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How Financial Markets Impact Your Small Business

We see it nearly every day in the financial press and on the financial news channels, the U.S. economy seems stuck in neutral. The credit crisis of 2008/2009 and the subsequent Great Recession disrupted capital flows so drastically that the ramifications are clearly felt nearly 8 years later. Central Banks across the globe have injected multiple phases of quantitative easing (QE) in an effort to stimulate economies and restore consumer confidence. The net result of these policies is an economic backdrop that affords: full employment, minimal inflation, historically low interest rates, affordable commodity prices, modest growth [defined by Gross Domestic Product (GDP)], and healthy equity market valuations.

Depending on which pundit you listen to, the current environment is either terrific for small businesses and entrepreneurs, or it is detrimental. While we are realists by nature, we take a “glass half-full” perspective on the current economic conditions and its impact on small business. Our perspective is predicated on the notion that if you were to reverse one or more of the economic underpinnings mentioned above, you would drastically alter the overall landscape and the dynamics would be decidedly less favorable for small businesses and start-ups.

In fact, a strong case could be made that the current setting is a “goldilocks economy” for consumers, and one that favors small business given the relative availability of capital. The limitation being that you need to be creditworthy, have a concept worth funding, and be able to present it effectively. This is where a well-constructed business plan is absolutely necessary.

We are not going to argue some of the structural issues that have emerged since the Great Recession, or tackle controversial topics like how the Federal Reserve and other Central Bank policies have manipulated and impacted global asset prices. We are, however, going to discuss and present guideposts in an effort to make more informed decisions regarding the capital markets and access to funding.

 

Business Maturity, Vision, and Sightlines

It happens to most entrepreneurs at some point – the business reaches an inflection point at which the operations require additional capital. In general, there are two conditions under which funding occurs:

1) an unprofitable business or concept requires money to continue operations; or

2) a profitable entity that requires capital to expand and grow its operations.

 

Beyond the start-up rounds of funding that customarily involve friends and family, most enterprises require an investment partner at some point. This associate can take the form of a bank, a private investor, a public entity, or possibly a combination thereof.

While there are exceptions for highly visible start-ups, the timeline for selectively raising capital can take anywhere from 6 months to a year, or longer. As a result, business owners need to plan accordingly. They need to identify their cash needs and, as we advocate in our narrative The Art and Science of Financial Modeling, maintain realistic financial assumptions. These expectations should be updated regularly and correspond to the reality reflected in the recent results.

Experience tells us that business owners usually wait far too long to begin their quest for money, and in the process put their operations in jeopardy. The dilemma faced is one in which cash begins to dwindle, and then financial results start to suffer. The primary difficulty in this situation is the negative perception it has on an organization when they seek additional funding. Moreover, companies in more immediate need are often faced with far less desirable terms from investors.

If profitability is in sight and the organization plans to grow its operations organically, then a mezzanine round of funding from a bank or investor may be all that is required. In such instances, procuring this level of financing may be easier than an infusion of private equity. The downside being, of course, the potential impact of interest costs on profitability.

If financial prosperity and autonomy is deemed to be a longer-term prospect (as is the case with many start-ups and complex businesses requiring multiple rounds), having a clear vision of how the additional funding will accelerate the path to profitability is necessary. Once again, this is where an accurate financial model predicated on realistic assumptions becomes imperative.

Given the ebb and flow of investment capital, the market environment for raising funds needs to be considered in the timeline. For start-ups in particular, this reality may alter the ultimate timing of when a firm actually begins its quest for funding.

 

Availability of Capital and the Business Cycle

The capital formation landscape typically goes hand-in-hand with the business cycle. Capital creation is often robust when interest rates are low and banks are awash in cash – as they are now. The problem is banks are not always willing to advance funds, which is a function of tight lending standards borne from lessons of the past.

Back in the heady dot-com days, investment banks (including the one where I was employed) identified a $1 million per quarter sales run-rate as a prerequisite for floating an initial public offering (IPO). At the time, many of these dot-coms did not have any profits – they had the PROMISE of profits. Talk about “selling the sizzle!” (In our missive, The Art and Science of Financial Modeling, we examine some of the overly inflated financial assumptions that drove these excesses during the late-90s.) Once this reckless era came to a climactic conclusion, investment capital became difficult to draw upon due in part to tight lending standards, and a general unwillingness for banks to lend to all but its most creditworthy clients.

Fast forward to the credit crisis of 2008/2009, and the subsequent Great Recession that ushered in another period of tight capital controls. Having been severely burned by what would be deemed lax and reckless lending standards in the early to mid-2000s, banks tightened their requirements to the point where credit became more or less frozen. Counter-party risk became the chief culprit this time around and unlike the dot-com bust a handful of years earlier, banks were not extending credit at all. And those that did, offered outrageous terms.

When traditional lines of bank financing are essentially closed to small businesses, private equity, venture capital, angel investors, and investment banks serve as the primary sources for capital. In this situation, and depending on the amount of capital at hand, the terms of funding are usually not as generous. In other words, the implicit cost of capital is higher and the terms not as generous, which plays to the detriment of business owners.

 

Cost of Funds

During NORMAL business cycles, interest rates run correspondingly with the rate of growth, measured by GDP. We emphasize “normal” in this instance because the last recession has been quite abnormal for reasons that go beyond the scope of this narrative. Historically, however, interest rates tend to be higher during periods of growth and excess (“boom times”), and tend to be low during recessionary times. Owing to the Great Recession of 2008/09 and the fallout that ensued, the cost of funds, defined by the London Interbank Offer Rate (LIBOR) and short-term U.S. Treasury rates (90-day T-bills and 2-year Notes), remain at historic low levels.

Due to the extraordinary circumstances not only are interest rates low, but the U.S. is in the midst of a prolonged period of modest growth. Business owners and start-ups should realize that this is highly unusual situation. A low cost of funds environment is traditionally observed during recessions, when growth is flat to negative.

For businesses that exhibit low cyclicality and depend less on the health of the consumer, a recessionary environment may not crimp sales as much as those that are highly cyclical in nature. In fact, some pundits argue that starting a company during periods of muted demand may not be worse thing, as long as ample cash is available.

In theory, opening a business when aggregate demand is lagging long-term trends can be problematic as sales are empirically more challenging to come by. However, as discussed in our narrative, When is the Best Time to Seek Funding?, we favor the basic principle that “you raise money when you can.” And it is almost always preferable to take advantage of a lower cost of funds environment. The advantage here is that once the market pivots into an expansionary phase, the business benefits from improving sales, as well as its low cost of capital.

 

Valuation

Aside from the availability and cost of capital, the amount of money a private company can raise at any point in time is in part a function of how the business is valued. Like many aspects of finance and investment, valuation is a bit of art and science. Private equity is similar in many respects to real estate as it is both a subjective and inefficient market. In an effort to appraise any deal, investors frequently turn to the valuations of similar entities (known as comparables or “comps”), whether they are publicly-traded or private in nature.

In the case of private markets, finding similar transactions within a particular industry can be more difficult. The availability of details surrounding capital formation is often lacking and the number of relevant, observable deals is smaller.

In contrast, public market valuations are readily discernible with daily price discovery. However, the pertinent companies within a specific industry are usually much, much larger and more complex, making their true comparability somewhat questionable.

Even though a vast majority of small organizations will never grow up to be publicly-traded entities, we advise business owners to be aware of public market valuations in their industry. For a private company in the medical device industry, for instance, it would be wise to compile a list of comparable entities and analyze their financials, as well as their average trading multiples.

Of the numerous valuation measurements available, enterprise value to EBITDA (earnings before interest taxes depreciation amortization) is often preferable within the investment community as it relates the total value of an organization (equity and debt) to its level of profitability (EBITDA). Other metrics such as price-to-earnings (P/E), price-to-book value (P/B) and price-to-cash flow (P/CF) have limited value by comparison, but can be useful to analyze potential deal metrics. Keep in mind that public equity valuations can be incredibly dynamic with prices being determined by financial markets that can exhibit considerable volatility.

 

Summary

While it is nearly impossible for anyone to operate a small business full-time and keep abreast of all relevant aspects of the market environment, we believe it is worthwhile to be aware of a few important aspects. In our view, enterprising owners are best served by being familiar with the conditions surrounding the availability of capital, the cost of funds, the valuation of similar organizations, and the state of the business cycle. In doing so, they are equipped to make better decisions regarding the timing of critical capital transactions that can ultimately reduce costs and increase the intrinsic value of the organization.