Capital. You’ll be hard-pressed to find a business that doesn’t need any to function and yet, for most businesses, understanding “capital” and capital needs can be a confusing and murky topic. Over the next two weeks, we hope to take out some of the mystery related to capital (both what it is and how to raise it) in this four-part series, Understanding Capital. In this first installment, we’re providing a primer on the different types of Capital. In Part 2 we’ll cover traditional ways to raise capital. In Part 3, we’ll talk about the non-traditional ways to raise capital. And finally, in Part 4, we’ll talk about how to get out from underneath capital.
What is Capital?
In its most basic sense, capital is anything a business will use to generate income. While capital can range from the people you employ to the equipment you use to produce your products, for purposes of this series, we’ll be focusing on financial capital and the three main types of financial capital that businesses employ on a daily basis: equity capital, debt capital, and specialty capital.
Otherwise known as “net worth” or “book value”, Equity Capital is calculated by taking your assets and subtracting your liabilities. Initially, when the owners of a business invest in that business they receive “equity interests” in return. If a business takes on additional owners, it is usually through the sale of membership interests or stock. The business is provided additional capital to operate and in exchange, the individual investing obtains an ownership interest. Depending on how the underlying business is structured, this ownership interest may entitle the individual to periodic dividends and a return on their investment should the company be sold. It also may allow the individual to have a say in how the business is operated.
There are some businesses that are funded entirely with equity capital (cash deposited by the shareholders or owners into the company that has no offsetting liabilities.) And while many new businesses favor this form, it can be expensive both in the amount of money to sustain the business and the value of the ownership interests sold to sustain the business. Instead, many companies turn to taking on additional forms capital as they grow.
Debt Capital is money infused into a business with the understanding that it must be paid back at a future date. In the meantime, the owner of the capital (typically a bank, bondholders, or a wealthy individual), agrees to accept interest in exchange for the use of its money. No equity exchanges hands, and typically the only hard cost associated with debt is the interest paid by the business. Using someone else’s money, i.e. incurring debt, has become standard operating procedure in the business world as the easiest way to expand.
Specialty Capital is a form of Debt Capital used in particular industries and includes vendor financing, receivable factoring and money floating.
- Vendor Financing. Vendor financing allows the business to sell to its customers and collect the funds from the sales before having to pay the vendor for the product sold. The business does not have its regular capital (either debt or equity) tied up in the business; it is financing its operations through its completed sales cycle.
- Receivable Factoring. Vendor financing is widely used in many manufacturing business segments. A similar financing structure has evolved for non-manufacturing / service industries. In this instance, a third-party purchaser “buys” the accounts receivable of the business by paying the business a percentage of the face value of the accounts receivable. The business shortens its revenue cycle and immediately creates cash which it uses to finance its future sales and thus its growth. The difference between the face value of the accounts receivable and the price that the vendor pays for the receivables is the cost of capital (i.e. the interest equivalent).
- Float. There are certain industries in which companies hold money but do not own the funds. Before having to pay out amounts with respect to the original funds collected, they use the funds collected to invest in other ventures. This money is called “float money”. This is the financing technique used by insurance companies.
What Type of Capital is Best?
Different types of businesses have different capital needs. Service-based businesses tend to have less financial capital needs and higher human capital investments, while product-based businesses require larger influxes of cash and equipment to produce their goods. Working with your financial advisors (i.e. your business accountant and CFO / Controller), you should ensure that you understand how much financial capital is required to operate your business and then seek out the type of capital that best suits your needs. Your attorney can help advise you on the risks associated with the capital and help structure your capital raises to best benefit your business.
This article is for informational purposes only and does not constitute legal advice nor does it create an attorney-client relationship. Always consult appropriate legal counsel for specific questions related to your business. Some states may consider this attorney advertising.
Linden Legal Strategies PLLC, is a Richmond, Virginia-based law firm focusing on business law and development. To learn more about how Linden Legal Strategies can help you start, grow and protect your business, schedule an initial consultation.