Lowering Your Cost of Capital
And, we’re back! I’m Jason, and this is INTRO to Finance — your easily digestible guide to financial topics for entrepreneurs. This week we’ll continue to build on last week’s topic of Cost of Capital. The question we are answering is:
“Am I making a mistake by taking a high-cost funding option?”
Counterintuitively, some higher-cost options might have some non-mathematical advantages to them. In some cases, the higher cost option might be the best/only option available to the company at that time. That doesn’t mean you’re making a mistake by taking expensive capital or that there aren’t techniques and strategies that can lower that cost over time.
Wait, what?
That’s right — you can, in fact, lower your overall Cost of Capital over time.
Bending Your Cost of Capital Curve
In many cases you can’t go back to your investor or lender and renegotiate the deal after receiving the financing. But you can lessen the dilution to yourself and your team by supplementing expensive (read: equity) capital with other lower-cost capital options.
Two examples of blending financial products to lower the total cost of capital were in headlines just this week:
New York’s Newest Unicorn: DigitalOcean Raises $50M At $1.15B Valuation →
DigitalOcean, which describes itself as “the cloud for developing modern apps,” announced today that it has raised a $50 million Series C at a valuation of $1.15 billion. Access Industries led the financing, which included participation from Andresseen Horowitz (a16z). It comes on the heels of a $320 million debt financing in February.
Envoy Has $20 Million In Fresh Funds And A New Mission: Safely Reopening Offices →
For that product push, and to maintain cash reserves through the pandemic, Envoy says it raised $20 million in venture debt from firm TriplePoint Capital, as well as a separate line of credit of up to $10 million for small acquisitions.
Using only expensive funding options, like equity, can make financings unnecessarily expensive for the business and dilutive for the team. From revenue to low-cost debt products, the more you can supplement and extend your equity raises, the more you can drive down the overall cost of capital to the business. This effect of lowering your cost of capital over time is thanks to a concept we like to call the Weighted Average.
I mean, we like to call it that, but so does literally everyone else.
Weighted Average
Unlike a simple average, the weighted average assigns more importance to the numbers in larger supply. In the real world, it’s highly unlikely that you’ve taken an equal amount of money from each funding source (unless you’ve only raised equity, which, c’mon!).
This means that each funding partner has different levels of influence, and taking a simple average would grossly underestimate the impact of the larger forms of capital that you’ve received. Instead, we need to assign credit to each form of capital that’s equal to its relative percentage of use in your business. We can accomplish this with the formula below:
Weighted Average =
(Cost of Option 1 * Option 1 % of total funding sources) +
(Cost of Option 2 * Option 2 % of total funding sources) +
(Cost of Option 3 * Option 3 % of total funding sources)
The best way to illustrate this point is with a simple example: If you’ve taken $1 at 300% ACP and $300 at 1% ACP, your blended cost of capital is only ~2%. This is because, although expensive, you’re not using the 300% cost as frequently as you’re using 1%. For every dollar that you use at 1%, you’re offsetting the 300% cost.
Confused?
Don’t worry. We made a calculator for you! Make a copy for yourself and customize as needed.
Rewrite The Playbook, Bend the Curve
The math doesn’t lie! Follow the footsteps of the savvy founders before you and seek out lower-cost of capital options to use them to your advantage.
One way of putting this into practice is to always raise some debt alongside your equity raise. Luckily this has become easier for startups raising venture capital because of the growing venture debt industry.
However, venture debt providers will generally only match a fraction of the amount raised in a given equity round. A good rule of thumb is that 25% of the equity raised could be available to you in debt. We’ve seen it as high as 50%.
While blending your raise can certainly help, our ol’ friend Weighted Average reminds us that smaller doses will only go so far in bending your cost of the capital curve. Transitioning your company away from predominantly ingesting high-cost options, such as equity, is the only way to have a major impact on lowering your blended cost of capital.
In the case of Envoy and DigitalOcean, this wasn’t an EITHER/OR decision but an AND. By leveraging lower-cost products in concert with equity raises, they were able to extend the time between fundraising, create more value in their businesses, and raise at higher valuations than they would have if they’d been relying on equity financing alone.
Do you want these posts delivered to your inbox every Thursday? Make sure to sign up below. Starting next week, we’ll be delaying publishing each issue online for a week. To make sure you don’t have to wait, sign up for the mailing list!
Have a question on funding options or looking to understand more about finance? Let us know!
