Startup Finance 101: Optimizing Capital Structures, Part 1

Economics 101 dictates that the objective of every free-market enterprise is to make money for its stakeholders. However, the old adage “You’ve got to spend money to make money” is true for a reason. Business owners must spend money to hire employees, build a product or execute a service, acquire supplies, keep the lights on in the office, and fund the day-to-day tasks that result in the execution of the company’s stated business model.

This article series will explore the various sources of capital available to entrepreneurs scaling built environment technology companies and explain why capital structures are important to the overall success of a startup. While the most common form of capital we cover at BuiltWorlds is venture capital, venture capital is not the only form of financing a startup utilizes—nor should it be.

The first installment of this series dives into the decisions governing how a company chooses to capitalize itself.

Choosing Financial Capital

Financial capital comes in many forms with three primary classifications: debt, equity and mezzanine (hybrid). Nuanced financial products within each of these three categories give decision makers the ability to use capital that will be most beneficial and least costly for their specialized needs.

Whether a business owner chooses to fund their enterprise with debt, equity, or a mix of the two depends on the expenses incurred and the product or service provided. To illustrate this, let’s imagine there are two companies, Company A and Company B.

Company A provides a product, specifically the manufacturing of construction robots. Acquiring a factory, equipment, machinery and materials will account for a majority of this company’s expenditures. Company A will also need to pay utilities to keep the production facility running and the salaries of the workers manufacturing the robots.

On the other hand, Company B provides a service, offering a scheduling software for construction managers. This business will have few physical assets to acquire, but will need to invest up front in developers, software infrastructure, sales and marketing.

It would be foolish to suggest that the owners of Company A and Company B capitalize their businesses in the same manner. Company B may not be able to access or afford the financial products that Company A uses. On the other hand, Company A will need to make more expensive purchases to acquire the assets it needs to manufacture its products. Company B’s financing strategy is not conducive to success for Company A’s asset-heavy business model.

If the cost of capital exceeds the intended benefit, a startup will spend more money than it makes. Almost all startups are “cash burning” in the early stages, meaning the company spends more money than it makes. Many startups can even afford to lose money for years because their investors believe that profitability will come in the future. However, when startups run out of money to pursue these future objectives, they fail.

Using the wrong sources of financial capital can overvalue and overburden startup companies, eventually leading funding to dry up. Improper use of financial products available to startups can lead to this scenario. So how do these business owners choose from the wide range of financial products available to fund their businesses into becoming profitable enterprises?

OpEx Versus CapEx

As simplistically depicted above, there are a wide variety of expenses a business can and will incur. Financial products are designed to service the gamut of these: operating expenses, capital expenses, cost of goods sold, financing expenses, non-operating expenses, prepaid expenses, depreciation and amortization, taxes, employee benefits, legal expenses, and more. In the early stages of a company, built world startup founders will be most concerned with financing operating expenses (OpEx) and capital expenditures (CapEx).

OpEx are short term in nature and involve the day-to-day needs to keep the business running, such as salaries, rent, utilities, marketing, office supplies and sales expenses. CapEx are associated with the purchases of the business’s long-term assets: machinery, equipment, real estate, vehicles and software development. The cost of goods sold is also relevant to early-stage product-based business models. It includes the raw materials, direct labor, and manufacturing overhead required to, using the example of Company A above, produce the robot.

Financing Growth Opportunities

As a startup company matures, it will also seek to finance its growth opportunities, which can be a mix of OpEx and CapEx. For example, Company A may choose to expand its sales efforts from the U.S. to Japan, requiring a regionally-based sales staff (OpEx). The company will also need to acquire an office building to house the new sales staff and serve as a distribution center to reach local customers (CapEx).

An acquisition of another company to reach new markets is also a growth opportunity. We have seen a few cases where a venture-backed startup acquires another venture-backed startup in the built environment. This is an uncommon scenario because when a VC invests in a startup, a substantial bet is made on that business succeeding; the VC is backing that particular management team and product in a race against other legacy and incumbent competitors. Venture-backed acquisitions are rare because it requires approval from two boards that are committed to their company succeeding. In other words, there needs to be an extremely compelling case for the synergies to be realized in the acquisition.

Growth opportunities can be extremely costly, as an acquisition can cost billions depending on the size of the target. Oftentimes, startups, or even mature companies, do not have sufficient cash on hand to perform the acquisition and need to raise money. Nuanced financial products can give financial managers flexibility to achieve these growth measures without overburdening the financial health of the company and causing capital to dry up.

Once the needs of the business have been determined, startup founders can then decide how to finance OpEx and CapEx through a variety of financial instruments stemming from three main trees: debt, equity, and mezzanine, which we will explore in Part 2.