What is Expansion Capital?
I wrote a blog post on the expansion stage of a company’s lifecycle recently. The basic idea is that during the expansion stage of a company’s development, the company is working on product development, customer development, and company development, all while the number of customers, customer issues, people, and people issues are increasing. Generally, it is the most difficult stage to manage a company through.
Expansion capital is capital that some companies put on their balance sheets to help them finance the expansion stage of their growth. From an operating perspective, the capital is generally used to help increase sales and marketing and fill out the management team, but it is also used to help increase the velocity of product and development and on other business growth strategies. From a balance sheet perspective, the capital also helps increase working capital (as the companies grow, the receivables grow and most of the time consume cash even when companies are profitable) and companies need some level of additional cash cushion (rainy day capital) that is somewhat proportional to a company’s size.
Expansion capital generally should be in the form of permanent equity capital, although an optimized capital structure in a profitable or near-profitable company would generally have some level of debt, mostly in the form of asset-based financing (receivables or equipment loans, for example). OpenView‘s general approach is to make expansion capital investments using equity capital and then to follow it up with small asset-based loans from one of the leading venture banks when and if more capital is necessary.
In our view as a firm that is highly tuned to capital efficiency, the best expansion capital investments for both the company and the investor are those where there are clear and known operating investments that will create solid growth in a company that increases the value of the company much more than the dilution created by the investment. An example of a really good reason for a company to take expansion capital is when they know that they can add sales and marketing resources and the economic results from those resources creates considerable revenue and contribution margin (net of the sales and market and cost of goods sold). A finance type would say that the net present value of the investment in sales and marketing is positive even with the high cost of equity capital (or alternatively, the internal rate of return of the investment is higher than the cost of capital for the investment).
Some companies raise capital during the expansion stage to repay debt or repurchase shares from existing investors (for example, early stage investors or founders “taking some money off of the table). While this is capital at the expansion stage, it is not technically expansion capital but rather capital that is used to help manage the company’s balance sheet and capitalization table.
Just to be clear, expansion stage venture capital firms like OpenView Venture Partners make investments in expansion stage companies for many reasons, including providing expansion capital, secondary purchases (such as for founder liquidity) and for acquisitions, but the technical definition of expansion capital is that it is capital that is used for expansion.
Hopefully, you have a good understanding of Expansion Capital! Sorry for the dry post…it is a dry subject.
Note: I used the terms net present value (NPV) and internal rate of return (IRR) in this post just for completeness. They are important terms in finance and very powerful concepts, but most people in most situations can get away with thinking “payback period”. If you have a cash expense and it does not pay you back in a reasonable period of time (like less than 18 months) then it is generally not a good investment for an expansion stage company. The math associated with NPV and IRR is more complex, but the tools generally do not provide any better insights than payback period. While the concepts behind NPV and IRR are quite useful to know, I can count on one hand the number of times I have found it necessary to use these more sophisticated tools.
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It’s not an easy decision, but most important ones in life aren’t.