In a previous article, we wrote about the importance of valuation for early stage companies and small businesses. The age-old adage echoed by economic developers across the United States, you should always have a succession plan can also mean that a small business should understand their value. Selling a business or selling shares of a company on a secondary exchange both require the same operational good governance and financial management.

A Tale of Two Industries

In practice, different funders rely on different frameworks to evaluate risk in early-stage companies. Startup funders rely on how KPI’s impact the financial model of an early stage company such as customer churn rate, revenue growth rate, etc. Since the financials can be largely a projection, does the model make sense? Is the market proven?

Established companies seeking debt financing through commercial banks rely on financial ratios such as sales to working capital, debt to worth, EBIT to interest, Sales to total assets, and several others.  

The Risk Management Association publishes an annual review of Financial Ratio Benchmarks across industry sector. The RMA is largely made of up commercial banks from across the United States. The RMA’s benchmarks are for firms less than 250 Million USD in Total Assets.

Startups outside of the major metros often lament the lack of risk or equity capital available for new businesses. Commercial bankers typically don’t lend to companies without established financials or intangible assets. Investors usually seek deals closely associated with their industry expertise.

Bridging the Gap

One standard framework for risk management across equity and debt financing would be helpful to investors in firms at all stages. Applying financial ratios to the financial projections of young firms could help that firm calibrate their growth trajectory in ways that align with industry benchmarks. Alternatively, applying KPIs to think of an established firm’s future growth as a model would help established companies continuously evaluate growth beyond cost cutting.

The divide between commercial banks and equity financiers for small business creates a significant information gap between equity and debt financing that is not existent in corporate finance. In corporate finance, financial theory tells us that within efficient markets debt and equity capital have no difference to the firm. Why should this change for small firms? Why should we have two different frameworks for valuing firms based on their choice of finance between equity and debt?