Sustainable expansion means a company grows without breaking its cash flow, product quality or team capacity. The funding option chosen by a company determines whether it will have the ability to sustainably grow or if it will break under financial stress. The funding decision made by a company depends on a variety of factors including the speed of growth of the company, the company’s profit margins, the company’s risk tolerance and the amount of control desired by the owners. Some companies are able to expand their business by simply reinvesting their profit dollars, while some require external funding to hire additional employees, increase inventory levels, etc., to enter new markets.
This article provides information on the various types of funding available to companies, the ways to align these funding sources with company objectives, the criteria used to evaluate funding options prior to committing to those options, and the strategies for protecting long term stability while expanding a company.
1. Establish a Practical Growth Plan and Financial Baseline Prior to Funding
Funding should always be aligned with a company’s growth plans, not the other way around. Companies that seek funding without a clear objective for that funding, often find themselves overspending and losing sight of their original objectives.
A good starting point includes establishing a practical baseline that includes:
- A definition of “growth” which could include adding new locations, new products, new markets, etc.
- A cost map which outlines the costs associated with hiring, marketing, tools, inventory and compliance issues.
- Unit economics which provide data on the gross margin of the company, the cost to acquire customers, the level of retention among customers, the time it takes for a customer to pay back the initial investment and the cash runway, i.e., how many months/years the company can continue to operate using only the current resources.
Prior to selecting a funding source, there are several key questions that should be answered:
- What specific milestone will the funding allow the company to reach?
- How will success be defined within the next six to twelve months?
- What will happen if the company experiences slower-than-expected growth?
By developing a clear baseline, a company can prevent the over-funding of their growth, reduce the level of risk that they face and ensure that the growth they experience is both efficient and effective.
2. Assess the Merits of Each Funding Option and Their Associated Costs and Risks
While the interest rates offered for funding today are very competitive, each funding option also carries a cost or a trade-off. The true cost of funding is based on the flexibility and control that the funding will provide to the company and the pressure it will place on the company to grow faster.
There are four common funding options:
- Bootstrapping: Reinvesting a portion of the company’s existing profits in order to grow the company at a controlled pace.
- Debt Financing: Loans, credit lines, etc.
- Equity Financing: Angel or venture capital investments, in exchange for an ownership position in the company.
- Strategic Capital: Partnerships that invest in a company for long-term value.
Here are some quick fit guidelines for choosing a funding option:
- Bootstrapping is suitable for companies with a stable cash flow and modest growth requirements.
- Debt is typically best suited for companies with consistent and predictable revenue and strong profit margins.
- Equity is usually best suited for companies that need to rapidly gain traction in a large market, and therefore do not yet generate significant profits.
- Strategic capital is generally best suited for companies that will benefit from the relationships provided by the partner(s), such as distribution, supplies or expertise.
The goal is to select a funding option that will support the company’s growth, but does not force the company to make decisions that are detrimental to its long term sustainability.
3. Align the Funding Option with the Company Model
Sustainable growth is dependent upon the type of model that the company uses. For example, companies with subscription or recurring revenue models may be able to utilize debt or revenue-based funding as long as the churn is relatively low. On the other hand, companies that rely heavily on inventory may need to obtain a working capital facility in order to meet demand. Companies that rely heavily on R&D to develop new products may need to utilize equity as it will take a long time to realize the returns from this type of investment. Service-based companies may be able to utilize bootstrapping as long as hiring can occur in incremental steps.
One general rule is to fund “repeated growth.” In other words, a company should only seek funding for activities that can be repeated. If a company cannot consistently produce results from the same spending patterns, then seeking more funding will only add to the overall risk.
4. Use Terms, Timing and Spending Controls to Ensure Sustainability
Most of the problems experienced during the process of expanding a company result from the terms of the funding and poor spending controls. Long-term scalable growth requires barriers. The smartest barriers to prevent over-spending include:
- Fund for a specific milestone, rather than a vague vision.
- Keep reserves; do not spend every dollar immediately.
- Establish spending rules; e.g., hiring and marketing expenses tied to performance metrics.
- Understand covenants and dilution; know what will trigger penalties and/or loss of control.
- Create reporting habits; report on cash, burn rate, and performance on a regular basis (weekly).
Some red flags to watch out for include:
- Funding that requires unrealistic growth projections.
- Overly restrictive loan terms that limit the company’s ability to operate.
- Equity deals that create misaligned incentives with the owners and the management team.
- Lack of discipline; allowing the company to spend money beyond the milestones that were established and not having the ability to adjust the spending when the circumstances of the company change.
By creating barriers and discipline, you can protect your company when the conditions surrounding your company change.
Conclusion
Selecting the proper funding option for sustainable expansion begins with a well-defined growth plan, solid unit economics and an understanding of the risks associated with a company’s current cash flow situation. While bootstrapping, debt financing, equity financing and strategic capital can all be viable options, each of these options will propel the company in a different direction. The most successful funding option will provide funding for repeatable growth, preserve the company’s flexibility and control, and align with the company’s timing and preference for control. Successful leaders treat funding as a tool that is limited to only providing the necessary funding to achieve the next milestone and manage capital with discipline to protect the long-term viability of their company.