Why business owners can fail, even during growth

By Bakley Smith, CFA

Most business owners – especially those in the startup space – have an eye fixed on valuation. At what level does the market value the company? The media, of course, feeds the frenzy with television shows, articles, podcasts and a steady stream of click bait, aimed at illuminating the opaque world of valuation.

Deciding where to invest money in a business can often seem like a perilous decision, even when the company is established. The opportunity cost of one investment over another is sometimes a rough guess, and, in some cases, capital is spent to take advantage of a new opportunity with no clear track record. As a result, business owners often find themselves gambling.

Cost of capital is a defining concept in business decision-making, but it’s also abstract. Born in academia, the concept has only a limited allowance for the day-to-day emotional process of owning a business.

Most businesses are in a constant push and pull between spending on growth and capturing the value that has been created. While every owner may want to pocket all the money coming through, most know it is wise to reinvest at least some of that in marketing, systems and human resources.

Just because the cost of capital is abstract does not it mean it has no value. Indeed all business owners should be familiar with the concept of weighted average cost of capital (WACC). Here we look at three things to consider when evaluating cost of capital during business-growth decisions.

How much debt should a business owner take on?

In a world free of the risk of bankruptcy, businesses would use 100 percent debt financing. Debt is cheaper than cash expense both because the required rate of return is generally lower and because the government allows interest expense to be deductible for tax purposes. This means debt is cheaper and saves tax money.

Since we are not free from the risk of bankruptcy, businesses have to weigh this risk when evaluating their cost of capital. The effects of an actual bankruptcy are obviously negative, and the effects of feared bankruptcy can be even more debilitating, particularly for a small business owner.

Businesses in fear of being put into receivership generally may not be making clear-headed decisions. Increasing the amount of debt on a company’s balance sheet has the benefit of lowering the cost of capital and has the negative impact of increasing the chance of bankruptcy.

What is the cost of owner’s equity?

Almost all business owners invest a tremendous amount into their businesses. This is true for big and small. It is not all cash investment either; indeed, most owners invest tremendous amounts of time and other resources into their businesses. These resources are not easily accounted for in the traditional WACC formula (another case where traditional economists miss the reality of running a real business).

WACC only accounts for cash investment, but most owners will say that their time is the most precious resource they invest. One way to address this is to ascribe a cash value to the owner’s time and then use that when weighting debt and equity. Another way is to increase the required return on equity beyond what may be prescribed to account for a higher required return for the owner’s cash given his or her time input.

However a business accounts for it, an owner’s time, especially in a smaller business, is a vital resource that is generally overlooked. This can help in making a choice of whether to invest further or sell the business, for example.

Pick a target

The truth is most businesses do not operate from numbers. They operate from what they think can happen. Successful businesses tend to manage off of real numbers and forecasts. It is more important to have a targeted cost of capital than to get the cost of capital right. As of this writing expected returns from treasuries, savings accounts and other high safety instruments are very low in absolute and historical terms. This means any return over 6 percent on invested capital makes decent sense.

Pick a number that makes sense and aim to generate that much return on capital from investment in the business. This will help when faced with rising costs and flat revenue. It may not be a good use of capital. It may be time to invest in a new direction.

If you were lost in the Australian Outback, the most important consideration when trying to get to your hotel would be: where are you? This is akin to getting a business’s books in order. A business valuation professional can help determine the value and financial opportunity for a company. Even when an owner is planning to hold for decades, a regular valuation every three to five years, or when a major investment is being considered, can diagnose financial risks and better prepare the company for growth.

You might also want to know which direction is north. Choosing a targeted cost of capital is a approximately like using a compass. It helps keep you headed in the right direction regardless of the distraction you might meet along the way.

About the Author Bakley Smith, CFA is the founder of Lead Agency, a service that connects top businesses with strategic, marketing and financial resources. He resides in New York City with his wife. Read his Blog