Monday, December 10, 2012
For several years after the VFI investment, BBE's business continued to grow. In the early days, I had been the only blogger, initially posting a blog once a week. Those weekly blogs had evolved into daily blogs on various topics. Between my blogging duties and managing the business, I found myself unable to adequately meet all of the demands on my time. I realized that I should cut back on my responsibilities and devote my time to what I did best, writing the material for the blogs. I shared my thoughts with the Board of Directors. They appointed Alice, a representative of VFI, the new President of BBE, and she took over day to day management of operations.
Over time, we had realized that there was a growing demand for blogs on some issues with which I had no familiarity. Consequently, we had hired additional employees to write blogs. BBE was now posting 4 different blogs every day. This led to higher revenues and earnings, which brought us back to the same place we had been before: once again, we needed to buy more servers, add more office space and expand our staff. The VFI investment had been the right decision, but it had simply bought us time. Ever more growth requires ever more equipment, employees and the space to house them all.
This time, however, the shareholders, including VFI, did not want BBE to issue (sell) any more shares, neither preferred nor common. Alice, our President, and Mary Jo, our financial consultant, suggested that it was time for BBE to add debt to its capital structure. Here is a link to a more detailed explanation of the term capital structure.
Put simply, a company's capital structure has two components. First is the equity capital contributed by the shareholders, whether common or preferred, plus the company's retained earnings. A company's retained earnings are those earnings remaining at the end of each year after all expenses, loan payments, dividends and taxes are paid: its net profit. Anything left over is "retained" by the company for future use. Here is a link to the calculation of retained earnings.
The second component of a company's capital structure is its debt capital, i.e., money the company borrows from lenders. There are various types of loans available to a business, each of which can be tailored for a specific need of the borrower. The simplest type of loan is an unsecured loan. This type of loan is made by a bank or other lending institution based solely on the financial strength of the borrowing company and the lender's belief that the company can and will repay the debt. Such a loan is evidenced by a promissory note, a written document signed by the company which contains the borrower's promise to repay the loan and the terms of the loan, i.e., the amount borrowed (the principal), the interest rate charged, the repayment schedule (monthly, quarterly, semi-annual or annual repayments) and the maturity of the note, the date by which all principal and interest must be repaid in full. An unsecured loan is generally a short term obligation which usually requires monthly payments of interest and, possibly, a portion of the principal. Such a loan matures within a year or so, generally no longer than 3 years.
A more familiar form of unsecured loan is the credit card, which can be used for daily expenses by companies and individuals. Some of the amount borrowed on the credit card plus interest is repaid monthly. The borrower/card holder has the option to repay the entire amount at any time. The terms of the credit card loan (a form of promissory note) are contained in the borrower's application and the explanatory materials (a form of promissory note) received at the time the card is issued. The terms of a credit card loan can be modified by the card issuer (the lender) upon prior notice. Because the risk of nonpayment or default is high on credit cards, the interest rates charged are also high, 12% or more in most instances.
BBE now has an established business with revenues of $75,000 and a good financial history at this point. It is already using credit cards for some of its routine expenses, but it would be a mistake to use a high interest credit card for a major purchase of the servers it needs. Alice decides to approach the bank where BBE has its checking and payroll accounts for a loan. Because of this relationship, the bank is already familiar with BBE's business.
We will pick up with her meeting with the banker in the next blog.
Comments are always welcome.