The difference between venture capital and working capital
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.