It's generally better to fund growth with cash flows from operations. But here are six cases when you should consider outside equity capital.
Sustainable, growing businesses, especially those in the middle market (typically $20 million to $1 billion in revenue), are in the best position to grow further. They have strategic assets they can leverage, they have the organization and tools to sustain growth, they are more nimble than their larger competitors, and they have more strategic choices in front of them than small or large businesses.
Often, however, midmarket businesses are capital constrained. So how do you capture these growth opportunities? The default choice is to live within your means and only pursue growth that can be funded from within the business. That means that instead of expanding to 10 new cities this year, you must limit yourself to one.
Is growth from existing cash flows the right choice? In most cases, it is, despite the risk of forgoing profitable growth. But there are some cases when you should consider raising capital from outside sources to fund your growth. Here are six criteria to consider before deciding whether to seek new equity capital:
1. You have proven your business model, and it is eminently scalable.
The most important factor in raising equity is a proven business model. You wouldn't fly an airplane before you determined whether the engines were powerful enough to sustain flight. Don't expand a business that hasn't proven that it can grow and significantly scale by repeating the business model in more places (e.g., geographies, products, customer segments).
2. You risk losing your competitive advantage by forgoing growth opportunities.
If you don't pursue growth, is there a competitor that will likely take that opportunity from you? If so, will your business suffer as a result? In this case, you should consider alternative ways to pursue the opportunity to protect your strategic assets.
3. You can raise equity without giving up control.
Raising equity capital means that you're selling part of your business. Will the new investors take control of the company? If so, you may want to consider growing more slowly so that you can retain control.
4. You can raise equity without adding significant distraction or cost to your organization.
Any equity transaction can be a huge cost burden to an organization, both in time and financial resources. Don't embark on this effort if it will distract your organization from your customers or the marketplace.
5. You can find the "perfect" investor.
It's not enough to have an investor who has the cash. The right investor is someone who shares your objectives and can add nonfinancial value to the business. See our previous article about the three characteristics of a great investor.
6. You have a clear and simple investment case that an investor can understand and believe in.
As an outsider, would you make an investment in this business? You must be able to articulate simple investment terms and an air-tight logic to describe how an investor will create returns.
If you meet at least five of these criteria, you may want to explore options to raise capital through outside investors. Otherwise, it's probably best to limit your growth, for now, to the investments that can be sustained within your current business model.
KARL STARK AND BILL STEWART are managing directors and co-founders of Avondale, a strategic advisory firm focused on growing companies. Avondale, based in Chicago, is a high-growth company itself and is a two-time Inc. 500 honoree. @karlstark