As a business owner in your round b or c of funding, you’re actively seeking extra funding to drive your growth. One question you might have asked yourself is: well…which of my options is the cheapest?
Many factors impact the cost of acquiring capital, and some of them are contingent on present market conditions. Some factors spur out of recent practice development in each funding category. Some others are timeless factors that are inherently tied to the very nature of each funding mean.
You will get a brief recap of the events that shaped the market conditions into what it currently offers.
On the flip side, some options are irremediably cheaper than others, notwithstanding the market conditions, and we will explain how.
Factors that Affect the Cost of Capital
Interest rates do affect the cost of acquiring capital. In traditional banking as in private debt, they have remained constant. While Private debt has higher interest rates, this type of lending partner is more eager to lend money to young companies in series b, or c.
However, while bank loan interest loans are regulated, private debt loans do not have this problem. Funds have guidelines issued for recommended rates, but they tend to remain roughly the same.
What happened last year which affected the cost of capital?
Well, things got back to normal, really. The exceptionally high margins, valuations, and multiples VCs pushed in 2021 finally came back to earth.
The red flags erupting at Clearpay, Gorilla, and countless other businesses which had valuations much higher than reasonable, slowed down the machine, and we're back to pre-pandemic figures. The year-to-year decrease in funding is, thus, nothing to be so alarmed by.
VCs have fewer funds pooled from LPs because of the drop in the public market (due to geopolitical and economic reasons), and the success of the latter depends on the availability of the former.
However, funding partners are still on the lookout for high-growth opportunities in tech, as long as they have strong metrics and reasonable business plans to attain such growth. This is particularly true in Venture Debt, a sector that’s more resilient to economic fluctuations than equity.
Equity
Decrease of variable: you give up more than twice as much of your shares to get the same money now as a year ago, with multipliers on this downward spiral.
Independently from current market trends, securing capital through equity will end up costing more to you as a founder, and it’s really easy to see why:
Let's say you secure a £2.5 million investment for your software company worth £25 Million ( that’s 5X ARR) today, and it gets sold for 250m after 5 years from now.
The cost of selling £2.5 million in shares of your company will have a bottom line cost of £25 million at exit. And that’s if you give up only 10% of equity, which is on the low end of general equity financing deals.
Equity takes a lot of time to secure, too, as opposed to other funding options. This time you will spend negotiating your deal with venture capitalists (who are famously difficult at negotiations), going through your DD process, etc… will affect your day-to-day operations and might come along with a dip in performance. This too affects the cost of acquiring capital.
A good rule of thumb is at least 6 months, up to 9+ months for an equity round to come to fruition.
The very time you will spend extra working on securing your deal might hinder your chances of getting the deal at all. A bump in performance in the middle of negotiations might add scepticism on the VCs' part, and have them either negotiating a less advantageous deal for you or stop the negotiations altogether.
This story is as old as time itself.
Debt
Stable interest rates and covenant-lite mitigate the impact of the current "recession", you're guaranteed the same amount to pay back, no matter what.
The interest paid on debt we refer to as “the cost of debt.” Unlike equity, where costs are paid to shareholders in exchange for their shares, the cost of debt will be less than the value of equity. This is why debt financing is typically less expensive than equity financing.
Why is that? Let’s take an example again:
Say you secure a Debt Investment of £2.5 Million over a 4-year term, non-amortising at 8% Interest and with a £200k Equity warrant.
After 5 years, say the company is now worth £250m. The total interest paid will stand at £200,000.
With one typical equity warrant at £ 2m which will be paid at your exit, either IPO or trade sale. Your total cost of debt will approximate £3m at exit.
This is because you have not diluted your equity. It’s probably the biggest element that factors in the
cost of acquiring.
Another very important detail for Debt financing is the apparition in the last 2 years of covenant-lite deals or cov-lite for short. They are the new standard in debt deals.
They protect borrowers, by putting less pressure on their key metrics throughout the debt repayment term. For example, cov-lite deals do not include maintenance covenants:
Maintenance covenants are conditions that borrowers must meet throughout the loan term, which can include credit ratios and operating metrics. These conditions are usually checked quarterly. For instance, a borrower may be required to maintain a debt-to-EBITDA ratio of 5.0x or less. If the borrower fails to meet this requirement due to underperformance, they would violate the loan agreement and considered in default.
This type of covenant would drastically increase the potential cost of acquiring debt. The recent suppression of such stringent deal terms made debt far less costly an operation for founders.
Conclusion
The cost of acquiring capital is a key factor in running your business. Equity brings great resources but can round up to be costly.
Debt is not going to bring as much cash on day one, but the cost of acquiring it is almost laughable compared to equity.
In the end, it all depends on what your strategy is at the moment for your company: Do you need a quick cash influx to extend your runway or perform an M&A? Debt is the solution.
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