The Cost of Capital: Returns
Investors may love you, your team, and your brilliant marketing strategy, but ultimately what gets – and keeps – them in the game is an expectation of higher than public market returns on their investment. If you/your company are planning to take on equity financing, then you should understand the terms and numbers around returns, and what they mean for you.
InvestorSpeak on returns:
“Multiple” = how much money an investor receives back multiplied by their original investment, usually referred to as “5x”, “10x”, etc.
“Internal Rate of Return” = usually referred to as “IRR”; the compound annual rate of return earned by the investment over the time period the investment is in place.
Important numbers to know:
The median return IRR for an angel fund is 33%
(Pepperdine University Private Capital Markets Report – 2020)
The median time to exit for an angel investor is 4.5 years
(Angel Capital Association Angel Returns and Portfolio Strategy, Angel University, May 28, 2020).
Adding it all up:
If it takes 4.5 years for angels to receive their returns and their median returns are 33%, then the median multiple they are earning on their investment is 4.5x.
In other words, over a time period of 4.5 years, an investment compounding at 33% will grow to 4.5 times the original investment. (It is a coincidence that the time frame is 4.5 years and the multiple is 4.5x).
Since “median” means “the middle”, if you are a star performer in their portfolio your investors are actually going to have a much higher IRR and multiple, perhaps 10x - 20x or even higher. While they will celebrate this, you need to understand that’s your cost of capital, and that cost comes right out of your pocket.
This is where Revenue Based Financing (RBF) can make a big difference in a savvy entrepreneur’s overall capitalization strategy: RBF investors have a capped return, typically 2-3x our investment.
To help illustrate this point, we put together the chart below. It shows the compounding effect of the interest rate over the life of the investment. Since the total amount paid back in the revenue-based investment is capped, you will see the following effects:
while the effective interest rate on an RBF investment may be similar to that of a typical equity investment, you will likely have the RBF investment on your books for a much shorter period of time – usually 3-4 years (even though the chart shows 9 years)
the longer it takes you to pay back the RBF investment, the lower the effective IRR will be
The conclusion we can draw from the above is that assuming it will take more than three years to have an exit, taking a revenue-based investment will almost always be cheaper than an equity investment. An additional bonus: once you pay back the revenue-based investment, you no longer have this investment on your books, and no longer have to share your success with those investors.
For more on the cost of capital to your business, see our other blog posts: Understanding the Cost of Capital and The Cost of Equity: Founder Dilution.
Sage Growth Capital makes revenue-based investments in companies who need growth capital. It is our mission to provide a more flexible funding option to growing companies who do not fit traditional equity or lending models. To learn more about Sage Growth Capital or to apply for funding visit: www.sagegrowthcapital.com.