At some point, raising capital may become a necessity for many companies. Whether you’re looking to expand organically into new markets through additional hires, through acquiring another company, purchasing additional business assets, investing in the supply chain, or just need help maintaining daily operations, there are a few things business owners should keep in mind when setting out to raise capital.

First and foremost, you need to prepare by knowing your business inside and out. Have an understanding of...

your mission, vision and values
your unique value proposition or differentiated product/service offering
key performance indicators
financial changes and impacts on the business year-over-year
sales, marketing and how you go to market
the competitive landscape
the strength of your management team and/or any holes that need to be filled
the company's growth opportunities
impact metrics and/or any measurable difference you’re creating for stakeholders

Finding and engaging someone to help you raise capital is often a beneficial step. They can help raise capital from values-aligned parties that understand your purpose and values, support your culture and people philosophy, and can help structure the investment(s) to create wins for all parties. Companies can often raise capital on their own or with some help from their lawyers or accountants, but including an investment banker to find aligned parties and the ideal structure can be especially important for those who are conscious of preserving mission, vision and values.

“To raise capital, you need to tell the business’ story that compels someone to invest,” says EPOCH Pi co-founder Lynn Carpenter. “Retaining an advisor who understands the company’s values not only increases value but outcomes.”

Additionally, as business owners set out to raise capital or sell their business, it’s important to normalize earnings. EBITDA (earnings before interest, taxes, depreciation, and amortization) is an important measure of a company’s performance and a significant component used in determining a company’s valuation and debt capacity. Adjusted EBITDA is calculated by adding or subtracting certain expenses in order to provide a clearer picture of a company’s profitability and to make it easier to compare the business’s performance year-over-year.

We have always advised our clients on the importance of adjusting historical operating results for non-business-related discretionary expenses, owner’s personal expenses, and for any unusual, non-recurring or extraordinary expenses (or income). The resulting “Adjusted EBITDA” normalizes a company’s financial performance by excluding distortions caused by unusual expenses and those not needed to operate the business on an ongoing basis. This is particularly relevant with the economic impact of COVID-19.

“A global pandemic is one of those things that aren’t normal to the business, so you have to normalize the impact of COVID,” says Lynn. “That’s a bit challenging right now because businesses have been affected differently, but in general, normalizing it adds to cash flow and that’s typically how businesses are valued, so you can show that cash flow was actually higher if those expenses had not occurred.”

To preserve value for raising capital or for future M&A, companies should keep track of all their COVID-19 expenses and losses so they are easily identifiable and supportable as addbacks. Excluding COVID-19’s impacts will present a clearer picture of profitability.

As you consider adjustments for the pandemic, it’s important to keep track not only of extraordinary expenses but also issues that created delayed or lost revenue. Here are some possible COVID-19 related addbacks:

Technology costs related to facilitating remote work
Delayed customer orders
Supplier shortages
Mandatory closures
Reduced production due to illness, safety or other COVID related challenges
Costs related to cleaning and disinfecting facilities and equipment more thoroughly or frequently
Costs to purchase face masks for employees and customers
Termination fees and other expenses related to canceling contracts or events

Types of Capital

Besides utilizing internally generated cash flows to fund preservation and growth, a business has two options to raise additional capital: debt and equity. Determining the best type of capital to raise (or a combination of the two) depends on what stage a company is in. For example; earlier-stage companies with minimal revenues likely don’t have the capacity to raise debt and will need to raise equity; while more mature companies with positive cash flow (i.e. EBITDA) and assets generally can support raising debt.

While every transaction should be approached with a personalized lens that best fits your needs and limitations, this section gives a high-level overview of the two types of capital sources as well as their respective advantages and disadvantages.

Debt Capital

Debt capital (also known as debt or loan financing) is generated by borrowing money from a lender. The lender will charge interest and will typically be paid back over time. There are two types of debt capital: senior debt and subordinated debt.

The biggest differences between these two types lies in lender priority, cost of capital, and repayment. Senior debt lenders typically look to the company’s assets and cash flow while subordinated debt lenders look predominantly at a company’s cash flow, total leverage, its business model, competitive position to ultimately determine the likelihood of repayment.

Subordinated debt

Lenders can be a bank but are often subordinated debt investor or business development corporation (“BDC”)
Typically interest only, with full repayment required at the end of the term
Typically take a second lien, behind the senior lender, but in some cases could be unsecured
Higher cost of capital to compensate for higher risk
Usually requires board representation or board observation rights

Senior debt

Lenders are typically commercial banks or private debt funds
Typically secured and take a senior lien against the company’s assets
Principals repayment required over the term of the loan
Lower cost of capital
No board representation

While debt capital comes with liens against assets, it’s an appealing option due to its lower cost of capital, limited board role, and less rigorous due diligence process. It is largely considered to be the more straightforward option of the two capital sources and also offers the added benefit of keeping all equity and ownership rights in the hands of existing owners. However, less observable costs of higher debt include limitations it places on a company’s flexibility. Debt requires repayment with interest — and if not repaid according to the agreed-upon terms — can force the company to make decisions counter to their values or could be pushed into bankruptcy.

Pros & Cons of Debt Financings

CONS

Repayment
Cash flow
Collateral/liens
Board representation

PROS

Lower cost of capital
Maintain management control
Accessibility
Tax-deductibility of interest

Debt capital could be a good option if… your business has positive cash flow, or EBITDA, has excess debt capacity and the owners do not want to give up control or ownership.

Equity

The term “equity capital” is most commonly used to refer to raising funds through the sale of preferred or common shares. You often hear of equity in relation to early-stage companies, but more established companies also raise equity to finance growth and/or recapitalize their company (recapitalization allows owners to take some of the wealth they have tied up in the company off the table but not relinquish control). Raising equity is also more time-consuming, involves significantly more due diligence, has a higher cost to capital, relinquishes some control, and dilutes ownership.

Pros & Cons of Equity Financing

Cons

Higher cost
Time and effort
Loss of control
Potential conflict or disagreements

Pros

No repayment
Access to investors network
Ability to learn and gain from partners
Long-term view

Equity capital could be a better choice if... your company is in a growth phase and not fully cash-flowing, you don’t have debt capacity because you are already leveraged or you are interested in a partial sale (recap) to achieve some liquidity but continue to operate the business and maintain control.

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EPOCH Pi specializes in purposeful investing. We take care to find values-aligned capital partners and structures for every business transaction. The advice we provide is tailored to each of our clients’ specific needs. Do you need to raise capital? Let us help you do it in a way that won’t compromise company culture, mission or core values. Learn more about our services here.