When companies consider larger growth plans, their internal resources may often be inadequate to fund the next, expansionary stage of development. As a result they need to turn to outside financing. Depending on life-cycle phase, growth strategy and financial needs, companies have a choice of financial instruments and partners. It is advisable to analyse the available options at an early stage when planning a growth project.
Growth strategies and financing options
It is necessary to distinguish between specific forms of financing on the basis of the company’s life-cycle phase and its strategic decision in favour of expansionary development: growth financing, capital expenditure financing, acquisition financing and project financing. In principle, all of these forms of financing are basically concerned with growth. Hence, it is not always possible to clearly distinguish or define the appropriate form of financing for the adopted strategic measure.
Sources of growth financing
The prime source of financing for risky projects are investors willing to bear the correspondingly higher level of risk. These may be existing shareholders or, depending on the risk involved, venture capital or private equity firms or risk-bearing providers of capital. As a reward for bearing greater risk they will expect to receive correspondingly higher returns. The degree of risk will also determine the form, conditions and sources of the financing:
In the expansionary phase, but also in the later phase, private equity is a possible and frequently used form of financing. In this case the growth capital is put up in the form of equity. This usually gives the private equity investors a considerable say in operations and, on account of their broad and solid industrial experience, they often assume management functions (as a rule through seats on the supervisory bodies). Because this form of financing does not involve interest or amortization payments that impact business performance, the financing costs are neutral in their effect on profits and demands on liquidity. With respect to expected returns, however, private equity is a very expensive financing vehicle. By putting in equity, private equity investors participate in the success of the business and, hence, share the risk in full. By accepting greater risk, private equity investors expect correspondingly high returns. This takes the form of appreciation in the value of their capital investment, which they realize by exiting the company through a stock market flotation, a sale or a buyback. Therefore, private equity investors are strongly exit-oriented.
Initial Public Offering (IPO)
SME’s relatively rarely use IPOs as a means of financing growth, which involve high financing costs on account of the numerous regulatory provisions. In addition, this form of raising capital involves conditions of long-term compliance with respect to company size, business model and investor and stakeholder relationship management.
Mezzanine financing is a hybrid form of financing that, depending how it is legally structured, usually takes the form of debt with equity-like components. Because it offers great flexibility in its structuring, mezzanine capital can be used for a variety of transactions. Besides leveraged buy-outs and spin-offs, it is often favoured for growth financing. In respect of financing costs (rate of interest and expected rate of return), mezzanine financing is cheaper than pure equity financing, but more expensive than classic debt financing.
Classic financing through bank loans is only one of various financing possibilities using external funds. As lenders usually require security and are only rarely prepared to finance risky projects, the use of classic loans for growth financing is restricted. In addition, financing using borrowed capital involves a specific term and is usually tied to a specific purpose. As regards financing costs, borrowed capital involves interest and amortization payments, which weigh on the business operations and liquidity of growth-oriented companies. The conditions attached to this form of financing depend on the company’s creditworthiness (company rating) and the purpose of the financing. Compared to forms of financing based on equity capital, for which the expected returns rise with risk, borrowed capital is a relatively cheap form of financing on account of the higher collateral requirements.
As an international, independent consulting firm focused on small and medium-sized companies (SMEs), we accompany and support you in your financing project. We look forward to welcoming you to a personal meeting to discuss your growth project and consider the suitable form of financing.