The Time Value of Money
A recent Pitchbook Analyst Note on the Venture Debt market indicated the following:
“Equity financing is one of the most expensive forms of VC capital for a company. Debt, on the other hand, can be cheap. For startups experiencing growth, selling a 10% stake to investors for $200,000 can cost millions when a company exits. Equity investors expect their capital will result in a company that has grown multitudes larger over the time of their investment. This is, of course, how the venture industry works, and the high potential returns are there to entice investors to pursue the high-risk strategy of funding companies that are likely to go out of business. Ultimately, however, the repayment of equity investments comes at the expense of founders and other investors whose shares have been diluted.”
Kyle Stanford. “Venture Debt a Maturing Market in VC.” Pitchbook Analysts
Note, https://pitchbook.com/news/reports/q1-2021-pitchbook-analyst-note-venture-debt-a-maturing-market-in-vc. March 2021.
The Sage Growth Capital team has found that often, entrepreneurs do not understand this principle. Equity investors expect to have strong returns on their investments to make up for the losses in their portfolio. That is why they aim for at least 10x returns over the life of the investment. We spend a lot of time explaining this concept and its partner, the time-value of money, when we speak on panels or to prospective funding applicants.
To help demonstrate how time impacts the value of money, we provide the following chart:
The yellow line in the graph shows a 35% internal rate of return (IRR) compared to the multiple an investor would need to achieve that IRR over some time period. For example: at 2 years, the investment would achieve a 35% IRR at a multiple of 2x, but to get the same IRR at 9 years into the investment the investor would need a 20x multiple. In other words, the longer an equity investor is in your deal the bigger return/exit they need you to have to achieve their optimal return.
This concept of time versus returns is very different when it comes to Revenue Based investing because the amount being repaid by the company is capped at the multiple which is set at the beginning of the investment. This means that a Revenue Based Investor is hoping that you will grow your business quickly to result in a higher IRR for them, but if you take longer their return is lower because of the capped multiple on their investment. Interestingly, this creates a better alignment between the investor and the entrepreneur, because everyone is focused on increasing revenue as quickly as possible.
As you start looking at options for growth capital for your company, please keep in mind the real cost of capital over time and what returns your investors will expect.
For more on the cost of capital to your business, see our other blog posts: Understanding the Cost of Capital The Cost of Equity: Founder Dilution and The Cost of Capital: Returns.
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.