Types of Capital and Cost of Capital

Posted on May 2, 2012

0


Introduction

For even the smallest business, access to capital is a critical part of success. Capital (in the form of available cash) allows a company to pay employees, invest in inventory and equipment, and pay for marketing, among many other things.

For most small businesses, the first source of capital is the owner’s personal resources. There are many stories of the entrepreneur who mortgaged his or her house to start a business and eventually became a great success. (There are many other stories of failure.)

But, as a business grows, other sources of capital are often needed. This week we will talk about sources of capital and their costs.

Cost of Capital

First, what are the general types of capital? At one end of the spectrum is “using your own money,” which costs you nothing (other than the return you would have gotten investing the money differently), and allows you to maintain complete control of your business. At the other end of the spectrum is a sale of a controlling equity interest in your company, which is a very expensive source of capital and costs you control of the business. In between are various forms of debt and minority equity investments.

The “cost of capital” (or required rate of return) is a term used in the field of financing to refer to the cost of a company’s funds (both debt and equity), or, from an investor’s point of view, “the shareholder’s required return on a portfolio of all the company’s existing securities.”

The cost of capital generally (and roughly) is as follows:
Debt Risk = 5-12 %
Mezzanine Risk (instruments that have debt and equity features) = 12-23%
Private Company Equity = 23% plus

The reason bank debt is the cheapest of these forms of capital is because in theory a commercial bank will only lend money when there is collateral adequate to support the loan. So if things go badly, the bank generally expects to be able to seize the company’s assets and liquidate them to recover the loan amount. Other forms of capital involve investors who are taking more risk, and they thus expect better returns. Below we will discuss these forms of capital in the small business context.

When you deal with public company stock and debt, the numbers are quite clear. You can go, and if the markets are open, you know precisely the price of one share of GE (or any other company). Additionally, you can know precisely the amount of debt when you enter into a personal or commercial loan agreement. You can look up prime on any day and know that this is the rate that the bank is lending to its best customers.

The market charges these rates. These are the rates that a person is willing to part with his or her money in order to be provided more money in the future. The amount of additional money that is received in the future should (if the market is efficient) reflect the amount of risk undertaken by the investor, i.e. risk versus reward.

More on Types of Capital

First, some simple definitions1 and financing basics:

A “debt” is an obligation owed by one party (the debtor) to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor… A debt is created when a creditor agrees to lend a sum of assets to a debtor. Debt is usually granted with expected repayment; in modern society, in most cases, this includes repayment of the original sum, plus interest. Debt ranges from normal bank loans, to asset based loans (often secured against receivables and inventory), to mezzanine debt (which may have very weak collateral).

“Equity” is a percentage of ownership, i.e. stock, in the company. Equity costs more than debt because if things go badly, the debt gets repaid in full before the equity gets anything.

To distinguish debt versus equity, a court will look at various factors including:

  • The names given to the certificates evidencing the indebtedness;
  • The presence or absence of a maturity date;
  • The source of the payments;
  • The right to enforce the payment of principal and interest;
  • Participation in management;
  • A status equal to or inferior to that of regular corporate creditors;
  • The intent of the parties;
  • “Thin” or adequate capitalization;
  • Identity of interest between creditor and stockholder;
  • Payment of interest only out of “dividend” money; and
  • The ability of the corporation to obtain loans from outside lending institutions.2

The reasons a court (or you) care if you have debt or equity include:

  • Tax treatment: interest on debt is deductable by a company; dividends are often not deductable
  • Liquidation preference: Debt gets paid before equity
  • Ability to foreclose: Debt generally can seize the assets of the Company or force a bankruptcy if not repaid; equity usually does not have these rights

Putting All This in the Small Business Context

So why are we talking about these relatively basic finance principles in a series on small business law? Because it is important to remember that these principles and the underlying economic fundamentals still apply even at the smallest level. As we begin talking about securities and raising money and all of the associated issues that are connected with it, we can get lost in the weeds. As a small business person goes forth and tries to capitalize his business, I believe the fundamental risk versus reward equation gets lost in the intangibles of the small capital markets.

To be clear, the small business capital market is full of deals, investments and investment requirements that are not simply risk versus rewards. Angel investors, for example, often genuinely want to invest in people and companies to encourage entrepreneurial development. Such motivation by the angel reflects an angel’s willingness to take more risk for less reward. Similarly, I have seen people invest to get their kids a job, investments made to gain a strategic partnership with a supplier or vendor, investments made because they like the entrepreneur (so called “friends, family and fools” investors).

All capital has cost. Sometime that cost is reflected simply in the risk versus reward scenario; a bank loans me money at 8%, at the end of the year, I pay the bank back $1.08. Sometimes, however, particularly in small businesses, that cost of capital is less tangible — a board member who wants a particular report in a particular manner, a vendor who is going to implicitly expect good deals, an employee who cannot be fired because he is related to an investor. Different types of capital generally have different non-financial costs, which increase with the amount of risk that an investor is taking.

Additionally, entrepreneurs must remember that they are only one side of the market (buyers of capital). One of the smartest things I have ever heard a client say to me was after a failed funding, he had realized that the market had spoken and his business was not what he believed it to be. “The market has spoken, and I need to realize that the business plan is not marketable,” he told me, and then he did the painful, but correct thing, of shutting his business down.

As we work through the law and the documentation approaches to take in capital, structuring investments in debt and equity, i.e., the capital structure, we must remember the fundamentals of financing. We can and should document the precise legal relationship. However, if there are other things going on in a transaction, it becomes more difficult, sometimes impossible to document. We have understandings (which of course can create conflict, but are essential to business). Small businesses need to understand the intangible elements in the capital markets and understand what the capital market is telling him or her. They must understand this in order to
evaluate when someone really is doing him or her a favor,3 and when someone really believes or does not believe in the business.

Conclusion

At the end of the day, the most important things for an entrepreneur to do when raising capital are:

1) Make sure you understand the deal and that the deal is reasonably in line with the marketplace
2) Make sure that there is clear documentation of what your arrangement with your lenders or investors actually is
3) Make sure you are not violating securities laws (more on this in coming weeks)

Some of the saddest stories I have seen in my career have come when entrepreneurs have not understood the deals they were making with lenders and equity investors, and did not understand the risks they were taking in accepting loans and investments. It is important to be thoughtful and not let the excitement of raising capital distract you from the risks and rewards of doing so.

Mike Goodrich
Goodrich Law Firm. LLC

1 Straight out of wikipedia.
2 Bauer v. Comm’r, 748 F.2d 1365 (9th Cir. 1984).
3 If someone is loaning your new venture money without security or a guaranty, they are probably doing you a favor.

About these ads