Debt vs equity: the true cost of capital for founders

Have you ever stopped to ponder the true cost of capital for your business? Not just the interest rates, fees or the number of shares your investors hold; we’re talking about the total lifecycle cost of any capital in your start-up or scale-up. As the saying goes, knowledge is power. And it’s only once you have the full picture of what different forms of capital cost, can you truly chart the best course for you and your business. So, let’s get started.

Capital classes

Debt and equity are two types of capital that can potentially offer start-ups and scale-ups large sums of flexible funding. And by funding that is flexible and substantial, we mean as compared to bootstrapping (such as founders personal savings) or fixed government grants.

What is debt financing?

Debt finance is essentially any loan for your business. Bank loans, credit cards, lines of credit, overdrafts, peer-to-peer loans, invoice financing and R&D financing are all types of debt finance. Although different types of debt are designed for different business circumstances and even different types of business, they have a few things in common.  All debt financing — unsecured or secured against business assets — is repaid with interest over a set period. Both the interest rate and repayment period are known and agreed to in advance by the borrower. For an in-depth look at debt finance, see our blog, How to leverage debt financing at every business stage.

What is equity financing?

Equity financing is exchanging (effectively selling) company shares to investors for capital. These investors can be (but are not limited to) family, friends, a business angel or a venture capitalist (VC). And investors can also obtain equity in your business via an initial public offering, where your company is listed on the stock market and its shares traded. And, as is the case with debt, there are different types of equity financing. Common shares, preferred shares and crowdfunded equity are all types of equity finance. Common shares typically have voting rights but no guarantee of dividends. Preferred shares, on the other hand, usually come with dividends but no voting rights. Although these different types of equity come with different benefits, they all deliver a stake in a business for the investor. For more on equity financing read our article, Crucial capital raising tips for every business stage.

Debt vs equity?

Debt vs equity is often pitched as a binary choice, with tropes and cautionary tales attached to each type of funding. For some founders, debt financing means high interest rates, upfront fees and transactional and timebound lender relationships, while for others these are upsides that let them stay in control. On the other hand, the ‘money tree’ reputation of VCs can lead many founders to view equity as the holy grail of start-up funding, while others fear the potential quagmire of being a founder of an investor-backed venture. With seemingly so many conflicting perspectives, let’s unpack these and other myths about debt and equity as we explore the true cost of each type of capital for your business.

Calculating the true cost of capital

Getting a handle of the true cost of capital for your business is harder than meets the eye. It involves looking at tangible costs, intangible costs and opportunity costs. And you need to consider all three during the time that the capital is in your business and until you, as a founder, exit.

Tangible costs

Tangible costs are ones you can quantify and measure within or over a period of time. And they’re related to a source or an asset you can readily identify.

Dollar cost of debt financing

Debt finance gets a bad rap with some founders because its monetary cost is often front loaded. Even for R&D financing where the payments are due months after the loan is granted, the dollar cost of the loan is apparent. Before borrowers sign any loan agreement, they see double-digit interest rates, arrangement fees and other potential charges, such as late payment penalties. Some debt finance is secured, so founders need to put up assets they or their businesses own as collateral, which can add to anxieties about the financing’s cost.

Depending on your company’s circumstances and borrowing opportunities, the amounts and costs, including the principal, interest, fees and loan duration, will vary. But let’s take the example of a fictional innovation start-up called Simulation Company. Simulation is currently valued at $6 million dollars and is looking to borrow $3 million. As Simulation has an eligible R&D Tax Incentive ( R&DTI) claim, the business decides to explore R&D finance as a cash-flow-friendly capital solution.

Simulation takes a $3 million R&D finance loan over six months with an approximate annual interest rate of 17% and pays $250,000 in interest and fees. Since the R&DTI refund covers the loan there is effectively no long-term financial burden. Ten years later, Simulation sells the business for a value of $45 million. At exit, the original owners retain 100% ownership and keep all the proceeds from the sale. Debt financing allows full ownership retention, meaning the founders benefit from the full upside of the business growth.

• Debt’s silver linings

The flip side to debt finance’s price shock is that founders may not end up paying those double-digit annual interest rates. If a term of a loan is less than a year, say a few months, then the interest will accrue on a pro-rata basis. So it will be less than the annual rate. Another benefit of debt financing is that the founder turned borrower has a high degree of certainty. You know what the capital you’ve borrowed is going to cost you under optimal and adverse scenarios. And you know how long the capital will remain in your business. Once the loan is repaid, the contract is completed.

• Pluses and minuses

The key takeaways here are that while debt financing can have high interest rates and some loans lack flexibility, founders retain a high degree of control. And if you want more debt finance, you can also apply for a new loan or extend or increase your borrowing if your lender agrees. A criticism of debt financing is that it can lack flexibility and scalability. But that reputation isn’t entirely deserved. Newer types of financing, in particular, R&D financing, can be quickly scaled to meet your research needs or for other business activities such as a product launch.

Dollar cost of equity financing

Generally speaking (but not always) equity financing offers start-ups and scale-ups access to larger sums of money than their businesses could borrow from a lender. But despite the big numbers, the dollar cost of equity financing is unknown until the business is sold or floated on the stock exchange. Equity’s appeal for founders is that it is ‘expense-free’ at the point of receipt. You can receive an inflow of investor capital in exchange for equity in your business. Equity funding can unlock your business growth and potential overnight. Other than having your business valued before striking a deal with investors, you don’t have to open your wallet. There are no interest rates, fees or charges. And if your business fails, you won’t lose your shirt either because you don’t have to repay your investors. For more information, read our blog, Five essential questions to ask before raising capital.

• Equity’s long-term cost

Equity finance sounds like a no-brainer. But here’s the kicker. While it’s not going to dent your expense accounts today or maybe tomorrow, it could seriously dent your earnings when you exit.

VC funds are backed by wealthy investors (individuals and institutions), and they expect a handsome return on the money they’ve entrusted to the VC. Your typical VC aims for a fivefold return for investors over 10 years across its portfolio. And if you’ve attracted a VC to invest in your business, the pressure is on to perform. ^[1] What equity will cost your business depends on how much capital you raise, and how well your company performs. And then there are different ways of calculating the cost of equity and different ways investors and founders may exit the business. But, by way of example, let’s imagine our fictional start-up, Simulation, raises $3 million dollars in investor funding.

With the same starting valuation of $6 million, Simulation raises $3 million dollars and pays $150,000 in fees for a 33% share of the business. The start-up delivers a fivefold return 10 years later. On exit, the business is sold for $45 million with the original owners retaining 67% of the value or $30 million. The cost to the original owners is $15 million and represents the value given up to investors in exchange for funding. Equity financing significantly reduces the founder’s final stake value ($30 million vs. $45 million).

• The price of returns

Remember the five times return a VC is seeking is the average. Most of VC investments won’t deliver but the ones that do will be knocking it out of the park to arrive at the desired average rate of return. The more successful you are, the more expensive ultimately your equity funding will be. And if your business is performing well, your investor may seek to increase their shareholding in your business. The amount that your investor pockets on exit directly correlates to the percentage of your business they own and how much the value of your business has grown. That can run into tens of millions of dollars for your investors that you miss out on. So the true cost of the equity financing for you and your business can often pale into insignificance when compared to a double-digit annual interest rate.

• Moving out of the driving seat

Another thing to bear in mind is that your VC is laser focused on returns and will have a clear idea of how to get results.  A VC’s share in your business doesn’t necessarily correlate with the true influence and control your investor has over future funding, dilution and strategic direction. Indeed, decisions about whether your business can apply for debt financing, or raise capital for a diverse capital stack could be out of your hands. Apple Founder Steve Jobs was famously fired by his investor-backed board of directors in 1985. ^[2] And Guy Kawasaki, Steve Jobs’ right-hand man, cautions that founders with a 51% stake with their businesses only have an illusion of control. ^[3] While equity financing has many upsides and is seen by many founders as a low-cost golden ticket to success, ultimately it can come with a high price tag and less control over your business.

Intangible costs

Intangible costs are ones you can identify but are not easy to quantify or estimate over time.

Debt financing’s intangible costs

If your start-up or scale-up begins to accumulate too much debt, your company could become more vulnerable to a market downturn or sudden change. If lean times hit, you could have difficulty servicing your debts and lack the flexibility to respond to market conditions. Highly geared companies are at higher risk, so it’s worth considering potential and as yet unquantifiable costs to going all-in on debt finance and becoming overly dependent on it as your financial strategy.

Equity financing’s intangible costs

The intangible costs of equity can be the personal toll of tensions and conflicts that can occur once you have an investor in your business. And with the rush of excitement of landing a financial backer, founders often overlook these intangible costs. Forewarned is forearmed, as you are now, if you’re founder courting investors and reading this. Experts advise getting good legal advice and putting contractual arrangements in place to mitigate and manage disagreements and disputes amicably. ^[4]

Opportunity costs

An opportunity cost is the potential benefit that a business or person (in this case a founder) gives up by choosing one option over another. It’s important for founders to identify and consider the opportunity costs of debt and equity financing.

Opportunity costs of debt financing

If a founder eschews equity for debt, they miss out on the credibility, recognition and new expertise and opportunities investors can bring to a business. Without the sizeable chunk of capital equity financing often delivers, businesses that are entirely debt financed are likely to miss out on the opportunity to grow as quickly as their equity-backed peers. That said, they also miss out on the negative elements of capital raising. They don’t lose time and momentum by courting investors. And they stay in control and avoid potential power struggles with their backers.

Opportunity costs of equity financing

The main opportunity costs of equity financing are the sheer amount of time and effort it takes to raise capital. That’s time that you don’t get back. And the distraction of raising capital can cause your business and R&D programs to lose pace. Embarking on a funding round is a risk. It might not work out. And if that happens, it’s a gamble that didn’t pay off that will send you back to square one and behind your competitors if you’re unlucky. The other leading opportunity cost of equity financing that we’ve discussed previously is loss of control. Sure, you get the money, but your golden ticket comes with strings attached.

Balancing your borrowing

Ultimately, once you know the lifecycle cost of different types of capital, and what that means for your business, it’s a case of weighing up which capital is best for your circumstances. For example, by calculating the true cost of capital at the beginning of its growth journey, Simulation could have made informed choices to optimise its funding mix and financial strategy.

Although debt vs equity is often presented as an ‘either/or’ choice, in our eight-plus years as an R&D lender, we’ve found it’s better to create a diverse capital stack. Our most successful clients use a combination of debt and equity to build their businesses successfully. Take ElectraLith, this Melbourne-based start-up leveraged an R&D loan as bridge finance to raise $27.5 million in its oversubscribed Series A round. So, taking a balanced approach and getting the best of both the debt and equity financing worlds is definitely worth considering.

 

*Radium Capital is a specialist R&D financier. The information this article contains is general. It is presented for information purposes only. It does not amount to financial or business advice and should not be considered as such.

 

[1] Bruyns, A. (2016). The real cost of equity for startups – Antoine Bruyns – Medium. [online] Medium. Available at: https://medium.com/@abruyns/the-real-cost-of-equity-for-startups-e9837bbd8095

 [2] Weinberger, M. (n.d.). This is why Steve Jobs got fired from Apple — and how he came back to save the company. [online] Business Insider. Available at: https://www.businessinsider.com/steve-jobs-apple-fired-returned-2017-7?op=1.

 [3] Anon, (2023). ‘Owning 51% Gives Founders An Illusion Of Control.’ – Guy Kawasaki. [online] Available at: https://thevcfactory.com/owning-51-gives-founders-an-illusion-of-control-guy-kawasaki/.

 [4] Mairs, K. (2021). The True Cost Of Capital That Entrepreneurs Pay For Investors. Forbes. [online] 10 Aug. Available at: https://www.forbes.com/councils/forbesbusinesscouncil/2021/08/10/the-true-cost-of-capital-that-entrepreneurs-pay-for-investors/.