Too Much Funding Can Kill Your Business
Funding is essential for a business to carry out daily operations. The choice of how to attain funding is a decision made by the business owners and there are multiple options available. The decision to seek a certain type of funding is not governed only by the owner’s discretion; there are external factors that affect a business’ funding choice. Examples of such factors include the solvency of the founders, the amount of money that is needed to run the business and the financing required to maintain the business.
The choices available to business owners for funding are diverse and characteristically different. This means that some forms of funding are preferred in certain situations than others. Bank loans are a popular choice for small businesses and opening a line of credit or corporate credit cards have also been popular choices. If a person wants to keep the business out of external risk, they can dip into their savings, take out a loan from a 401k or get in investment from family and friends.
In this article we will review the 1) importance of funding for a business, 2) the dangers of too much funding, 3) financial leverage, and 4) concerns related to financial leverage.
IMPORTANCE OF FUNDING FOR A BUSINESS
Before a company can get started, it needs seed money. This covers the most basic startup expenses. Seed money triggers the initial push a company needs to enter into the market. Typically seed money is used to buy materials that get the business into ignition. This includes office supplies, other office equipment, setting up a business website, business cards, etc.
The next reason for funding is the cash flow a business needs. When a business starts to operate the profit and revenue is generally low and cannot cover much of the regular expenses. The business owner themselves need to get a salary for personal expenditure and if they have employees, their wages or salaries need to be paid on time as well. Apart from the people, the business operating site require rent, utilities, insurance and a list of other regular expenses that need to be taken care of.
Your business is now doing well, it has taken off and the demand for your products or services has increased. Expansion is the next step and with it come new expenses. If your company has outgrown its current operating offices and you require a bigger space, that means more rent. Increased demand for your product creates the need to increase manufacturing, hire new employees and therefore an increase in funding. Thus to expand your business you need funds, the amount of which depends on the extent and type of expansion.
When running a business you cannot expect everything to run smoothly. Natural disasters can occur and completely uproot a business, and even though there is insurance that provides cover for such incidents during repair times, there are expenses that need attention. Coming to less disastrous outcomes, there might be equipment that needs to be fixed; some of the outdated machines might need to be upgraded. And for such tasks, external funding options can come in handy.
DANGERS OF GETTING TOO MUCH FUNDING
The decisions that people make in the starting stages of their business regarding funding leave a lasting impact. The decisions made in the initial stages of business have an impact on how the company will mature and grow. So, decisions regarding funding need to be made in an informed manner.
Below we discuss some of the dangers of too much funding.
Raising Too High of a Valuation
Although taking on greater funding might seem like a good idea, it does have its downside. Gathering high valuations initially can lead to expectations that maybe out of the reach of a company that has only just begun operations. Companies that are new market entrants might not have the market knowledge to achieve targets that come coupled with high value funding.
There is also the need to manage company expectations; during the seed period companies do not have substantial evidence to support the ability to deliver high targets, thus creating concerns of the business being overvalued. A better idea for a seed-stage business would be to begin with small amounts and achievable targets; this will create a solid base to attract better quality investors who can nudge the company in the right direction.
Not Being Selective About Who You Want Investing In Your Business
Business owners need to scan and filter the potential investors they have attracted so that they can maintain a small and efficient investor base. The idea behind being selective of investors stems from the notion that a large number of investors can be difficult to manage. It is better to have a small number of investors fill a financial quota than several. Let’s say a small business has sixty investors (a large number for a small business) this means that when making decisions the business proprietor will need to take into account sixty opinions and sixty expectations.
Regarding this point institutional investors are a great choice; they generally invest for a long time and can be very helpful. On the downside institutional investors can be high maintenance. The second choice of private and small investors leads to more agile investors but handling them can be time consuming.
Choosing the Wrong Angel Route
As a follow up to the previous point, there is also the need for entrepreneurs to scan and filter investors for quality. The number of investors should be small and well informed; this cuts back the time it takes to explain to investors menial things. If you have a large investor base then you should establish a one person proxy for a group of investors.
When you are scanning and filtering investors for quality choose those who have had experience investing in your respective industry. They can provide helpful information and explain some of the workings of the industry to new industry entrants.
Financial leverage refers to borrowing of funds in order to expand business, increase production, increase sales and earnings. Its figure value is calculated by dividing the total debt of a company by the total assets of the company. The larger the figure, the greater is the financial leverage.
A widely recognized measure, financial leverage is used in numerous business analyses. Helpful in the case of both institutional investors and small private investors, it helps in determining whether a business can help in achieving the objectives or not.
Managing a business’ financial leverage is an important decision. The decision is never black or white, increasing your financial leverage can be good under certain conditions; for example during times of economic boom it is generally beneficial for businesses to borrow funds to attempt to increase revenue. But during recessions high leverage can cause serious cash flow problems for businesses.
The question regarding financial leverage is not only about borrowing funds, but also how much to borrow. On the plus side, given favorable conditions, borrowing more funds and increasing your financial leverage helps the company grow and can also help in increasing revenue so taking on greater leverage under favorable conditions seems like the right choice. In contrast borrowing more funds leaves your business with higher interest expenses and the potential for greater loss, since higher interest costs increase a business’ breakeven point. A large amount of leverage also means greater debt; this can cause a person to lose control of their business as covering the debt becomes a primary objective of business operations thus restricting the business.
CONCERNS RELATED TO FINANCIAL LEVERAGE
Occasionally described as a double edged sword, financial leverage is important in business management. Helpful when employed correctly, financial leverage has the potential to be highly beneficial to a business. It can also be damaging to a business, taking on more debt can ruin a business’ image in the market not only for investors but also for financing institutions as a falling credit rating will only be harmful to the business. Greater fixed costs due to interest expenses also have the potential to reduce profits.
Taking on financial leverage has certain side effects on a business that can affect it minutely or significantly. It is the process of employing the gathered funds that is determinant of business prosperity or decline. There are external factors out of the control of business owners that play a part in how effective the gathered funds are.
Below we expand on some of the concerns related to financial leverage.
Interest expense is a tax deductible expense; this characteristic is a motive for businesses to borrow as borrowing now becomes a cheaper source of financing. But the cheaper source of financing requires the return of the principle amount plus interest. So when a business takes on too much debt the interest expense increases accordingly, this puts a drain on the business profits as more and more of the revenue is spent to cover the interest expenses.
Taking on large amounts of borrowed finance may also make creditors suspicious about a business’ ability to repay the debt. This will make future financing difficult and may lead to the business’ credit rating to fall. The higher interest expense also drains cash and liquidity, leaving the business at risk of bankruptcy should cash fall short.
When a company takes on leverage to better its performance, there are cases where the debt has negative side-effects. Successfully employed financial debt can help in expanding the business and increasing revenue which in turn increases a company’s EPS. The higher EPS is beneficial not only for the company but also for potential investors.
But when businesses take on too much debt the increasing interest expenses and default risk act as a disincentive for investors. The high default risk causes potential investors to look at the business as a potential failure and also causes existing investors to take out their investments from the business. The decreased demand for company shares coupled with existing investments being drawn out lead to the decline of the company stock. And because too much leverage leads to difficulties in selling equity, the company has to take on more debt to finance itself. This extends into a circle of taking on more debt that eventually ends in bankruptcy.
Even though the purpose of taking on financial leverage is to magnify profits, it can also result in the magnification of losses that a business might incur. It is under favorable conditions that a business can magnify its profits and pay off the debt it has taken on. But in the case of a business not going smoothly the losses that might occur are also magnified. This is the case because when a business has taken on more debt it has increased its interest payments. So if the business is not earning enough revenue and cannot cover its fixed costs, the higher interest expense only increase the losses that the business in incurring.
Explaining this concept using examples, we assume that a business has borrowed immensely to fund new capital it plans to use in production. As it starts the increased production the demand for their product decreases in the market, this leads the excess product as well as some of the previously produced product to become surplus. Now with higher fixed costs due to taking on greater debt the loss for the company is magnified.
Higher Break-even Point
The concept behind a business earning profits is earning enough revenue to cover all its costs and still have some money left over. The costs consist of fixed costs, the costs that have to be primarily filled and variable costs, whose values can be altered. When a business takes on financial leverage and borrows funds to help it grow, the interest payments become a part of the fixed costs. This means that before other tasks the objective of the revenue generated is to fulfill the interest payments.
Now as a business takes on more and more debt the fixed costs keep on increasing due to the addition of new interest expenses. This demands that the business generate more revenue if it is to maintain its level of profit. The demand for greater revenue to earn profit is the higher break-even point for the business.
In conclusion more debt leads to higher interest expenses (higher fixed costs) which require greater revenue to be fulfilled thus a greater break-even point for the business.