“What’s the APR? What’s the rate?”
It’s usually the first or second question when discussing brand capital strategy. And it’s the wrong question.
The right questions for brand leaders in evaluating capital options, in order of importance, are:
- Can we get enough capital now and in the future?
- Do the funding and repayment cycles match how we will use the capital?
- Is the cost of capital lower than our expected return if we used our own cash?
There are obviously other important considerations about quality of the capital partner, terms and covenants, but assuming those are all satisfactory, your core criteria are the above three.
Price doesn’t matter if you don’t get what you need
“Our APR is 10%” says the senior lender.
“Wow” you think, “I am in the big leagues. This price is too good to pass up.” But when you get down to actually working through the terms, you get a sinking feeling. Between the restrictions on eligible inventory and the advance rate, you can expect to draw somewhere between 40% and 50% of the cost basis of the inventory sitting in your warehouse.
Let’s say you need $2 million for inventory over the next 6 months and those payments are due 45 days before the inventory actually shows up in the warehouse. You have to float the payments, then you can only draw 40% or 50% of the value once it shows up.
You signed up for relatively cheap capital, but you aren’t getting nearly enough. Where does the additional money come from? Not that senior lender. Their incentive to increase advance rates disappeared the second you signed. A junior lender? Only if you can get the senior lender to approve it. You’re going to max that senior line and then juggle free cash flow like crazy to scrounge up what you can. But hey, you can brag about that low rate you negotiated.
Fast cash doesn’t matter if the cycles are off
Imagine you need $200,000 for an inventory invoice. A capital provider says, “Great! No problem. I’ll have $200,000 in your account tomorrow.” Sounds awesome. But then the provider says, “I’ll just need that $200K plus my premium returned to me at the end of the week.”
Where am I going to get $200K plus in a week!?”
That is essentially what happens with MCA’s and short term lenders. They don’t ask for it back in a week. Maybe they want all of it back within 90 or 120 days. But they do want some of it back starting tomorrow or in a week. So that 90 or 120 day ‘term’ is closer to half that on a weighted average basis.
Because your borrowing and repayment cycles don’t match your ability to buy the inventory and sell it, you can quickly get caught in a negative debt spiral. Specifically, you are borrowing and repaying well before you buy and then sell. You need to borrow ever more from the future in order to pay back what you borrowed in the past.
Now combine the mismatched fast repayment cycle with not getting enough capital. The MCA or short term lender doesn’t give you an unlimited credit limit. They know what they are doing. So, what typically happens is the brand maxes out their credit with MCA 1 and then goes out and signs up with more short term lenders and stacks MCA’s 2, 3, 4 and 5 on top of each other borrowing every more from tomorrow to pay off yesterday. Each month is a crazy juggling of credit cards and lenders with an ever narrowing window of escape. Usually this ends in a bankruptcy. Some brands can clean up their balance sheet with new equity and senior debt. A rare few can self rescue from organic free cash flow.
How to really think about cost of capital
It’s not price. We all want to know price. We are in the business of selling things, so pricing is always top of mind. How can you properly compare options without knowing the price?
Before I explain how to properly compare prices of capital, I want to make a critical point.
The true cost of capital is your opportunity cost.
For brands, this opportunity cost is the growth in valuation that can happen when you use one form of capital versus another. The price of the capital isn’t what really matters. What matters is the growth you captured or missed through your choices of capital products. This is worth a post by itself, so I will tackle it later. But for now, let’s answer the question of how to price capital.
What would my return be if I used my own cash? Being able to answer that question gives you the tools to properly price capital and that tool is an IRR.
For example, if in buying and selling your inventory you can earn a 60% IRR using your own free cash flow then you should be willing to borrow that money at any IRR below 60%.
This process can obviously get more precise and complicated and sophisticated. But I would encourage every brand leader to at least understand at a quick and dirty level the rate of return or IRR they can achieve from the various ways they deploy their capital.
Using your cash is like making investments or placing bets. You don’t just take cash and make bets without some assessment of the risk reward. This is the same thing.
If you think you can earn 60% on your money annually through buying and selling inventory, aren’t you better off borrowing all of what you need at a rate well below that and risking none of your own capital?
Running a couple of IRR’s helps you understand your return using your own capital as well as the IRR’s of your various capital options. But here’s where it gets tricky. Not all capital works the same. Each option has different limits and timing of borrowings and repayments. It’s how these options align with your needs and business cycles and the growth they enable or inhibit that determine how well they fit for you.
Think of your brand as a machine that you are constantly adding to and improving. The machine has multiple cycles running at the same time. The longest cycle is starting and growing the brand over years or even decades. Then there’s the faster cycle of buying inventory and selling it. There’s also the cycle of customer acquisition where you build awareness and word of mouth, run ads, convert and then harvest repeat sales.
In an ideal world, we would have capital products for each of those cycles. We would use equity for the longest term and most uncertain cycle of brand building. We would use an inventory finance product that actually matched our buying and selling cycle and we would even have a customer acquisition product that matched our rhythm of acquiring and monetizing customers over time. These products would match our uses and the cycles of those uses. And they would provide the right amount of capital, when needed to fully fund the use for which they are intended.
At Elephant Herd Capital we are working to make this ideal world a reality. Our inventory finance product fully funds inventory and matches repayments to the buying and selling cycle of the brand. It’s not for everyone. But it is exceptional capital for exceptional brands.
www.elephantherdcapital.com
“What’s the APR? What’s the rate?”
It’s usually the first or second question in a capital conversation. And it’s the wrong one.
For brand leaders, the priority questions are:
- Can we get enough capital now and later?
- Do funding and repayment match how we actually use capital?
- Is the cost of capital lower than the return we’d earn using our own cash?
Price doesn’t matter if you can’t access enough. 10% APR sounds great until you realize you can only draw 40% to 50% against inventory once it lands. If you need $2M but can only get $750K, you are still underfunded and forced to patch the gap with cash flow or trying to convince the senior lender to accept junior capital.
Speed doesn’t matter if the cycle is wrong. “We’ll fund you tomorrow” sounds great until repayments start immediately. That is why MCAs and short-term lenders can create a negative spiral: you repay before you’ve bought, sold, and collected.
What’s the return you would earn from investing your own capital? The tool you use to determine that is an IRR and that’s the tool you should you use to compare prices of capital options.
But price is not how we should think of the cost of capital. The real punchline is that the true cost of capital is opportunity cost. How much growth in valuation did the use of this capital enable or prevent?
The above is a LinkedIn shortened version of the full post with much more detail and explanation. You can read the full post here:
https://elephantherdconsulting.com/blog/blog-database/how-you-think-of-capital-is-wrong
At Elephant Herd Capital we are working to bring the best capital products to brands. Our inventory finance product fully funds inventory and matches repayments to the buying and selling cycle of the brand. It’s not for everyone. But it is exceptional capital for exceptional brands.