INTRO to Finance — The Cost of Capital
Over the last few months, we’ve been rolling out our new INTRO product. As part of those efforts, we launched a weekly newsletter called INTRO to Finance. The goal of INTRO to Finance is to break down complicated financial topics and financing questions into easily digestible and actionable answers.
Another Thursday, another newsletter. I’m Jason — welcome back to INTRO to Finance where we answer financing questions you’re too afraid to ask your VCs.
We have a meaty question to answer this week: “What is the difference in cost between debt and equity?”
Admittedly, this was a tough answer to keep brief… so we didn’t. We’re going to go into more detail than our previous issues because it’s an important question and one that we’ll be returning to again and again. So hang in there! This is going to be fun.
We’re big fans of using equity-efficient funding to fuel growth. Understanding the cost associated with using any financing option, or Cost of Capital, is key to why we think equity financing shouldn’t be taken as a foregone conclusion. It should be weighed against all the other funding options available to your business.
Despite the burning unicorn, we are not anti-equity financing! Each type of financing has a time and place. But, unlike cash flow, equity is not a renewable resource. Once it’s gone, it’s gone.
We want to see founders use it wisely against the backdrop of all their other funding options. Balancing the amount and types of funding that a company takes, in the form of equity and/or debt, is an art that has been around since long before venture capital was an industry.
The math involved can be complicated — that’s why we’ve included a simple framework below to return to when making your own financing decisions.
You down with ACP? — The Cost of Capital
Whether you’re taking on a venture capital investment, revenue-based financing, or a bank loan; it’s all money. No matter how you brand that money, it’s given to founders with the expectation of being paid back, PLUS compensating the financier for taking the risk. Debt requires regularly scheduled repayment including interest as compensation. Interest and equity investment requires compensation via the increased share value or dividends. BUT don’t get it twisted — everyone is giving you money to make themselves money.
Before taking any financing, ask yourself, “what is the cost of using this money?” Having too much debt service can leave your company with too little cash to invest in growth. But, maybe more importantly, selling too much equity can leave the common shareholders at the bottom of the capital stack, with little to no reward for creating an amazing company. Optimizing both is a winning strategy for building a stable business and creating value for everyone involved.
A Simple Way to Calculate the Cost of Capital
When trying to choose between different types of financing, it can be confusing to understand how the costs compare. We’re going to keep it simple (for now). It may not be the most precise analysis, but it will serve as a consistent tool for a quick comparison of options. We’re going to convert all financing options to a simple Annualized Cost Percentage (ACP). Having a percentage to work with, regardless of financing type, will create a more apples-to-apples framework for future comparisons.
We’ve created an ACP calculator for you to use. Just copy the sheet and you’ll be set.
The ACP helps you understand what percentage of the financing amount you would be effectively paying back on an annual basis.
For example — if you received funding of $2M and were required to pay back a total of $3.8M over 10 years, your Annualized Cost Percentage would be 9%.
If this financing required annual payments, you would be paying $180k a year in cost beyond repayment to use the money. That’s 9% of the $2M funding amount that would be paid each year.
Every term sheet or financing product may not provide these exact inputs. Let’s break down each piece of the equation to understand the moving parts.
Let’s start with the Financing Amount. This is exactly what you think it is — the total amount of the funding that you’ll receive. Nothing more, nothing less.
Profit for the Financier
Next, we find the Profit for the Financier. This is the expected amount of money to be paid above and beyond the Financing Amount.
The easiest way to calculate this is to find the total amount expected to be paid out to the financier for the deal and subtract the initial funding amount.
Profit for the Financier = Total Compensation to Financier — Financing Amount
For debt, this is fairly easy to accomplish. Add up the total amount of debt payments required, and subtract the Financing Amount.
For equity, calculating this may not be as straightforward. You can back into Profit for the Financier by understanding the total return that the investor is looking for and subtracting the Financing Amount. Equity investor expectations deserves its own post in the future, but if you don’t know what the investor’s expectations are, we urge you to ask. Given that most early-stage (seed to Series B) equity returns follow a power law, a good rule of thumb is that each investment should have the potential of returning their entire fund.
Number of Years
Lastly, you need to understand the Number of Years. This is the expectation in years that it takes to repay the capital.
Most debt makes this easy for you to understand by giving you a payoff date or a number of months/years required to make payments.
One of the benefits of taking equity is that there isn’t a time requirement to repay or penalty for not paying anything back. But VCs have their own expectations of when they would ultimately like to see their return. For early-stage investors, you can generally use 10 years for the Number of Years.
In the absence of a defined timeline for repayment (à la more modern products like revenue-based finance), you can run a simple forecast of consistent monthly growth to determine the date the final repayment will be made.
How does this stack up?
Now that you have a simple framework to compare capital costs, we’ll offer a quick reference guide for different financing options and the relevant lowest Cost of Capital you could expect from a given financial product. The goal here is not completeness, but to give context for the true cost of capital of each financing option, and inform which path you should choose:
This is Only The Beginning
Thanks for sticking with us! The Cost of Capital concept is a foundational piece for optimizing your optionality as an entrepreneur. We’ll continue building on it in future issues. It’s natural to get caught up in all the marketing and value-add that equity investors bring to the table, but there’s a cost associated with that capital that should be weighed against all of the other options available to you.
As always, send us your questions and we’ll answer them in future issues. For now, we have one question for you: You down with ACP?