All professions have their own language. The language of private business or for that matter any business is finance. But when I speak with private business owners, I often confront a general lack of understanding of finance and why it's important.
One of the things many owners don't understand is the cost of their own capital. I didn't either - until I spent some time thinking about the issue and realized how it was affecting the company I used to own. As we all know, investing in a business carries significant financial risk. Investing in a private company carries more risk than investing in public companies, because private companies are more likely to fail. That means an investor needs to be rewarded with a higher rate of return. And that means that the cost of obtaining capital is higher for most small companies than it is for most big companies.
This puts additional pressure on small companies to turn a profit. Obviously, all companies want to make a prof it, and a big profit is better than a small profit. But it's more complicated than that, and this is the part that many owners (including me) sometimes struggle to appreciate. You have to make enough of a profit that you cover your cost of capital. If you don't, you won't be able to attract investors or lenders because they won't believe they are going to get a sufficient return.
And if you can't attract investors or lendors, you may doom your business to an endless cycle of trying and failing to get ahead. Rob Slee of the Midas Institute has been railing about private businesses not covering their cost of capital for years. His research shows that only 25 percent of private businesses in this country cover their cost of capital and create enough cash for growth. When I ran my vending company, we often made a profit, we got by - but I rarely covered our cost of capital. Although we did find banks to lend us money, we never raised enough ca pital to grow the business to a significant size. Nor did we create enough excess cash to get an outside investor excited.
Pepperdine University has done an exhaustive study on cost of capital for private business owners. It shows that the cost can be twice as high for a business with more than $25 million in revenue as it is for a business with less than $1 million. Businesses need profits to provide cash distributions for investors, cash for growth and cash for a rainy day - but many smaller businesses just don't generate enough profits to cover theses needs.
My vending business rarely had a 5-percent profit margin before taxes, and that didn't provide enough cash to satisfy our needs. To allow outside providers of capital to feel comfortable extending credit to the company and to grow the business, we would have needed almost twice the profits. But we could never get there. As a result, the only option, if the company was going to grow, was for the money to co me from our own internally generated resources. I didn't fully understand this at first, but that was never going to happen.
We as business owners need to look at our businesses the way those who provide capital look at them. We get frustrated when we are not able to raise the money we need for growth. Too often, however, we keep doing the same things and hope something will change. Instead, owners have to come to a better understanding of what their financial drivers are and figure out ways to produce the needed returns. Or, if that can't be done, you can do what I did and decide the industry is never going to allow you to make the returns you need and find a way to leave.
Do you evaluate whether you are getting the return on your business that an outsider would want? What changes would you need to make so that your return is what investors would want if they were to invest in your company?
Josh Patrick is a founder and Principal at Stage 2 Planning Partne rs where he works with private business owners on wealth management issues.
