Now That’s Pessimistic
When we last saw my friend with the not sufficiently pessimistic financial model, he was going to go back to forecast higher levels of volatility in the commodity business he was thinking about buying in order to determine if the deal he had on the table made sense. He did that, and the answer was that if revenue declined by 20%, he wouldn’t be able to service the debt he proposed to put on the balance sheet.
Could that happen?
Well, since the relative standard deviation of the commodity price that drove sales at this business was 26%, the potential for a 20% decline in sales was very much on the table. He could hedge, of course, but that didn’t seem practical for a business of this size, so the question was “What next?”
If you’re ever in a position where you need to predict how a business will behave, the thing to look at is its capital structure. In other words, is it funded by debt or equity, how much of each, who are the actors, and what are the terms? In this case, my friend wanted to buy a business and reinvest in capabilities in order to grow, but his cap table with far more debt than equity would never enable him to do that even after leaving aside the potential for top line volatility.
So I said, “You’re already raising money from investors to do this deal. Can you raise more and swap out some of the debt with equity?”
“I could,” he responded, “but then the returns will be lower.”
And that’s a true fact. Equity capital is more expensive than debt with its cost borne directly by other equity holders. Yet what selling equity won’t do is bankrupt you.
Or here’s how Stripe cofounder John Collison phrased it on Patrick O’Shaughnessy’s Invest Like the Best podcast recently: “Credit financing is fixed cost to the borrower…[but] has the unbounded risk of destroying your business. Equity capital has unbounded costs, but does not come with the embedded risk of possibly blowing up your business.”
That’s a great way to look at it. So a question to ask of your cap table is what is the risk of it blowing up my business and how much is it worth to me not to?
Given that my friend was personally guaranteeing this loan, relocating his family, and staking his savings and employment in the deal, when he thought about it, not blowing up turned out to be really valuable to him. Further, when he went out to raise additional equity and explained why, he found that his investors now wanted to give him more money despite the lower return profile because lowering the risk of their losing their investment was valuable to them as well.
In other words, it can pay to be pessimistic, particularly if your pessimism is realistic, and helps you align the funding of your business with the funding it needs.
– By Tim Hanson
