The cost of capital

(Sponsor post authored by Bart Dillashaw.) At one of the recent Lunch & Learns put on by the Mastercraft Advisors, John Grose and Doug Sutko of First National Bank discussed the “cost of capital” of debt and equity. Entrepreneurs often fail to think about this concept as much as they should, and it is a…

Sponsor: Thanks to Mastercraft Advisors, a consortium of four service providers, for supporting Silicon Prairie News. The group will be providing posts each month throughout 2013.

About the authorBart Dillashaw is an attorney with Koley Jessen and a member of the Mastercraft Advisors team.

 

At one of the recent Lunch & Learns put on by the Mastercraft Advisors, John Grose and Doug Sutko of First National Bank discussed the “cost of capital” of debt and equity. Entrepreneurs often fail to think about this concept as much as they should, and it is a topic worth exploring in more detail.

Those in financial circles throw around the term “cost of capital” generally to refer to the level of return a given investment is going to have to deliver to attract investors. Cost of capital tends to be proportionate to risk, so the riskier an investment, the higher the expected return. As the chart (above) indicates, a bank may charge less than 10 percent interest on a loan, but an equity investor is going to expect a five to ten times higher return because there is a much greater risk associated with the investment.

For loans, the cost of capital is the interest payment plus the effect of any financial covenant limitations imposed on the business as part of the loan. While banks do not expect as high a return, they do want very strong assurances that they will get paid back. Accordingly, banks generally loan to companies that have significant assets, very steady cash flows, or other dependable resources to draw upon.

The cost of equity is a little less obvious, because rather than getting paid back a fixed amount, the equity investor will receive a portion of any proceeds distributed to equity holders, usually through an acquisition or future dividends. Equity investments are much riskier because equity does not get paid anything until all of the business’ debts are paid off, and there are rarely any assurances of ever getting a return at all, much less any commitments as to when. However, equity investors will take a significant percentage of funds that would have otherwise gone to the founders, which, if the business is successful, could be far in excess of what the business would have paid in interest for an equivalent amount of debt.

All else being equal and assuming you think your business will be successful, a person would choose debt over equity, since the direct cost of debt is so much less. However, the true cost of capital to a business can be much more complicated to calculate when you start to consider the full implications of each type of financing. Although interest rates tend to be relatively low, loans can be troubling for startups because they require payments to be made regularly or on a specific date, no matter what. Even when cash flow is available, the business may have a better use for it than paying down debt (such as hiring that next marketing executive to help increase sales), and the consequences for missing a payment can be quite severe, including forcing the business into bankruptcy. Equity on the other hand can provide more freedom to operate, since it will only be paid back when the business is ready, willing, and able to do so, or when someone else buys the business.

There are countless variations on the spectrum of debt to equity, not to mention the myriad of other financing alternatives. However, each alternative has its own cost of capital, and entrepreneurs have to be aware of the risks, restrictions, and benefits of each option. Do not assume that a bank line, convertible note, or preferred stock round is the best option for your company just because you read about those alternatives or heard that was what another company did. Understanding the full cost of capital to a business will also help entrepreneurs to negotiate which terms and restrictions can be traded for others to get the best deal for their business. Entrepreneurs should fully understand what they are agreeing to before blindly accepting a term sheet. The fundraising process involves complicated decisions that have ramifications that go far beyond the immediate influx of cash, and skilled and experienced advisors can be invaluable in navigating this process.

 

This blog post has been authored by our sponsor, Mastercraft Advisors. 


About the author: Bart Dillashaw is an attorney with Koley Jessen and a member of the Mastercraft Advisors team. His practice focuses on emerging growth companies and venture capital and angel investors. Prior to joining Koley Jessen, Bart worked for Wilson Sonsini Goodrich & Rosati in Palo Alto, Calif., where he represented venture capital funds, startup companies and public technology companies. He currently serves as the president of Nebraska Angels, Nebraska’s largest network of angel investors. In addition, he is a network mentor for the Pipeline entrepreneurship program and a member of the advisory board of the Entrepreneurship Clinic at the University of Nebraska College of Law.

Find Dillashaw on Twitter, @bdillashaw.

About our sponsor: Mastercraft Advisors combines expertise in the critical business areas of legal, banking, accounting and IT tailored to meet the needs of startups and entrepreneurs. Four established and respected organizations – Advent IP, First National Bank, Koley Jessen and Lutz – have come together in Omaha’s Mastercraft building to bridge the gap between startups and service providers and better serve this important segment of the business community.

This story is part of the AIM Archive

This story is part of the AIM Institute Archive on Silicon Prairie News. AIM gifted SPN to the Nebraska Journalism Trust in January 2023. Learn more about SPN’s origin »

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