The Time Value of Money II
If I give you a dollar today, what is it worth to you? What if I promise to give you a dollar tomorrow? Tomorrow’s dollar is probably not worth as much as the dollar today, right? Well, this principal, called “the time value of money,” is ever present in investing but sometimes I think that entrepreneurs don’t really understand it. A good case in point is the rash of merchant cash advance (MCA) lending that companies appear to be readily taking without understanding the true cost of the dollars they are borrowing. Now, don’t get me wrong, I’m not saying that this type of lending is bad. If you need capital and MCA is the only source available to you then by all means take it. But understand the math so you can make an informed decision.
Here is an example of a conversation I’ve had with many companies looking at Sage’s revenue-based financing: “Your capital is really expensive; you want to be paid back 2x the original capital over four years. I could go get an MCA loan with a payback of 1.1x instead.” But if you only look at the payback multiple, you are ignoring the time value of money. Paying back 1.1x the investment over six months likely results in a higher effective interest rate (technically known as the internal rate of return, or IRR) than paying back 2x the investment over four years. And of course, you only have use of the cash for six months maximum.
Yes, Sage’s capital is expensive. From an IRR perspective it ranges from 15% to 40% depending on how you pay it back – one lump sum at the end or some sort of payments over the life of the investment. But the investment is repaid over 4 years.
On the other hand, the 1.1x on the MCA is usually repaid over a time period of 6 months. The IRR is somewhere between 25% and 100% depending on how you pay it back.
To demonstrate, here’s a table illustrating the effective interest rates
What does this mean to you as the entrepreneur? Don’t look only at the multiple. You have to also include the variable of time to make an informed decision. And of course, there are other factors to consider such as how long you need the capital, and whether you want the repayment to be based upon cash flow.
For more on the time value of money or the cost of capital to your business, see our other blog posts: The Time Value of Money, 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.