Media Coverage

The Experts: Venture capital
Outside funding is often a necessity

Column by Lin Earley, Inside Business - Hampton Roads, January 28, 2008

Entrepreneurs of small to mid-size growing companies sometimes tell me, “The accountant says we’re making money, but I never have much cash.”

The harsh reality these entrepreneurs are learning is that growing businesses, even profitable businesses, absorb cash.

For companies large and small there is a limit to how fast they can grow using internally generated funds. If the company is growing beyond that limit, it will be unable to self-finance and will run short on cash.

A meaningful growth in sales requires carrying more inventory and holding more accounts receivable, i.e., more working capital. Unless the company is extraordinarily profitable, outside funding is generally required to finance the growth in working capital.

This situation should not be confused with the method of cash absorption from growing sales at a loss, which involves making limited sales to establish a presence in the market, then increasing prices, reducing costs, or both. This is analogous to establishing a beachhead in time of war. It can be very costly to the military and businesses. Many companies cannot make inroads past the “beach”where, after generating unprofitable sales, the entire company collapses for lack of staying power.

Most business owners agree that a steady increase in sales is a good problem to have. It means the company is successful and growing. However, the cash from revenues may not materialize instantaneously, which limits the ability of the company to bring in the additional staff, inventory and infrastructure to grow accordingly.

Entrepreneurs in this situation either maintain the status quo or find external funding, which can come from a variety of sources such as friends and family, banks, angel investors, commercial lenders and venture capitalists.

Before seeking a loan, business owners should conduct a thorough analysis to determine the cause of the cash shortfall.

If the cash shortfall is caused by a short-term spike in sales, then traditional bank lines of credit or other short-term financing options are ideal. Companies could also push the collection of accounts receivable to make up the shortfall.

If the increase in sales is more permanent, then long-term financing is more appropriate and typically requires some form of equity investor, venture capital firm, long-term bank loan or a combination of these.

The key strategic issue for an outside investor looking to finance a growing company is profitability. Is the company growing profitably or is it losing money as it operates? There is an extraordinary difference between a profitable company that needs money to grow and a failing company asking for money to forestall the inevitable.

The most efficient way for an investor to determine if a company is profitable or not is to look at well-prepared, current financial statements. These documents should be no more than 30 days old and prepared using consistent accounting procedures. Stale or incomplete financials are most frequently a symptom of a badly managed company. A situation like that begs the question, “How can I decide whether to invest in this company if no one knows if they are making money or not?”

Timely and accurate financial statements help an investor understand the effectiveness of a management team. When that team needs cash to grow, they'll usually find it relatively easy to get funded.

Lin Earley is CEO of Waterside Capital Corp., a Norfolk-based SBIC with $2.3 million of loans and investments in 14 companies. He can be reached at www.watersidecapital.com.