Corporate Finance is a key pillar of the Strategic Finance umbrella. The objective is to find the right equity and debt mix to arrive at the lowest cost of capital. A low cost of capital enables funding the business for sustainable growth and generate a positive return greater than the cost of capital. This traditional model of funding has faded somewhat in the last decade with the rise of Venture Capital and Angel Investors for the technology startups.
While equity capital is abundantly available, especially for technology startups, founders are seeing significant dilution in their stakes with each funding round. Startups chasing growth, see a high cash burn rate as they try to drive customer acquisition while still building a viable product. Debt is generally not available in the early stages as the business. Without predictable cash flows a lender cannot finance the business without taking a significant risk.
Free Cash Flow
For continued equity funded rounds, the business needs to establish product market fit, a growing customer base that pays for the company products and services. This demonstrates value generation at the company and pricing power. Ultimately, business scalability is achieved with either new products or deeper penetration to provide confidence on sustainable self funding growth via positive cash flow. If additional funding rounds are required to keep the business running, there is a risk of equity dilution for the founders. Management then loses control of the company to outside investors if the founders hold a minority stake. The cap table grows too large with multiple outside investors to manage.
The CFO’s role then is to partner with the management to on Strategic Finance and map a path towards building a sustainable business model. This model is focused towards generating free cash flow and the ability to service debt without destroying the value of the business. One of the key roles of the CFO is to keep an eye on the cash balances and the ability to generate, sustain and maintain positive cash flow generation. Being selective on what areas of the business to invest in without hemorrhaging cash is a critical skill. Once the business scales up, becomes credit worthy and the markets have confidence in the business to service the debt while still managing to grow the business, then it is possible to be in a happy space from a Corporate Finance perspective.
Traditionally equity has been more expensive to raise than debt. This is because equity shareholders take a higher risk if the business fails and they may not be able to recover their investment fully. Debt is usually a low cost option where often the debt is secured via collateral or some form of guarantee for periodic interest payments. Debt usually ranks higher than equity when a business is wound up and creditors are paid prior to equity shareholders.
The final component to the Corporate Finance model is the return. Traditionally dividends paid were a way to return capital to the investors. Dividends have lost favor in recent years due to potential tax leakage depending on in-country tax rules. When companies have the ability to reinvest earnings to generate a higher Return on Investment (ROI) on the capital than the investors would be able to generate on their own from dividend payments, there is a case to use internally generated profits to be reinvested in the business as a lower cost of funding option for the business. The reward for delaying instant gratification in terms of lost dividends could be a multiple expansion in the share value down the road in terms of an IPO for an unlisted company or for a listed company the traded share price on the stock market.