When is the Best Time to Seek Funding?
If there is anyone who can identify the exact moment (day and hour) a company should seek funding to optimize terms, they should be considered for a spot on Mount Rushmore or have a bust displayed in the Smithsonian Institute. Kidding aside, the decision of when to go to market, like many aspects of investing, is a combination of art and science. The reality is that no one knows if and when the financial markets will accelerate, creating a healthier investment environment and the opportunity to either raise more capital or do so at better terms. While we can apply some general rules and a few basic, fundamental indicators to make an intelligent and informed decision, we are still venturing into the unknown.
Many years ago and when I was just starting out in the investment world, a senior colleague told me as a matter of fact, “you raise money when you can.” It may seem strange, but few assertions have stayed with me the way this one has. If you ponder that statement long enough it will not only drive you nuts, but also lead you down a path that considers many aspects of corporate and investment doctrine that regularly fills collegiate and professional textbooks.
In an effort to not bury the lead, the rather simplistic notion that “you raise money when you can” is generally correct with its roots firmly tied to some imprecise rationale. But we have found a few instances where it does not necessarily hold up, and those should be understood as well. Accordingly, we analyze both sides of this argument.
“Go on, take the money and run”
The idea that “you raise money when you can” certainly holds for any company that requires additional funding either because it has fallen on hard times, or because it is running low on cash for a multitude of possible reasons. The challenge here is that when an organization has its back against the wall, it has to submit to the terms of the investor – definitely a seller’s market if there ever was one.
While it is fairly clear why a distressed organization may need to raise capital, it is less transparent why a profitable entity may want to raise funds. The answer lies in the opportunities (foreseen or otherwise) that require large sums of investment and working capital.
Strategic acquisitions, expanded product lines, and extended distribution and operations involve significant investments that typically require more capital than what can be generated organically from profits. Depending on the type of business, organizational structure, and financial optics, expansion is likely to either improve profitability or diversify the organization (thereby reducing risk).
Sometimes the decision to raise additional debt or equity is driven by the desire to alter the firm’s capital structure. Depending on the relative costs of financing, it may be advantageous to issue debt, pad the balance sheet, pay equity holders a dividend (or increase the dividend payout), or retire equity shareholders (leveraged buyout). We are quick to note that these types of corporate actions usually involve a measured analysis of variables such as taxation, leverage, and enterprise value.
Raising Capital May Not be Beneficial
The reason the thesis “you raise money when you can” might be incorrect has its foundation tied to dilution and risk, primarily to the detriment of equity shareholders. Within a normal capital structure, gathering additional equity funding is potentially dilutive to existing stakeholders. This, of course, does not account for anti-dilutive provisions and rights offerings that might be in place with prior subscriptions.
Alternatively, and without considering the potential impact on taxes, debt funding will naturally increase the risk profile of an organization by introducing interest payments that curtail profits over time. Moreover, a debt offering will alter the capital structure of an equity-financed firm, allowing debt holders to be paid ahead of equity stakeholders during forced liquidations (i.e, bankruptcy).
An Indictment of Debt Funding?
Based on our rudimentary presentation thus far, it would seem as though firms should only consider equity financing – not so fast. From a cost of capital standpoint, there are instances when the term structure of interest rates and the tax benefits of debt financing outweigh the corresponding equity premiums.
Large, mature organizations frequently have multiple sources of capital on their balance sheet, reflecting the cyclicality of the capital markets and opportunities presented over time. These enterprises typically employ sophisticated treasury operations that analyze funding options relative to their weighted average cost of capital (WACC). Take a look at the balance sheet of any sizeable public company and you will likely see remnants of multiple offerings that have taken place over the past 10 to 20 years, or longer. This certainly supports the notion that “you raise money when you can.”
A Glass Half Full
From our lens, there are periods of time when capital formation is less favorable. Much of this is dependent on the availability of equity financing, the structure of interest rates, and the shape of the yield curve. However, recent history shows that those periods are generally short-lived and quantified in periods of months rather than years.
Conversely, the phase during which raising funds is attractive is characteristically much longer in duration. Further, experience tells us that potential investors rarely lose their appetite for opportunities that will earn a strong return on invested capital (ROIC). In other words, few savvy investors ever pass up the chance to make money.
For these reasons, we are staunch advocates that you raise capital when the opportunity presents itself, recognizing that the potential negative side effects – namely, dilution and heightened risk – must be clearly identified and understood.
Finally, we are quick to note that throughout history deliberate and measured growth has rarely, if ever, worked against a company. In fact, it often ushers in a prolonged period of success and wealth creation. And at the end of the day, this is the primary reason why most organizations are formed in the first place.