Funding growth with a strong capital structure

Growth plans take many forms, but central to each of them is a capital structure that allows businesses to seize opportunities faster than industry peers, improving their negotiating capacity when opportunity presents.

Business leaders and shareholders should be constantly ensuring their capital structure is aligned to the businesses strategy – keeping it robust, fit for purpose, and ready to support business and personal goals. 

Defining a ‘healthy’ capital structure

At its heart, a business’ ‘capital structure’ is how it uses both debt and equity to sustain its day-to-day operations and fund its growth.

Precisely what constitutes a ‘healthy’ capital structure varies. It depends on several factors including the type of business, the assets it holds and its strategic targets.

“There is no one-size-fits-all solution,” says Nicholas Sweeney, Head of Middle Market at Macquarie Bank, who leads a team focused on providing growth capital solutions to mid-market businesses.  

“Getting it right can be complex, and it really comes down to the risk appetite of a business' shareholders. However, capital solutions long enjoyed by larger organisations are now available for small and mid-sized businesses.”

What lenders look for

Michael Scanlan, State Leader for Professional Services in NSW and the ACT at Macquarie Bank, leads a team who look after the business banking needs of professional services firms. He notes that some attributes and behaviours are more favourable to borrowing capacity.

“Some businesses that have high levels of debt or have lower profit margins can't go and borrow more, because they're capped out due to servicing constraints,” he says.

To this end, it’s important for business leaders to understand the importance of the habits they demonstrate to a lender, including their ability to focus on paying down debt.

Olivia Ellis, National Head of Accounting and Financial Services at Macquarie Bank, leads a team focused on providing growth solutions to accounting and financial planning businesses. She notes businesses that develop this habit early on often find themselves in a better position than their competitors.

“During an economic downturn, these businesses already have the right habits in place and are continuing to create more equity within their balance sheet,” she said.

“They’re not necessarily feeling those creeping interest rate rises as heavily because their debt position is amortising - that is, they’re repaying principal from their headline loan value.”

The M&A opportunity

One way for businesses to pursue growth is through mergers and acquisitions (M&A) – buying new businesses to scale operations, complement an existing offering, or enter new markets.

Acquiring another business, however, typically requires financing – making the right capital structure crucial to striking a successful deal.

“There are real opportunities in the market right now to make acquisitions and gain scale,” Scanlan says. “But typically, businesses need low levels of debt to make the most of those opportunities.”

“If a business is amortising consistently, their debt level will be lower, so we're more likely to be in a position to provide them interest-only or amortisation support if and when needed,” he adds, echoing Ellis.

“But if they're geared up to the maximum and start having cashflow stress, we're not always in a position to help. By continuing to amortise even in good times, you’re building resilience into your capital structure.”

Risks to consider in M&A

“One of the key risks to avoid when growing your business is in pursuing growth for growth’s sake,” Sweeney says.

“There’s a risk of overpaying for an asset without an underlying strategic rationale,” he says.

Business leaders should focus on a thorough due diligence process which ensures alignment at key levels, such as culture.

“Cover everything in your due diligence – a thorough process is about more than just financials. Consider, amongst other things, HR, licensing, contracts, and cultural alignment,” Sweeney says.

It’s also important to mitigate integration risks, he adds.

“A successful acquisition involves several aspects of the business coming together. Having the right skill set in your business to integrate an acquisition cannot be underestimated,” he says. “Business integration will present many risks and roadblocks to foresee and manage.”

Beware short-term thinking  

It’s also important to look out for strategies that seem appealing but can hamper a business’ growth plans or limit its options.

“We’ve seen some shareholders take out buy-in loans that simply take security over their shares in the business, not the business itself.” Scanlan says.

“That can sound like a good idea because the business does not provide any form of security to support the shareholder loans. However, in a situation where the business is geared itself (at say 60% loan to value ratio) and shareholders each borrow against the value of their shares (at say 60% loan to value ratio), the value of the business is now double geared at 120%. There is more debt against the business and the shares in the business, than there is value in the business itself. This is obviously a very precarious position to put the business in. As soon as there's some cashflow strain or a slight downturn in the market, there may not be enough profits to service the business debt as well as the buy-in loan debt.”

Managing margin squeeze

The cost and margin pressures for businesses are well known, with the combined force of cash rate rises, a tight labour market and high inflation having a direct impact on balance sheets.

“The pressures businesses are feeling are the tight labour market and wage pressures. If a business has a high level of debt, that's going to exacerbate those wage pressure and labour market challenges,” Scanlan says.

“We're not seeing that stress play out in cashflow strain. We’re potentially seeing it instead in those businesses that don't have the ability to borrow more funds because their servicing calculations are no longer in surplus,” he says.

While businesses that have reached their borrowing limits may start to feel the pinch, both Scanlan and Ellis agreed that those on the other end of the spectrum can leverage their position to accelerate growth or secure key staff.

Always on

The question many business owners will be asking themselves is this: when should they be re-evaluating their capital structure to make sure it’s appropriate?

The current economic environment brings to the fore the importance of a robust capital structure. However, as a matter of best practice, capital management should be ongoing.

“It's something you should be talking about as a business consistently – which may include conversations with trusted partners such as bankers, brokers, advisers and accountants,” Ellis says.

Importantly, by keeping their banker well-informed, business owners can keep track of their borrowing capacity at any moment and make quick decisions as new opportunities arise.

These conversations can also help prevent some businesses from implementing capital structures and strategies that limit opportunities and choices, and instead, set those businesses up for success.