The Real Cost of Capital
What's the real cost of capital for your business? Do you know? Or just think you do? The concept of cost of capital comes straight out of Finance 101: When a business raises capital, how much does that capital cost? Business owners know with certainty the cost of their other expenses—they see them on their income statement, and they feel it when they pay their suppliers and vendors each month.
But capital is different. Small business owners don’t see it as the same kind of expense. Because it is fungible and usually gives the provider of capital some control of the company, it is harder for a business owner to understand its true price.
Cost of capital includes both its explicit financial price and how much control the owner gives up to raise it.
The first source of capital that goes into a company is usually is the entrepreneur’s own money. The owner puts his or her savings to work in the company―taking that capital from some other personal source, such as equity in their home, savings from a lifetime of work or family wealth, to invest it in a new venture.
When fully considered, the cost of that capital can be astronomically high. That capital could otherwise be invested in a diversified pool of other financial assets, used to pay down debt, or to finance a child’s education. The business owner presumes the return on the business will be greater than the returns of those three choices—the owner believes he or she will beat the stock market, earn more than they pay on credit cards or generate more wealth than investing in someone’s education. While high, it is a cost that a business owner won’t ever see on an income statement. The owner is also effectively saying the business opportunity is better than others—again, a high standard. On the other hand, the owner controls this capital and the company, making this the “friendliest” form of capital (and the most patient). There is no loss of control when you invest in yourself.
The second source of capital is usually debt. Companies use debt because it is the most available, predictable and institutionally-offered source of capital (and it doesn’t hurt that it is effectively tax-deductible). After running through their own capital (and that of family and friends), a business owner often turns to debt to finance the cash flow of their company. Debt pricing varies with market conditions and availability. Its biggest cost advantage is that debt doesn’t require an entrepreneur to give up ownership in the company, unless the company is unable to repay the loan. Debt brings some rigor to the company’s financials, covenants, and requirements to repay. These costs may squelch some further growth, but do not dilute the owner’s ownership in the company. Future upside in the company all goes to the owner, once debt is repaid. And the cost of debt is easy to see—in interest and fees. A harder to value cost of debt is a personal guarantee—some lenders require the owner’s personal balance sheet to stand behind the company.
Next, small companies may turn to venture capital, growth capital and private equity. These forms of capital combine higher cost with more dilution and loss of control for the owner. This capital is flat-out expensive. The folks who offer it see each opportunity as a risk, so they use the cost of the capital to pay for that risk and combine it with control features to mitigate their risk. Private equity investors will also create a board of directors, forcing the owner to come to them to make big decisions about the company and sharing in the proceeds when the company is eventually sold. These investors also will also likely set the manager-owner’s salary and set limits on how much cash a manager-owner can take out of the company.
So, how should you view cost of capital in your company?
- Your own: Take a step away from your company. Ask yourself if this is the highest best use of your own capital. Is there a higher-returning asset you could invest in? Would you invest in the exact same company if someone else were running it? What would you demand as a return from that company?
- Your debt: Shop for debt to make sure you are getting the best pricing and overall best terms. Consider the total cost of debt—if one provider offers a cheaper interest rate, are they also setting tighter covenants that may change how you run your business?
- Other people’s money: Consider the cost of having someone else participating in your decision-making. Look at the upside and downside scenarios for your company—what sort of return will the capital provider receive in each. Does that seem fair to you?
Don’t let the availability of capital, or the lack thereof, make you forget to consider its true cost. Whether capital comes from your own savings, a bank or an investor, it comes at a price.
ED POWERS | Columnist | Head of Capital Access Funds, Bank of America
Based in New York, Ed Powers is a managing director and head of the Capital Access Funds team at Bank of America Merrill Lynch. Capital Access Funds is an experienced, returns-driven private equity fund-of-funds.