Strengthening Your Balance Sheet

Consider, for example, the experience of Fermentas International, a global leader in the field of molecular biology products. The company provides researchers in university and commercial laboratories with nearly 1,000 products suitable for cutting edge life sciences research. Fermentas grew organically for more than three decades. However, by 2007, Fermentas' management team believed that in a rapidly consolidating industry, their best growth opportunity lay in acquisitions. A stronger balance sheet, they maintained, would allow them to acquire larger, more attractive companies.

In October 2007, Fermentas received substantial private equity financing from my firm. About half the proceeds went to provide a partial return to early investors. The remainder was added to the company's balance sheet as equity capital. Fermentas is currently evaluating acquisition candidates, seeking out companies with additional products and technologies that can be sold through the Fermentas global distribution network.

My firm has have helped dozens of entrepreneurs improve their balance sheets, giving them the flexibility to pursue many different kinds of growth strategies. Based on our experience, here are three key questions that entrepreneurs should consider as they evaluate balance sheet issues:

(1) How much cash do you need?

For starters, companies need to understand their working capital needs. Working capital is the difference between current assets and current liabilities. You want to make sure that your company has enough short-term assets to cover short-term liabilities-in other words, enough cash and near-term collectible receivables on hand to run the business. In addition, though, you may want to have cash on the balance sheet as a form of growth capital in reserve. This additional cash can fund acquisitions, expansions in plant and facilities, R&D, or any number of growth initiatives. When you have cash on your balance sheet to fund these initiatives, you may not have to borrow additional funds to expand. Moreover, just having additional cash can make it easier to borrow. As one of entrepreneur told me, "If you've got a big pile of money, banks are always willing to lend you more."

(2) Can you have too much cash?

In general, additional cash on the balance sheet is positive, since it gives you the flexibility to pursue a variety of opportunities, such as acquisitions, upgraded facilities and equipment, and increased R&D and product development. However, remember that this cash will only earn a modest rate of return, most likely less than 5 percent. Investing in the growth of your business will almost always generate a higher return than holding cash. If you have a good amount of cash on the balance sheet for an extended period of time, your return on equity may be lower than it should be.

(3) How much debt can you take on?

Strengthening the balance sheet does not necessarily require eliminating or even reducing debt. In fact, debt is an important part of nearly any company's capital structure. Many companies -- particularly in the technology industry -- are actually under-leveraged. They would be far more efficient, from a capital structure point of view, if they were to borrow a modest amount of money. We see debt becoming a problem only rarely. Companies whose cash flows fluctuate substantially from quarter to quarter may need to be more conservative in the amount of leverage they take on, so as not to risk violating a covenant -- or worse, missing an interest or principal payment during lean periods.

In other cases, issues arise because of broader problems in the business that can reduce cash flows: for example, the emergence of new competitors, the loss of key customers, or a more difficult regulatory environment. In these cases, companies overburdened by debt may find that interest or principal payments constrain their ability to make investments in the business or to acquire complementary companies.

Still, as a rule of thumb, most companies can take on debt of up to three times cash flow after capital expenditures. These figures vary somewhat by industry, however, and it may make sense to look at debt levels at comparable public companies in determining your ideal capital structure.

Structuring your balance sheet effectively can provide a sound financial foundation, offering the resources for your company to meet its current operating needs and plan for the future. Adding cash to your balance sheet via a private equity investment can give you the flexibility you require to grow internally or finance acquisitions and help your company reach its full potential.

Walter G. Kortschak is a managing director of Summit Partners, a private equity and venture capital firm with offices in Boston, Palo Alto, and London. Since 1984, Summit Partners has invested in nearly 300 growing, profitable companies across the United States and Europe. Walter can be reached at 650.614.6600 or wkortschak@summitpartners.com.