Understanding the Cost of Capital
All capital has costs, and every entrepreneur should consider both the monetary and non-monetary costs of each type of capital they are seeking. We explored this topic in our recent webinar Sage Advice: The True Cost of Equity (available for viewing here). This blog post explores the concept a bit further.
One way to think of the cost of capital is in terms of an equivalent interest rate. For example, the interest rate on a bank loan might be 5%. If you sell equity, and you are successful, that equity will likely cost the company between 25-35% compounded annually for the life of the company.
(See for example the returns published by the Tech Coast Angels of Southern California, one of the leading angel groups in the United State at https://www.techcoastangels.com/performance/ (accessed July 2, 2020)
But the equivalent interest rate, or “price” is only one way to look at the cost of capital. Here’s a chart comparing various “costs” by type of capital. Green is good, red is not so good, and of course yellow is someplace in between.
See below for a definition of all terms.
Bootstrapping is by far the least expensive, least constrictive source of capital. By using the cash generated by the business to finance its future growth you can grow your business without being required to report to others (governance), give up equity (dilution) or payout a return (price). Of course, the tradeoff is it takes time to get a company to generate cash, which may mean the company misses the market opportunity.
VC funding can be the most expensive. In addition to wanting large returns (upwards of 20x), it’s very hard to access, takes a great deal of meetings and time to procure, and the entrepreneur can be forced to effectively give up control of the company.
Revenue-based capital may seem expensive if the only thing you look at is the equivalent interest rate. But if you qualify, it’s quick and fairly easy to access. It is non-dilutive meaning it goes away once it’s repaid and does not require governance or other long term commitments.
Always remember the sale of any stock, whether to family and friends, to angels or to VCs is a permanent transaction. Once you sell that stock, you have shareholders – and an expectation that they be paid back - for the life of your company.
So, when exploring all the sources of capital for your company’s growth, be sure to consider all the costs, both monetary and non-monetary. It’s a common misperception among entrepreneurs that selling stock is basically free money, but that’s a dangerous and costly mistake to make.
Price is the lifetime cost of capital in terms of an interest rate.
Dilution is the impact of capital in reducing the entrepreneur’s share of ownership.
Ease of access is how difficult/time consuming it is to obtain this type of capital.
Governance restrictions means what constraints will be placed on the operations of the company as a condition of funding.
Length of obligation means how long the company will be constrained by this type of capital.
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.