How to calculate your cost of capital
- Find out your company’s cost of capital with the Cost of Equity Calculator
- The lower the cost of capital, the more an owner retains at exit.
- Financing with equity means giving up ownership, while financing with debt is something a business pays back over time and is non-dilutive.
- If a business is running at an operating loss and has a low cash balance, debt financing might not be viable.
Controlling your cost of capital
52 years ago, the most famous investor of our time, Warren Buffett, purchased National Indemnity Company and another smaller insurer for $8.6 million. Buffett was eager to expand Berkshire Hathaway’s portfolio, and the surplus cash from insurance premiums helped finance this expansion at extremely low cost. The key lesson here is one of controlling your cost of capital. The less you pay to finance the expansion of your business, the greater your competitive edge, and the more of your company you ultimately keep.
For most of us, acquiring an insurer to access low-cost financing isn’t an option. We either sell equity or borrow funds that we pay back with interest. At Hum Capital we created the Cost of Equity Calculator to help our fellow entrepreneurs understand and lower their current cost of capital. We walk you through this analysis, below.
We’re passionate about helping companies scale non-dilutively. If you’d prefer to skip the theory and start a conversation about opening a facility, go ahead and get in touch!
Understanding your profit machine
You can think of a business as a machine that takes inputs and outputs cash flow:
The “human capital” input starts off as your founding team, and quickly grows to include your employees. “Raw materials” refers to everything else that goes into doing what you do, whether that’s offering a service, a software platform, or a physical product. We can think about how quickly your business produces cash from these inputs as an “internal rate of return.” IRR is essentially an annual interest rate that shows how good your business is at turning invested capital into profit. A business that combines $1 of wages with $1 of raw material to produce $4 of cash flow, for example, would produce produce the following IRRs over 1-, 3-, and 5-year time horizons:
Now to spend $2 on people and materials, the business must access capital. Equity can be a great way to finance younger, riskier ventures. Founding teams get cash in the bank free of any short-term repayment obligation or restrictive covenants. The catch is that when you take equity, you’ve sold that piece of your company forever. If you build a successful business, that can get very expensive. Debt, on the other hand, charges an interest rate on capital lent. When you pay it off, you’re done. This results in a cost of capital that is decoupled from value creation. Even high-APR debt options can be very good deals when compared with the cost of incrementally selling pieces of your business as you scale.
The difference is illustrated below where a company requires $10m in capital. At exit, the company that raised equity paid 8x more to its investors than the company that raised debt at a 15% interest rate. The company that raised debt incurred a total cost of capital of $7.5m over its lifetime while the company that raised equity incurred a cost of $60m. Both companies had access to $10m to invest in their equally productive machines and created equal amounts of corporate value but different capital structures drove value to be allocated differently between investors and founders at exit.
Some math and an example
The IRR that equity investors receive from investing in your company is analogous to your “cost” of accepting their investment. Defining the following terms…
…we can calculate your investors’ IRR on equity as the i that balances the following equation:
0 = r1 / (1+i)t1 - t1 + r2 / (1+i)t2 - t1 + ... + rn / (1+i)tn - t1 + E * OIe / (1+i)te - t1
Here’s a concrete example. If your business raises equity according to this schedule, and exits November, 2022 at a $750M valuation…
…your current cost of equity is 42%.
How to think about the tradeoff
By expressing the cost of equity in terms of IRR, we’ve created a framework for comparing your “costs of equity financing” with alternatives. In general, if you have financing alternatives at a lower cost, you should take those. For many companies this will mean actively exploring debt options that may not have otherwise considered, which is why we made the the Cost of Equity Calculator for. The only caveat to this is that debt bites now, whereas equity bites later. If your business is running an operating loss and has a low cash balance, keeping cash on hand in the short-term is essential and debt might not be a good option for you.
We hope that this post, along with the calculator, has given you a toolkit for evaluating your own financing options. If you’re running a growing business with sound underlying unit economics, are interested in scaling non-dilutively, and have been unimpressed by the debt financing options that you’ve encountered to date we would love to speak with you about how we can help.