Aubyn Hill
DURING MY long banking career in many parts of the world I have noticed that a great deal of financial pain, personal disappointment and business failure has been caused by entrepreneurs' (and sometimes experienced business practitioners') failure to understand that any business or financial super-structure can be sustained in perpetuity only when built on a strong equity base.
Translated from financial jargon, 'equity base' means the amount of money that shareholders (business promoters and their associates) put into a company. In the last three years I have had the privilege of concentrating on business practices here in Jamaica and if anything, the absence of a strong equity base is even more prevalent than in many other places that I have worked. Most recently as a consultant, it has been brought even more forcibly to my attention how really under-capitalised many businesses are in Jamaica.
LOAN OR CART FOR EQUITY HORSE
Many people, and often new entrepreneurs, have little or no real appreciation for the central and stabilising role of equity in their company. Whenever they have what might be an excellent idea to start a business in order to create a product or services that people in the general marketplace will purchase, they naturally think of getting some money to start the business. At this point one of the most endearing characteristics of money - the fact that it is fungible - becomes the focus of the budding entrepreneur.
The further separation of money into equity - the cash that shareholders put into a company and which is repaid generally only when the company makes a profit - from a loan which has to be repaid on a regular basis, with interest, to a lender is not considered or is completely ignored in the heat and excitement of starting the business. A heavy loan composition in the financial structure of a new company, or even an established one, heightens significantly the risk of failure. This is so because most new businesses will face unplanned difficulties, no matter how well-crafted and thought out the business plan may have been. Those rough and rocky parts of the journey are when most business failures occur because a combination of unexpectedly low revenues (due to production or start-up problems) and the burden of interest and principal repayments on loans will combine to damage severely or destroy a new company. This is also true of even well-established companies whose financial structures get weakened because of insufficient equity and too much debt.
ASSET AND LIABILITY MISMATCH
A closely related problem to the too little equity and too much debt issue is the risk management takes when it uses short-term liabilities (overdraft and short-term loans) to finance long-term assets such as a new piece of heavy equipment, a new factory or a new building. Some managers and owners get lulled into the belief that they will avoid the financial risk because initially, revenues from the new acquisition may be strong. However, if for any reason the expected revenues fail to materialise or changes in the marketplace reduce the flow of cash from sales, then the burden of the need to repay principal and interest on the short-term loans when the long-term assets are no longer producing the expected revenues - at least for a period of time - will cause financial strain, pain and sometimes disaster. Many more entrepreneurs, mangers and shareholders need to fully understand and insist that long-term assets must be financed by long-term liabilities (long-term loans and injection of cash by shareholders in the form of equity). They must further recognise that if they agree to or put in place mismatched financial structures, they are putting their companies and the money of investors at risk.
SOLUTION
The first step entrepreneurs have to take when they need equity is to adjust their mindsets to the fact that getting investors to inject money into a company that is primarily an idea is a tough task. It is also one that takes a considerable amount of time. People in the venture capital business have to always take the long view and be prepared to explain to prospective investors over and over again and from different angles, as well as answer an endless string of questions, before a new investor will take the decision to inject funds into a new company. I was reminded of this most forcefully recently when I attended a venture capital and private equity conference at Harvard Business School. The professors shared case after case where entrepreneurs and business promoters spent months and even years searching for investors and promoting their new companies' ideas before investors would give them cash to start their businesses. Many of these ideas are now household names of successful companies.
NON-TRANSPARENT RIDICULE
New entrepreneurs or established business leaders who seek to take their companies public are often surprised at the scepticism, doubt and non-transparent ridicule they face when they start to sell their ideas to cash-rich investors who now know how difficult it is to make money. Nonetheless, entrepreneurs and business leaders who seek to take their companies public can get professional help to refine their ideas, prepare professional and credible business plans and winning prospectuses which can be the positive lever to get investors to inject cash in the form of equity into their companies. Once the company is properly capitalised with a good business plan then the appropriate amount of debt funding can be arranged from lenders. If the borrowing cart is put before the equity horse then eventual disaster can be expected. On the other hand, getting the right amount of shareholder's equity in place before any borrowing is undertaken is generally a good signal to the lender to lend, and it is the right financial structure on which to build a successful company.
Aubyn Hill is the CEO of Corporate Strategies Ltd., a restructuring and financial advisory firm. Respond to: writerhill@gmail.com
