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Debt can be a more cost-effective financing tool for your business, so long as it’s used for the right purpose and managed responsibly, says veteran deal adviser Joseph Valentic. Case in point: The 2018 demise of Toys ‘R’ Us.

“Toys ‘R’ Us died because they had $5.3 billion of debt and could not pivot,” says Valentic, founder and president of The Growth Advocate. “That's a cautionary tale that a business owner needs to consider. Yes, you can use debt capital. But the purpose of the capital must fit the type of credit you're getting.”

If your business can’t get in and out of seasonal needs based on short-term borrowing, then you really need to be looking at an alternate form of capital, he says. “There's something there that's not working. It could be capital, but it could also be a fundamental problem with the operation of the business.

“Bottom line, you don't want to use debt to mask and ignore symptoms that need to be addressed.”

Valentic works with middle-market companies to develop more effective dealmaking strategies. We caught up with him to talk about how to optimize your capital needs and better support your company’s growth plan.

Know your why

Before you get into a deep discussion on the types of capital that are available or the amount of funding your business needs, you should have a clear understanding of why you need that money. The capital provider, whether it’s a bank, a private equity firm or an investor, needs to know what you plan to do with their money and assess the merits of your plan.

“If the business owner has not clearly defined their why, then they can't possibly define their personal goals and objectives,” Valentic says. “And if those points aren't clearly defined, then they really don't have a clear strategy for the business. So when we say optimizing capital, it actually starts for us not with a calculation of capital or a type of capital. It first starts with the question of why.”

More and more, this question of the why has become a critical piece in the capital raising formula.

“Twenty years ago, capital transactions were more debt-oriented and they were more a question of short-term perspective on what do we need to get from A to B,” Valentic says. “Today, the sophistication level of underwriting, at the senior debt level, the equity level or at the mezzanine level, has gotten far more focused. We really need to understand the why behind the business. We need to understand the story.”

Valentic is fond of a Russian proverb often used by President Ronald Reagan as he was negotiating nuclear disarmament options with the former Soviet Union.

“Trust, but verify,” Valentic says. “Capital sources want to trust you, but they must also verify. So they will do more scrutiny around what the business owner’s frame of mind is. Is this model thoroughly thought through? If this is not the case, it can create a significant risk of failure to obtain capital.”

When this process is conducted properly, it should either give you the funding you need — or save you from making a costly mistake.

“There is an abundance of capital out there,” Valentic says. “But that’s all the more reason to go back to the very original question of why. If that's not clearly defined, you can get yourself in a heap of trouble by choosing the wrong capital structure.

Look at all the options

Once the why has been firmed up, you can begin to look at the resources, people, equipment and other components that will be necessary to implement your plan.

“The next step is to do financial modeling to reverse engineer what the capital need is,” Valentic says. “If we think we're going to generate 20 percent in profit, how much of that needs to go back into the business?”

You need to determine if your profit is sufficient to fund growth or if you need additional capital.

“Once we model and find out what our capital deficiencies are, only then should we be getting to the question of what’s the exact capital that we need. That gets us to the question of not only the amount of capital, but what type of capital is best for the business?”

Prior to the Great Recession of 2008, capital markets were primarily reserved for businesses that had at least $500 million in revenue, Valentic says.

“Now, we have an amazing variety of capital in the marketplace that reaches all the way down into the pre-revenue stages of businesses,” he says. “But the middle market, in particular, has become a focus for private equity and direct lending, as well as mezzanine and equity capital providers. I don't think the knowledge of the diversity of capital is something many middle-market business owners are really aware of because many of them grew up in an era where the only source of capital was the bank.”

The process to identify how much funding you’ll need and the best source to provide that funding is not foolproof. But the knowledge you gain can go a long way to minimize your risk of mistakes.

“We want business owners to really take the time with their team to sit down and look at their plan in detail,” Valentic says. “If they do that and they plan well, usually, they're able to have the flexibility to grow at the pace they want.”

Related story: A Good M&A Strategy Starts With A Compelling Story