Whether debt or equity: capital comes at a cost. Startups need to keep an eye on the cost of capital when funding their business and work capital efficiently. How can they achieve this?
Internationalization, product development, or new employees: When a company decides to invest, it has to weigh up the opportunities and risks. The cost of capital plays an important role in this process.
What is the definition of the cost of capital? How is it calculated? What are the implicit and explicit costs of capital? And what impact does the cost of capital have on startups and their capital efficiency?
What is the cost of capital?
Whether equity or debt, every company has costs when raising capital. They are called capital costs or cost of capital and consist of equity and debt capital costs.
But not all capital is the same. Debt capital incurs explicit capital costs – namely interest, which is contractually fixed in advance. Companies pay interest as a regular (usually monthly) cost of capital.
The situation is different for equity financing. Here, there is no explicit but implicit cost of capital. Investors expect a return on their investment. However, the return is not charged to the company until a later date, for example in the form of profit sharing.
For investors, the greater the risk of their capital transfer, the higher the expected return. In the case of VC financing, a fixed return is rarely set in advance. Rather, it is measured by the number of shares the VC fund receives and later sells at a profit. Since this is in the future, it's hard to calculate a concrete cost of capital for equity financing.
The total cost of capital is the sum of the weighted cost of equity and debt. Equity and debt are weighted according to the company's share of a assets.
How to calculate the cost of capital?
Companies can use various formulas to calculate the cost of capital. One cost of the capital formula is the WACC approach. WACC stands for "Weighted Average Cost of Capital". Usually, big corporations use it not startups.
The WACC formula
(Equity/Total Capital) * Interest on Equity + (Debt/Total Capital) * Interest on Debt * (1 - Income Tax Rate)
Cost of capital within the startup environment
Startups, lacking initial revenue, require capital to commence operations. They need to finance themselves with debt or equity capital. The capital is then utilized for their first product or hiring new employees, fostering growth.
What role does the cost of capital play here, and how does it affect investment decisions?
Exit or IPO: how equity can affect the cost of capital
Nowadays, there are many instruments available to young companies in the context of financing. Common equity financing methods include venture capital and business angels. The startup sells its company shares and receives equity in return.
This may cause implicit capital costs, which are unknown in advance.
The "true" costs of equity financing are different. Dilution reduces the influence of the founders on their own company. They hand over part of their ownership to external parties.
In addition, they profit less from the future increase in the company's value in the event of an exit or IPO. In the case of equity, the costs become real if parts of the company belong to the investors when it's sold and a portion of the profits goes to the investors.
Interest or warrants: debt capital is guaranteed to affect capital costs
The situation is different in the case of financing with debt capital.
Banks are no longer the only providers of debt financing. Term and growth loans, recurring revenue financing/revenue-based financing, or venture debt: the list of alternative financing options beyond traditional lenders is long.
Debt funding involves explicit costs in the form of interest, with varying interest models and payment methods available, such as monthly, quarterly, annual, or even pay-in-kind loans.
Here, the explicit capital costs can be precisely quantified and are known in advance. As a result, they can be structured more efficiently.
In some situations, opting for debt financing with direct interest burdens instead of equity might be more advantageous. Such a decision can potentially enhance the company's long-term value.
Short- and long-term impacts
As mentioned at the beginning, startups can access various forms of debt financing. With a term loan, for example, they receive a large sum in a single swoop. What is positive in the short-term can become a challenge in the long-term.
On the one hand, the company has a huge plus in its account. On the other hand, interest accrues directly on the debt capital. Usually, a startup can not invest the whole funding amount. It takes several months, sometimes even a year, until the capital is put to work.
A large part of the money remains in the bank. There it causes capital costs.
Overfunding drives the cost of capital
In this scenario, overfunding arises when a startup retains excess capital without utilizing or investing it. While gathering a bit more cash than necessary can be prudent to avoid liquidity bottlenecks, it impacts capital efficiency.
Efficiently deploying available capital for results becomes crucial, as inefficiencies arise when money remains unused while incurring costs.
Term loans, a popular choice among startups, contribute to this effect. They typically feature
- fixed interest rate at the beginning of the term,
- regular interest payment that remains the same throughout the term of the loan, and
- longer repayment period of between one and ten years.
Though such loans provide immediate access to the whole financing volume, the direct interest payment can pose challenges. Careful management becomes essential to maintain capital efficiency and avoid potential issues.
Does the money sit in the bank, or is it deployed directly?
Indeed, when financing, capital needs may significantly differ from the actual payout amount. And these needs can fluctuate monthly or quarterly.
Opting for a long-term loan offers security and stability, but this also affects a company's cost of capital and capital efficiency over the long haul. Two reasons account for this:
- Even if the business doesn't develop as expected, the startup must still pay interest and may need to adjust its business plan accordingly.
- While having ample capital is advantageous, it must be deployed efficiently within a specific timeframe (capital deployment). However, some investments may not be viable or useful for several months.
Unutilized capital incurs unnecessary costs, and this money remains idle in the bank account. Startups should carefully consider whether securing a large debt financing all at once is the best approach.
How can I reduce the cost of capital?
Fortunately, overfunding's adverse impacts on the cost of capital and capital efficiency can be mitigated through alternative financing models. Tailored debt solutions, like re:cap, present viable options that reduce capital costs significantly.
By choosing re:cap, businesses can expect approximately 40 to 60% lower capital costs compared to debt alternatives such as term loans.
Achieving this benefit involves conducting an individual needs analysis of revenue development and the business plan. With a clear understanding of a company's monthly capital requirement, they can customize their financing accordingly, ensuring optimal financial efficiency and strategic growth.
Funding adapted to business – not the other way around
Young companies, in particular, find great benefits in adapting their financing to match their business development. Within their financing framework, they access external capital only when necessary, minimizing capital costs.
Therefore, the key are tailored solutions to create customized funding and repayment plans based on the company's capital needs.
This approach allows for precise monthly and daily determination of requirements, ensuring efficient cost of capital. Timing and amounts align with the business plan and current developments. The financing volume is adjusted accordingly, increasing or decreasing as needed.
For startups, these advantages are significant:
- They avoid overfunding, securing funds according to their actual capital needs.
- The cost of capital remains lower due to precise financing arrangements.
- They operate in a capital-efficient manner.
- The revolving financing volume adapts to their needs, providing flexibility to increase or decrease financing based on the situation.
This approach empowers startups to make optimal financial decisions and maintain a stable financial position, fostering sustainable growth and success.
Conclusion: Keep an eye on your cost of capital
For startups, the cost of capital holds significant importance in investment decisions. To make informed choices, young companies must evaluate critical questions: When is capital needed? How much is required? What funding amount suits their needs?
By answering these questions, startups can identify the financing model that aligns with their use case. Crucially, the cost of capital should not have a lasting, adverse effect on a company's ability to meet financial obligations.
If this occurs, the investment might yield outcomes opposite to what the founders envisioned. Prioritizing well-considered financial planning and selecting the right financing options can pave the way for long-term success and growth.