The Growth Paradox – The More You Grow, the More Capital You Need

Posted on: December 22nd, 2017

growth paradox Projected growth is usually thought in terms of revenue and profit increases. When people project out what the future holds, they tend to think through the prism of increased revenue leading to increased profit.

As the EBITDA builds in the outer years, people take comfort in the underlying soundness of their matrix of model assumptions. P&L assumptions tend to be painstakingly arrived at based on product lines, customers and seasonality.

When it comes to balance sheet projections, companies often apply historical ratios. The thinking goes that if working capital behaved a certain way over the last three years, then it will likely behave the same way over the next 3 years.

Management usually views the P&L projection as the most important target to achieve, and assumes that as long as that is achieved, then the balance sheet will fall into place. History does not bear this logic out.

Middle market growth can become a graveyard of ambition, if a company fails to understand the Growth Paradox – that the more you grow, the more capital you need to support that growth. Growth causes your outlays for expense and other expenditures to increase.

Growth also causes receivables to grow over their prior level, creating a use of cash. The combination of increased spending and illiquid receivable growth can have a deleterious effect on a company’s liquidity, especially if the growth unfolds unevenly.

Most companies fall into the uneven growth camp, due to the lack of control over the timing of customer purchase decisions. A fast and uneven growth spurt can constrain your capital and affect your ability to execute operationally.

So what are the best ways to get out in front of the pernicious growth paradox, to ensure you can grow strongly and seamlessly:

Overcapitalize your balance sheet- always have a liquidity buffer built into your balance sheet to absorb unplanned uses of cash. Even if your most rosy balance sheet projection shows little need for it, you should have extra cash. The opportunity cost of hitting the wall due to fast growth are simply too high.
Understand your real working capital drivers – many companies put too little emphasis on balance sheet analysis as they see the road to riches through the P&L. Understanding your working capital is critical because it is the cash flow spigot for your business. If you are building large illiquid levels of current assets, your cash flow will slow to a trickle, putting you in a jam.
Don’t leverage your working capital to fund an acquisition – many acquirers cannot resist the lure of low interest rates on a line of credit when sourcing acquisition financing. They raise a large loan against the assets to buy the company and then shortchange the amount of funding they have for working capital increases. Do not fall into this trap as you can become illiquid pretty quickly. Make sure you have enough asset based availability to support growth.

In the acquisition financing arena, capital availability is destiny as companies require reliable access to capital to grow over the long term. Unforeseen capital needs usually arise when acquirers least expect it. This can cause some concern for the acquisition financing provider, especially when covenants tighten up and that working capital availability is utilized faster than expected.

Mezzanine debt borrowing is usually a straightforward activity that many companies use for funding of transitional growth. Mezzanine debt lenders are highly transparent about their due diligence approach and their post-closing loan management making it easy for companies to engage with.

Elections have consequences and positive ones at that for the acquisition financing middle market. While much media attention is paid to the direction of the yield curve and the Fed’s likely rate cuts, scant attention is paid to the more important drivers of the acquisition financing market – business psychology and regulatory climate.