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So your company has gained traction and has reached a point of success. The pressure for growth doesn’t dissipate as it’s critical that executives demonstrate the capability to enhance the bottom line and widen the profit margin. The executive’s appetite for additional risk in order to expand the size of the business exposes the company to additional internal and external environmental factors. One of those internal factors is the use of available cash towards the funding of growth opportunities. The decision for growth can be applied over time, as is the case of organic growth, or can be executed quickly through an acquisition.

Organic growth is usually a slow process that, over time, drains cash flow as resources are brought on to expand research and development, manufacturing, marketing and sales functions. Though organic growth doesn’t have large upfront costs, it does require a constant investment in operations. To stay competitive, management has to be careful with a slow-growth strategy, as some industries are dynamic and change quickly, which could leave the company behind if it doesn’t react fast enough. It’s important for the company to consider its overall position in the marketplace to determine if growing organically is the best solution. If the company operates in a fast moving industry, it may want to consider the benefits of an acquisition.

An acquisition usually involves an outlay of cash, debt and/or equity. Any of these options have individual challenges that place a strain on capital resources.

Cash: The release of cash obviously impacts the liquidity of the company which doesn’t just end with the acquisition. It’s highly probable that the company will have to spend more cash as it begins to merge the operations of both companies. One of the largest expenditures will be restructuring as the acquiring company begins to eliminate the redundancies between the two businesses. Outlay of cash will have an immediate impact on working capital, thereby reducing liquidity. With reduced liquidity comes the need to closely monitor the timing of cash receipts and payouts which management must balance along with the efforts associated with the acquisition.

Debt: The benefit of issuing debt or borrowing from a financial institution is that it will not require an immediate reduction of the Company’s working capital, but it will burden it with future interest costs. Borrowing from lenders usually bring upon debt covenants that burden the company with restrictions. These restrictions are designed to limit the loan holders risk and control certain aspects of the company. To avoid some of these restrictions that are imposed by financial institutions, the company can also consider the benefits of issuing bonds. Bonds usually are less restrictive as the terms can be controlled by the issuing company.

However, these terms have to be in alignment with the company’s risk profile as measured against comparable profiles for similar bond offerings. Different types of bonds can be offered which will impact the marketability and interest rate. For example, convertible bonds have features that allow the bondholder to convert the bond to equity during some designated period based on varying contingencies. These types of bonds need to be carefully analyzed by the management to ensure the outcome of any conversion falls within their range of acceptance for diluting ownership.

Equity: Issuing equity may dilute the interest of the shareholders, but it usually doesn’t place any immediate or future cash flow strain on the company. Equity can be distributed through different products: common shares, preferred shares, and warrants. Each of these products has advantages and disadvantages that need to be assessed by management to ensure that it’s in balance with the stakeholders’ tolerance level.

Common Shares: These shares can be issued to expand ownership and attract investment into the company. The advantage of common shares is that stock dividends are not mandatory, but the disadvantage is that additional ownership reduces the current ownership’s interest in the company and reduces their voting power. The new investors’ interest may not be in complete alignment with management which could cause further disruptions to the overall performance of the company.

Preferred Stock: This type of stock is considered a financial product that falls between bonds and common stock. Preferred shares/stock commonly have a fixed dividend that gets paid before common shareholders and normally do not have any voting rights. The benefit of preferred stock over bonds is that the fixed dividend doesn’t have to be paid as it can be suspended by the board of directors. Preferred stock can take the form of many types: convertible, cumulative and callable.

Convertible preferred stock can be converted to a set number of common stock at or before an established date. Preferred stock usually has a cumulative feature that requires the company to pay out all prior withheld dividends prior to any dividend being paid to common shareholders. Some preferred stock can have a callable feature that will allow the company to purchase these shares back based on parameters that can be pre-established prior to issuance.

Stock Warrants: This is another form of ‘currency’ that a company could use for acquisition purposes. This product gives the holder a right to buy securities in the company at a stated price and within a stipulated timeframe. This right is not in the form of an obligation on either party. However, in order to accept this as a form of consideration, the holder has to believe that the fair value of the stock will sufficiently exceed the stated purchase price prior to the expiration date of the warrant. It’s important that the company consider the dilution impact that stock warrants will have on the ownership if and when they are converted.

Whether the company decides to grow organically or through acquisitions, it must place emphasis on cash management. As we discussed, financing growth can take on many forms but they all ultimately lead to an outlay of cash. Understanding the owners’ appetite for timing of these cash outlays and the potential for diluting ownership are ultimately the two most important considerations.

Jeffrey Luft resides in New York and is an active CPA. He currently works for NewNet Communication Technologies (a Skyview Capital portfolio company) and previously worked for Arthur Andersen, Goldman Sachs and KPMG.