Editor’s note: Jason Spencer is a relationship manager in the RTP office of Silicon Valley Bank (www.svbank.com ), which provides financial services to emerging growth and mature companies. This is the latest in a series of guest columns for LTW from the membership of the Council for Entrepreneurial Development (CED).
_______________________________________________________________________________________Raising money is painful, so don’t add to it by overlooking your cost of capital:
Everything comes at a price, and unfortunately money is no different. You already know many of the costs of fundraising all too well: the blur of plane flights and networking events, the endless stream of “dog and pony” presentations to potential investors, the late nights away from your family reading term sheets. While I know you would prefer to forget all of these costs, there is one cost that you need to remember: your cost of capital.
Why? Because paying too much for your funding can cause pain down the line for you, your employees, and your current investors. Evaluating your cost of capital can be tricky. To help you in that effort, I will cover some basics and debunk a couple popular myths.
I’m too busy to crunch numbers, just cut to the chase.
Higher risk = higher cost of capital, that is the rule to live by. If an investor is taking more risk, then naturally he will expect to be paid more for his capital to compensate for that risk. The risk level is partly determined by what claim the investor has on company assets and partly by the general stability of your business (e.g. no revenue/profits, lack of liquidity). For example, a senior debt investor typically holds a claim on all assets, which mitigates the risk of losing money, so that investor will charge less for its money than an equity investor, who has no priority claim on assets. Below is a quick list of different funding types/cost:
When raising money, part of what you want to consider is that your capital cost matches your business need. For example, if you are making a large purchase of equipment that can be used as collateral for a loan, debt financing makes more sense than equity. If you have to pay 25 percent for equity money but can get the same amount at 12 percent with an equipment specific loan, the cost of debt is compelling.
If I want some detailed numbers, where can I get them?
Your best bet is from an investment banker. If you have a relationship with an investment bank, they can provide you with a Weighted Average Cost of Capital analysis that shows the cost of your current funding sources relative to other financing options. Other business partners who could provide a WACC analysis would be a venture debt provider (either a bank or fund), your accountant, or potentially someone on your finance staff with an MBA or a background in security valuation.
Myth # 1: Equity Is Free Money
Your equity backers are key allies to your company. Their involvement provides not only operating capital but a wealth of experience and contacts to aid your business development efforts. Equity backers only win when your business does. This is a risky proposition that, as we talked about earlier, prompts equity investors to seek a relatively high price for their money. Overall, the cost of equity will be at minimum the hurdle rate demanded by a fund’s limited partners plus an additional margin for their own overhead. While this figure is a moving target, it will easily be north of 20 percent. Please remember that this money is deservedly expensive because it lives and dies with your business — it is truly critical funding. Equity is not “free” and should be deployed only on essential initiatives like an IP purchase. Conversely, equity should not be used on “mundane”/tactical items such as equipment or working capital — lower cost funding such as debt would be more appropriate. Remember, make sure to align your funding source with your business need.
Myth # 2: Debt Is Bad for My Company and My Investors
Countless Wall Street presentations, MBA classes and accounting seminars preach the wisdom that debt enhances equity returns. While slick pitch books and fancy graphs may make you skeptical, the fact is that this statement is true. Well-placed debt allows moderately priced funding for initiatives that provide robust income or valuation gains for equity holders. For example, growth capital debt can be procured to fund the hiring of key sales reps that produce significant account wins over the coming year. The revenue from these new accounts produces a geometric increase in valuation while you pay a fixed debt cost. By contrast, obtaining additional equity funding from an outside source would be tied to valuation and potential sales milestones, thereby diluting current shareholders and making the valuation uptick much less attractive.
Although we have only scratched the surface on the topic of cost of capital, hopefully it has sparked the thought that careful consideration of funding sources and cost when growing your business can add significant value to everyone at the table. And in more practical terms, making sure that the price is right can result in savings that make for a nice trip to Hawaii when bonus time comes around.
Jason Spencer is a relationship manager in the RTP office of Silicon Valley Bank. Before receiving an MBA at UNC-Chapel Hill, Spencer worked in investment banking and business development.
Representatives from Silicon Valley Bank have helped organize a panel discussion on “Squeezing Blood from a Turnip: Financing Your Start-up” at CED’s InfoTech 2005 conference, set for Oct. 12 at the RTP Sheraton Imperial Hotel & Convention Center. Visit www.cednc.org/infotech for more details on InfoTech 2005.