Why borrowing at 20% may be ‘cheaper’
When you take money from investors to build your business, it costs something. The true ‘cost’ of that investment money, or capital, can be difficult to determine depending on the financing.
The primary ways for people to give you capital are either:
1. Lend you money via debt
2. Invest in your business via equity
3. A combination of debt and equity
If you can get it, pure debt has a fairly straightforward and clear ‘cost’. The lender charges interest at a certain rate depending on your risk profile and underlying guarantees. If it is a pure debt deal, then the ‘cost’ of capital is simply the fees and interest rate charged.
If you are lucky enough to attract angel or venture capital as an investor, the cost of capital is much more difficult to determine. As an active angel equity investor and debt fund manager, I often ask companies looking for money, what they think the cost of equity capital is. The answers are all over the map.
From “Equity is free and there is no cost of capital when I sell shares”
To “Equity is the most expensive cost of capital known to man and is the last resort to raise money”
Which is it? What is the real cost of equity capital? Turns out both the answers above (could) be true, depending on the circumstances.
All investors, whether equity or debt, have to look at the risk-adjusted rate of return on their investment. That is why mortgage rates, where the bank has first claim on your house, have a fairly low interest cost as the underlying asset is strong and relatively low risk. Other lenders will charge more, depending on the perceived risk in the underlying investment.
Equity can seem free as there are no interest payments, but investors are still balancing the risk/reward ratio when they invest in equity. Equity is higher risk as in the event of company failure, the common shareholders rank last in bankruptcy. If your company goes bankrupt, then truly, the return to your investor was negative and the cost of equity for a bankrupt company is zero. Recent research shows that 3 out of 4 startups fail by not returning investor’s capital to them. It stands to reason then, that equity investors have to make this up by earning a much higher rate of return on their investment and a much higher cost of capital to successful companies when they take equity.
Assuming you expect your company to be a big success and not go bankrupt, then you need to understand the true cost of capital. Here is an illustrative example:
You need to raise $1 million to fund your company. You approach angel investors and perhaps seed stage venture capital. So you sell a 25% stake in your company for $1 million and low and behold your business takes off. Five years later, you are lucky enough to sell your company for $25 million and everyone is happy including your equity investor(s). The investor’s portion of your sale has netted them $6.25 million on their $1 million investment after 5 years. That works out to a 44% annualized return. In this case, your cost of equity capital is over 44%. If you pull off a major winner and sell the company after only two years that equity capital cost is over 145%.
That 44% may seem excessive but the truth is venture capital expects to make between 35%-50% on their money to make the fund economics work. Good example is here where Fred Wilson shows the detail behind 39% gross returns for his VC fund. They are in a high risk game where there will be many complete failures in their portfolio, so they have to reward their investors with a higher return.
An option often overlooked by early and mid-stage tech companies is debt financing. When reaching out to equity investors, companies should explore debt financing and may be surprised to find it is ultimately a less expensive option. Banks probably won’t be interested unless you have lots of assets and cash flow. However, companies like Espresso Capital and Wellington Fund can often find a way to lend the growth capital alongside or in replacement of equity capital. Using debt intelligently enables entrepreneurs to lower the cost of capital over the long run which makes for higher capital efficiency and happier shareholders.
In summary, your best option is to grow your company using your own cash and organic growth funded by customers. If you need capital to fund growth, you might consider debt capital. Taking money from investors is expensive so make sure you understand the cost before taking the cheque.