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Know your cost of capital
Is cost of capital anything a small business needs to worry about? After all, no one wants to lend you money, your stock is not publicly traded, and potential investors tend to want control. So, what does it matter?
Or you may just be laughing at the concept of capital. "What,
my business has capital? We're the very definition of under capitalized."
You're not alone.
You want to know your cost of capital so that you can make good
decisions that impact the use of capital or the production of cash
flow. It's almost the same as knowing the cost of widgets - you
want to find the best deal that meets your minimum requirements
for quality, delivery options, service, etc.
You may be making capital decisions without realizing it. You get your brochures printed at the corner copy place because you've met the owner and he lets you pay at the end of the month. He'll even let you ride for another month if you make a partial payment. You buy your office supplies at Staples because you have a Staples credit card.
Then there are those that you realize are capital decisions, but you may not be sure of the costs. You lease a computer, and have to pay an up front service fee of $70 to process the lease. You get cash advances from your personal credit cards to fund operations for another month. You spend hours on a business plan and financial projections to apply for an SBA backed loan. You convince Uncle Fred you've got the next Microsoft, and hire your cousin Fred Jr. as a condition of the investment.
There are five main cost components of capital for the entrepreneur:
1. The time it takes to arrange for the capital in the first place
2. Interest and fees
3. The time it takes to "service" the capital provider
4. Loss of control
5. Higher prices from suppliers willing to extend credit
Let's take a look at these individually:
1. The time it takes to arrange for the capital in the first place
For a bank loan, this can be significant. You may have to factor in preparation time, meetings, filling out applications and the fact that you may get several rejections before finding someone willing to lend you money. If you have nothing better to do, that is not so bad. If your time is tight, and you could be doing more customer work, billing more time, then you had better factor this into the cost equation.
One reason credit cards are such an attractive form of small business
finance is that they take so little time to arrange in the first
place. Often you are just responding to an offer that says "sign
here and we'll send you your pre-approved card." After you've
stumbled once or twice, you'll get offers saying "sign here
and send us $49 and we might give you a limit of $300 if you're
lucky."
Computer lessors such as Dell have been savvy about minimizing the
amount of time it takes to arrange a computer lease. This lowers
the real total cost to the customer, while allowing them to earn
a very decent return on their capital. The nice thing about leasing
(nice for them) is that they don't have to disclose an annual percentage
rate. It might be nice for you to know what rate they are charging
on the off chance that you have an alternative means to finance
the computer.
2. Interest and Fees
The interest is pretty obvious. But don't forget to consider "fees": any fees required to secure a loan should be part of the equation. This might be an upfront servicing fee for a computer lease, annual membership fee for a credit card, appraisal fee for a second mortgage, or penalty from the IRS if you decide to take your time remitting payroll withholding taxes. Late fees and over limit fees apply.
3. The time it takes to "service" the capital provider
You can stop your snickering any time. In the case where you convinced an investor to put up some money, you might have regular meetings and phone calls to keep him up to date. Or time with your lawyer to defend the lawsuit. If you've borrowed from the IRS, you might have to spend time stroking your friendly revenue agent to convince her not to seize assets. This is where credit cards get more expensive: I know of a "friend" who once spent 4 hours a month making payments on 35 different accounts.
4. Loss of control
This is impossible to quantify, and there can be gray areas, but it is something you have to consider. Most of us are entrepreneurs because we want to be our own bosses. Loss of control is a big, big deal.
Some control issues are obvious. "I invest $100,000 in your business, and you give me 51% of the stock." Or it could be a bank covenant.
Or a government regulation. "You dip into the withholding taxes, and you are ineligible for an SBA backed loan until it is paid back - including interest and penalties."
5. Higher prices from vendors willing to extend credit
You've probably heard the saying "small business is the biggest source of lending to small business" or something to that effect. This could be your marketing consultant who bills monthly, and let's you ride on occasion, or the corner print shop that let's you sign for the work instead of demanding cash on delivery. In some cases you will find that the vendor extending credit is not the lowest cost supplier.
I ran into a stark example of this in the mid 90's when a salesman I had hired from the printing industry sought some bids for printing some brochures. He found a supplier in another state willing to do the job for 1/3 of what my downstairs print shop was offering. The only hitch was that they wanted cash in advance (not just cash on delivery). Part of the premium for the corner print shop guy could be attributed to comfort and risk reduction. In general, you never want to pay for a product or service before receiving it. (1/2 up front, ½ after delivery seems like a nice way to share the risk in a new relationship). But clearly there was a huge cost of doing business with the corner print shop guy based on getting credit terms. Depending on my capital situation (what was my marginal cost of capital at that point in time?) the decision could go either way. When the marginal cost of capital is infinite, the corner print shop guy looks very attractive, especially if the brochures will produce revenue and profits in a short period of time.
Another lesson here is the power of credit terms to win business. If you've dealt with large companies, you know that they take whatever credit terms they desire. You may ask for payment in 15 days, but that has no impact on when you actually get paid.
However when selling to small businesses, offering credit terms can be a key competitive advantage.
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