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Growth Constraints

Jan 5, 2013   //   by Skip Nagelvoort   //   White Papers  //  No Comments

Survival versus growth options for small businesses

It is well known that most small businesses fail within the first five years of start-up. Those that survive are the subject of this article. Many of these firms that survive rarely have sufficient depth of financial capital or access to financial capital to fund the working capital part of the additional capital needed to fund growth. Growth is expensive. Most small businesses have marginal growth beyond a certain point and rarely prosper to the point of being able to hire management specialists.

Financial Growth Constraints

It is our experience at the Collaboration Center that the greatest immediate constraint for these firms is financial capital to support the rapidly expanded working capital demands required by growth. The proper analysis is to carefully estimate from prior years changes in sales the increase in working capital per dollar of incremental sales. Such increases in working capital can equal or exceed $1 of incremental sales for a period of time. This can be a great hurdle.

Analysis of the marginal funds needed to generate the next level of growth is one of those measurements that is usually ignored or left for whatever reason just undone. Thus, in the effort to expand sales, illiquidity becomes a very unpleasant companion. Trade payables get stretched and suppliers become unhappy. The supply base becomes problematic as their exposure increases with expanded payable balances. These factors unfortunately can result in delayed shipments and inefficient operations. And unfortunately, the actual amount of dollars is, in fact, often rather modest. The financial analysis for growth is often ignored because the financial function at small business is more along the lines of bookkeeping and basic accounting instead of more sophisticated projections that take into account the peculiarities of the specific small business. Often advisers are not equipped to go beyond their software and are limited by their resources in terms of providing more accurate and more dynamic estimates of need that could be helpful to negotiate expanded arrangement ahead of time and prepare for this liquidity need. This we refer to as the invisible demand for liquidity with increasing sales. It is the financial gremlin of growth.

It is really remarkable that there is a greater opportunity to raise capital for fixed capital expansion like plant and equipment. In fact, financial markets(commercial banks) are oriented to providing capital for long term fixed asset expansion, not working capital. Certain SBA loans are helpful here in terms of 504 or their 7 (a) program loans. There is what is generally accepted more “solid collateral” in these hard assets. While this feeling of solid collateral is common place, we know that it is often not true and even

“solid collateral” can be illiquid or have a decline in value. Recent experience in the last few years has reinforced this uncomfortable reality. After all, it is cash flow that repays successful loans and not collateral.
The final fact of small business funding is that there is rarely a liquid reserve for growth. This is often due to the comingling of personal funds and corporate funds, not in irresponsible way, but induced, in part , since the personal guaranty of the owners is invoked. There can be a reversed motivation not to be overly liquid in personal accounts. One alternative here is a “C” corporation that accumulates cash with an effort for the owner to avoid a personal guaranty. See our recent white paper on taxes, corporate structure and growth, the changing tide of corporate organizational activity.

The More Precious Capital

We believe that the really scarce capital for small business growth is intellectual capital. We believe this inevitably trumps financial capital needs , because it provides financial capital solutions in more than the short term; therefore solving that constraint. Again, our experience with small firms is that they are very heavily reliant on one or two key people with critical skills. The growth of those firms tend to be constrained or ignited directly in proportion to the efficacy of those skills.

These skills are usually vital to the survival of the business. However, they are often not necessarily the skills needed to bring the business to the next level of growth. In this context, we are talking about the ability to drive the business from a survival level of X sales to a more permanent 2-5X level of sales. The entire architecture of management decisions, planning and resource needs are highly expanded in this process.

The owner needs to find human capital to fuel this growth. Decisions on the appropriate human capital additions are needed, but in smaller firms there is little expertise in the organization to identify and evaluate this talent. It often means bringing in people with different approaches that test the status quo and may change reporting systems. These are in fact very big risk decisions to be made by people not experienced in these matters. The other issues, of course, are if a poor people decision is made here it is expensive and can be harmful to the organization, even setting it back for a year or two. The other fascinating factor is that the right person at this juncture may not necessarily be the right person three years hence as the business grows.

The Collaboration Center exists to help small businesses identify these needs, to provide the talent on a short term basis and to minimize the risk and costs of these decisions.

Organization Structure, Taxes and Growth: A New Orientation

Jan 5, 2013   //   by Skip Nagelvoort   //   White Papers  //  No Comments

A New Orientation

“Different times require different methods”, as the saying goes. We are certainly facing a changing environment in which to run a business. As usual, those who adapt early and best have an advantage. There are two major forces which small business owners face. A changing tax environment and continued volatility in the global and local economy. This paper reviews some strategies for preparing for both of these events.

“C” Corp for Capital Accumulations

For years, advice given to small businesses has been to form sub chapter S corporations or do business as an LLC. This trend may be changing rapidly. Yes, there can be double taxation in this situation, but we believe a series of benefits will be offsetting and depending on the management and style of the business the differences can be dramatically in favor of the “C” corp.

There seems to be few questions that personal rates, certainly on higher income people will be rising, even since December 31, 2012. We know that taxes will be changing more in 2013 and beyond. It is also true that deductions will become more limited. It looks like personal rates and alterations of the Alternate minimum tax will provide a higher tax burden on small business operating on a tax flow through basis. Further, capital gains rates will be rising. We expect that Cap Gain rates will tend to remain somewhat below regular income tax rates due to the investment incentive that historically have been ascribed to favor capital gain treatment. Whether these are, in fact, incentives that actually encourage investment, which is seen as a benefit to the economy, can be argued, but we believe there will be lingering support for the sentiment. So, actual taxes on the individual are highly likely to rise, both due to the pressure for increasing rates and the probabilities of lessening effective deductions to offset taxes that will generally have the effect of rising tax bills.

At the same time, corporate rates are likely to fall from the mid to upper 30’s to the mid 20’s. This will put the corporate rate in the middle of the national corporate tax rates for most of the industrialized nations in the OECD. Deductions will likely remain protected more broadly than tax deductions for individuals.

There is much to say about this shift, but we envision well-advised firms will shift to the “C” corp and learn aggressive, new techniques for managing cash in the corporation for the benefit of the owners. We have always been able to provide loans particularly within the tax year in a “C” corporation. Also the opportunity to creatively use various types of classes of stock should provide incentives that can be taxed based on capital gains rates, which if there continues to be an advantage can provide a significant tax benefit to larger chunks of income.
In the meantime, salaries and bonuses will continue to be treated as deductions and as paid to receive individual treatment, but perhaps with more limited deductions.

Corporate Capital

So if there is cash accumulation in a “C” Corporation there will continue to be excess cash rules which are somewhat vague and wise use of these reserves can be a powerful stimulant to the growth of the business which is rarely the situation in LLC’s and sub S corps, where accumulations for a variety of reasons are less common. The growth of capital in corporations should also help in resisting banker’ s global and personal guaranties.

We believe this trend will change a lot of banking relationships. The combination of small business capital accumulations, freedom from some personal guaranties now opens to small business a bevy of new cash management higher return options, particularly in light of the expected secularly low or negative real interest rates growth opportunities that are often not available to small business.

These trends will require more sophisticated financial advice, often not available to small businesses but for those who do take advantage of the options, they can expect their margins and return on capital to be rising.

The notion of managing small business in a period of negative real interest rates with some cash accumulated is new to the United States and somewhat more European in style. It also shifts what should be financed, the sources of financial capital and affects pricing models.
The powerful aspect of internal corporate capital availability is that financing is available when more convention institutional sources go dry and often when the SBA oriented small business facilities become too cumbersome or costly.

We view this plan to build corporate cash as a powerful tool to insure flexibility and provide options for the successful growth prospects for small businesses.

The Collaboration Center is prepared to be helpful in this kind of planning.

Becoming your own Bank

It is our experience in advising that among their chief concerns has been the minimization of income taxes, which in itself is not a bad strategy, but it can obscure profit enhancement opportunities and often results in an emphasis that can muffle profit growth. It is a lower risk strategy that often leads to lower profits or gets small business owners locked in illiquid asset positions. Often the advisers surrounding the small business owner reinforces this thinking.

Over the years, we have found the single biggest asset to permit profit maximization is a large cash reserve that permits the business owner to take advantage of opportunity, which inevitably occurs. However, when the disciplines of the organization are not aimed at building cash, many opportunities are lost. If these opportunities fall outside the span of high advance rates from whatever collateral the banks prefer, then they are often lost due to lack of funding.

So small businesses often confuse bank capital for growth capital. It is true this capital can be expansion capital, hard assets like buildings with traditional collateral value. It is the incredibility valuable additions of intellectual capital or working capital which are very difficult to and should not be funded by financial institutions. These same institutions talk about raising equity capital, but they have most of the owners personal capital locked up; this is impractical although understandable demand.

By businesses intentionally becoming their own bank, they open significant opportunities for themselves including the availability of capital when opportunity knocks and in spite of the institutional health of the financial system. In a period of high volatility and global risk a local business often has less risk than financial intermediaries, but are constrained by the financial constraints of the system. We certainly have seen that in recent years.

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