Capital Sources and Related Costs of Capital
Early-stage, cash-burning or high-growth companies oftentimes can’t, or choose not to, fund operations and new growth initiatives with company earnings. To bring cash onto the balance sheet for company use, companies must choose from a variety of debt and equity instruments. All capital comes at a cost to the company, which is essentially driven by the required allocation of future company cash flows or proceeds back to the capital provider. The specific cost of capital for each debt or equity instrument is based on current interest rates, market rates of return, and the risk/return profile of the company.
Debt is the most broadly understood and common capital source. To oversimplify, a lender provides the company with cash now in exchange for regular payments for a defined period into the future, which generate a predictable rate of return for the lender. The cost of debt is a function of the initial cash provided by the lender, the agreed-upon interest rate, and the company’s marginal tax rate since interest payments can be deducted from operating income to reduce the company’s tax liability. The company may have to provide a guarantee for that series of payments in the form of collateral (company assets), the company’s value, or the majority owners’ personal wealth. Some debt instruments may have related covenants requiring the company to meet specific criteria, such as having a minimum amount of working capital on hand, to remain in good standing with the lender. Debt holders generally sit senior to all other capital providers in terms of payback priority – i.e., if the company has a liquidity event (sale, bankruptcy, other majority recapitalization), the debt holders will receive their capital/return before all others. Generally speaking, debt is the most protective instrument for the provider (and most expensive for the company) in a downside scenario, but the return is capped in a high upside scenario (in which case it becomes the least expensive to the company).
Equity is another method of obtaining capital for company use by selling ownership in the company itself. In exchange for cash now, the company agrees to the capital provider’s claim on a future liquidity event. Various equity offerings have different rights attached to the investor’s claim on the company, including priority/seniority of payback, minimum or guaranteed rate of return, and associated voting rights around company decisions to attempt to influence a positive outcome for the capital provider. The cost of equity is dependent on interest rates, market rates of return, and the risk/return profile of the company. Equity holders sit junior to debt holders in the priority of payback but typically have uncapped upside along with the other equity owners.
There’s a spectrum of instruments between traditional debt and pure equity. Convertible equity, convertible notes, and preferred equity, as examples, can have elements of both debt and equity built-in and act as one or the other depending on various terms, optionality for either the company or capital provider or objective milestones that dictate the result. One of the more common instruments on this spectrum is convertible notes. The benefit of convertible notes to the company is that they can defer the determination of a valuation (or “pricing” of the equity) to a more favorable stage in the future. Convertible notes are also cheaper and quicker to draft and raise for the company, which is why they are often used as “bridges” between the priced equity rounds. The benefit to the convertible note holder is that they typically accrue interest and convert into equity at a discount to future equity investors. Preferred equity can be attractive to investors based on special rights, payback priority, or defined cash distributions.
Companies should be thoughtful and proactive when evaluating the various sources of available capital and their associated costs. Conventional wisdom might suggest that a healthy balance of both debt and equity is ultimately the best capital strategy, but every company is unique. The holistic view of all capital sources and their associated costs is referred to as the company’s weighted average cost of capital or “WACC.” Tracking this metric allows the management team to monitor their average cost of financing across all categories.