company has the option of borrowing $50,000 at 20% or selling 20% of its stock for $50,000. The company expects to make $100,000 in profit this year. The tax rate is 30. If the company borrows, the cost of capital is: The interest rate times 1 minus the tax rate (what remains after taxes have been paid), or

20(1-.30)= 20(.7)=14%.

If the loan could be paid off in one year, the interest cost would be $7,000 and the company would retain $93,000 in net income. It=s total payment would be $57,000 (the loan principal and the interest), leaving the company $43,000, or $30,100 after taxes.

In addition to the computable direct cost of borrowing money one must consider the additional costs of complying with the lenders rules, or covenants. These are of two types, the negative covenants which cover what a borrower can=t do, and the positive ones which tell the borrower what he must do.

They are all designed to protect the lender=s investment. The lender will generally require the borrower to provide financial information on a regular basis. The lender may restrict the borrower=s ability to borrow any more and may set limits to the amount of dividends or other distributions the borrower can make. The lender may also require the borrower to maintain specific amounts of working capital and limit accounts receivable or excess inventory to raise cash.

The generally accepted formula for the cost of equity is the new owners= stake of the profits divided by the amount they invested.

Since the new investors bought 20% of the company, they are entitled to $14,000 of the $70,000 net after tax profits. Thus, the cost of equity is $14,000/$50,000= 28% about twice the cost of debt.

The reality is that while you have to pay the bank both principal and interest, no one would expect a fast growing corporation to distribute 20% of its profits to its investors. Partnerships might do that, but since corporate dividends are taxed twice (the corporation has to pay taxes before it distributes dividends and the recipient must declare the dividends as income on his taxes), such a distribution would make no sense. The investor wants the value of his stock to increase so he can recognize a profit when he sells. The corporation has the use of the money and never truly pays it back.

But what happens next year? The company which borrowed $50,000 last year, has retained $30,100, and so must borrow $19,900 to make its $50,000 investment. The company which sold equity has retained $70,000 which it can invest and will not have to sell anymore equity, or borrow. It will, presumably, make a $140,000 before tax profit, $98,000 after taxes. The borrowing option would leave the company with a net after tax profit of $53,284. Now, although neither company has to borrow, the company which sold equity is clearly well ahead of the company which borrowed.

The real expense comes from the fact that when an investor buys a share of common stock, equity, he is putting his money at risk. He has no collateral as he would for a loan. In exchange for taking that risk, the investor expects, if the company is successful, to make a higher return on his money than he would get from a secured investment. How much more depends on how risky the investment is perceived to be. In mature companies with very little apparent room for growth, the investor demands a dividend in addition to the possibility that others might think the shares are worth more than he paid for them and bid the share price up.

In the case of a growing company, equity investors realize that their future profits depend on the company retaining as much money as possible, so they are willing to forego their dividend in the belief that the company will get a better return from that money than the investor can. That better return will translate to a higher stock price some time in the future.

The putative high cost of equity comes from the fact that the investor is expected to demand a large part of the company in return for his investment. For instance, assume that a company wants to raise $1 million by selling 10 percent of its shares. That means that the company is saying that it is worth $10 million. The investors might say that the company has much too high an opinion of itself and they will not buy the stock unless it represents 20 or 30 percent of the company, in which case, the company would be worth only $5 million or $3.3 million. If the company agrees, it will buy $1 million worth of capital with what it believes is $2 million or more of equity.

If the company's management is right and the company is worth $10 million, the value of the stock it sold for $1 million would be $2 million. The company paid twice as much in equity as it should have.

Determining what your company is worth is a complex process which starts out as pure guesswork when the company is in the formative stage and progresses to confusion as the company matures. There are something like 30 recognized measures for determining a company's value, not one of which produces a result equal to the result obtained by using any of the other methods.

The value of a small, or startup company depends on the ability of management and the validity of their idea. Unless there is a large pool of companies in the same business with the same technology, it would be impossible to arrive at an accurate appraisal of the company=s future value. The combination of the idea and management can produce a whole which is either larger or smaller than the sum of its parts.

If the future value of the company cannot be determined, the cost of equity capital cannot be computed.

In point of fact, most investors in small company stock don't really consider the value of the company, or how much of the company their investment buys. They buy as much as they can afford, if they believe that the company's idea has merit. Since it is extremely difficult to evaluate a company with a future, but no past, perhaps they are correct to do so. A number of small companies which the investment professionals thought were priced too high have made handsome profits for their investors.

Almost everyone thinking about starting a business considers whether to buy or rent a place of business and any machinery that might be needed for that business. Nowadays, even the workforce can be rented, thus relieving the company of a considerable financial burden at the cost of loyalty and team building.

Very few of us think of borrowing money as renting it. and even fewer think of buying it.

While the choice between purchasing and renting is extremely important in its own right, that importance pales beside the simple realization that one is not selling stock, or bonds, one is buying capital. When you think of selling something, you are generally getting rid of something for which you no longer have any use in exchange for "what you can get for it." When we buy things, we operate under two important thoughts. The first is, "What will I have to give up to get what I want?" The second is, "what is the capital I will get really worth to me."

The balance between how much purchased and rented money a company is using is the company's capital structure. Capital structure, in turn, is a measure of corporate flexibility. There is a definable limit to how much a company can borrow. If the company reaches that limit, there may be things it really should do, but can't. On the other hand, if the company gives up too much equity in exchange for capital, you may lose the right to determine what to do with that capital since you will no longer control the company.

No one has come up with a way to determine the best capital structure for businesses in general. The rule that does work is to match the expense with the appropriate style of capital. For instance, a company should not borrow money to pay its workers. Wages are an ongoing cost. The workers will have to be paid every week. No company could afford, or would be able, to continuously borrow funds for that purpose.

Dividend payments are used to compute the cost of equity capital, but they don't usually figure in the cost equation for small businesses. A growth company is not expected to pay dividends. The investors expect to harvest profits when one of three things occur: 1) The company is sold, 2) the company does a public offering, or 3) the company's management gets tired of sharing the company and buys out the investors. In those cases, how expensive equity capital turns out to be depends on how much of the company the founders are prepared to give up in their purchase of capital.

Stewart-Gordon Associates, Inc.
P.O. Box 781992
Dallas TX 75378-1992
voice (972) 620-2489
fax (972) 406-0213
e-mail Tom Stewart-Gordon