.

the mathematical notation for infinity, which is supposed to be the resultant equity return. The formula is intended to convey that a business generating cash flow and funded entirely with OPM will yield an infinite rate of return to the owners of the business. Of course, equity rates of return would not be computed this way. Instead, operating cash flow would be divided into the equity investment of zero to arrive at an effective infinite rate of return. Mort simply wanted to make the point of the importance of OPM. Saying it in Yiddish elevated the amusement level. In my years in business, I have seen a number of people successfully start or buy businesses with no equity. It is possible, but not easy.

Consistent with Mort's Model, forming a capital stack begins with a determination of the maximum amount of OPM you can get. In the end, you may not want to maximize your use of OPM, but it is good to know the art of the possible. As I noted in the conclusion to the last chapter, companies go out of business because they run out of cash. So, understanding where liquidity can be accessed outside of business operating cash flow is important. Plus, understanding how to maximize OPM will give you the best shot of minimizing equity and achieve something close to Mort's Model.

      At a high level, when it comes to the puzzle of how to assemble an equity stack, there are just three simple steps:

      Step 1: Start with money that has the longest repayment requirements. Hard assets like real estate and equipment can be financed for a long time and may even be leased.

      Another area where long-term money is to be found is with asset-based loans (ABLs), whereby lenders advance money against accounts receivable and inventory. Such loans are often in the form of lines of credit that can mature in a year or two. However, they require no repayment and can generally be readily extended, since they are based on accepted formulaic advance rates against assets that can be easily valued. Accountants often think of such credit lines as short-term, owing to their debt maturity time frame. Finance experts tend to think differently, because they know such lines to be readily extendable.

      Another source of long-term money, if you are buying a business, can be in the form of notes payable to the prior owner, which are often unsecured corporate obligations.

      Financing assets through OPM that involve long-term repayment (as in equipment or real estate loans) or modest to no repayment (as in equipment leases, real estate leases, or ABL facilities) provides several benefits: OPM can be maximized, monthly payments can be minimized, and the capital stack can be stable.

      OPM that is repaid quickly will alter the capital stack over time to elevate equity. That may sound nice, but an altered capital stack will tend to lower equity returns and potentially lessen corporate cash flow that can otherwise be invested in expansion. Repaying OPM and tilting the capital stack to 100% equity is fine, so long as your business has nothing more productive to do with the cash.

Step 2: Your next step is to turn to short-term money. In general, this will be money that has limited collateral and is repayable from free cash flows expected to be thrown off by the business after all the other OPM obligations have been met. Such loans will tend to amortize more quickly and represent a more volatile form of OPM because they are less universally available. Economic cycles come and go, lender risk tolerance rises and falls, and corporate cash flow loans are the most vulnerable to such changing environments.

      There may be an order of operations to determining OPM and a capital stack, but there is no standard OPM portion of a capital stack. Daymond John was declined 26 times for bank loans before finally borrowing money from a subsidiary of a South Korean conglomerate that he would not have found but for his newspaper advertisement. Indeed, commercial banks are not all the same. Likewise, there are a myriad of equipment and real estate leasing companies having diverse views of investment risk. And then there are non-bank lenders, such as small business investment companies (SBICs), business development companies (BDCs), and a host of non-bank direct lenders that collectively amounted to over $800 billion in assets at the end of 2019 from less than $30 billion in deployed capital in 2000.

      When it comes to OPM, there is a lot to choose from, which means that it's important to be informed and selective. Take time to shop.

      Step 3: Your final step is to determine the amount of equity required. Once the OPM portion of the capital stack is determined, then the amount of equity you require is simple. It's the difference between your required business investment and OPM.

Equity Sourcing

Having solved for the required amount of equity, the question is, where does the equity come from? In the case of Daymond John, he was unable to get any OPM to start up FUBU, so he had to put up all the money himself in the form of equity by pledging a personal asset to the bank. He would later get OPM from Samsung and others as he grew FUBU into the success that it became.

      As you might guess from our discussions up to now, there is a limit to the amount of equity you should invest. Equity is entitled to all the free cash flow remaining after paying the OPM obligations. The relationship of that free cash flow to the equity you invest, combined with the potential growth of that cash flow and the risks in the business, will determine whether you have the potential to create EMVA.

      Equity does not have to all come from you. Most entrepreneurs I have known began their careers with little in the way of financial resources. After he became a financial success story, Daymond John landed a spot as a “shark” on the syndicated show Shark Tank. Each week, select entrepreneurs seeking capital to start or grow their business would pitch their offerings to Daymond and other sharks, all highly successful businesspeople, in the hopes of raising added equity without giving away too much of their companies. In essence, the sharks became OPM equity for business founders and brought with them added skills to help the companies (and their personal investments) succeed. With that said, for simplicity I will start with the notion that all equity is your own money, which I also call YOM. OPM equity will be a subject for later.

Notes

      1 1. In 1996, we created the first US real estate master trust. The idea was to borrow against a pool of real estate by issuing bonds. Then, later, we would grow the vehicle by adding pools of real estate in subsequent years. In this way, unlike traditional real estate bond issuance, where the bond holders are secured by the specific pool they invested in, master trust bondholders would be secured by the collective the real estate held in past and future pools. For investors, the disadvantage was that they would invest in a pool of notes secured by real estate, but without fully knowing what their ultimate collateral would look like, since we could add to and occasionally substitute the collateral. However, the clear advantage for investors was that the pool could grow larger and become far more diverse over time, with a resultant likelihood that it would perform consistently. By contrast, traditional individual pool borrowings could be expected to have a higher level of performance variability. For us, the master trust delivered secured vehicle where we could service and control our own assets, giving us the ability to sell, improve, or substitute real estate to maximize the value of the pooled assets. Alignments of interest are always important, especially since commercial real estate note issuances are done without recourse to the issuers. In our case, we had an equity commitment amounting to 30% of the real estate investment amount.

      2 2. A present value is computed by discounting back future lease payments to be made at a company's estimated cost of borrowings to arrive at a theoretical borrowing equivalent. While the borrowing equivalent may be a reasonable approximation, the discounted value will not tend to equal the amount of OPM used, which is key in evaluating comparative corporate capital stacks. The present value of lease streams is also somewhat irrelevant, since companies nearly always extend leases or replace them with other leases. In that sense, computing the present value of a lease stream does not treat companies like going concerns.