What Is Cost of Capital and Why Should You Care?

Raising capital for your business is always a daunting task. Do you ask friends, family, and/or a bank for a loan, do you raise public equity capital through a stock exchange, or do you sell off private equity in your business to an investor or part owner? While each of these options creates capital to be used to grow your business each one comes with varying costs and it is important to understand the implications of each.

Private Equity is essentially selling a portion of your business for a stake in your company and a claim to a share of annual net income. Before you ever consider this option you should hire a professional financial consultant to help you determine the minimum, fair, and maximum market value of your organization. Once you understand your total value you are in a better position to negotiate for a certain percentage of your business. As an example if your business is valued at $1M and an investor offers you $50,000 for a 10% stake he has offered 5% value for 10% ownership. This method of capital typically comes at the highest costs, at 10% stake you would be required to payout 10% of all net profits to this investor indefinitely. 

Public equity is when a business lists itself on a stock exchange and holds an IPO to allow the public to buy stake in the organization. Depending on the valuation of your business and the demand for your shares this can raise a substantial amount of capital for less than private equity but your company will be under more scrutiny to follow SEC and GAAP standards and any negative PR can have devastating effects on your share price. This is not a typical option for small startup businesses.

Debt equity is the most common form of capital for businesses across all industries, partly because it is the most easily understood. Most consumers have had a mortgage, car loan, or credit card, these are all examples of personal debt. Business loans aren’t much different, except when it comes to repayment. While payments towards your principal balance are cash-out flows from your financing cash flow, interest on the loan is recordable as interest expense and lowers your tax liability during the repayment period. Basically the loan interest is tax deductible. For this reason debt equity is not only the most common but on average the most inexpensive method for raising capital. To secure a business loan your company will need a comprehensive business plan with at a minimum 2-years of financial data. A business consultant can help with a portion of the business plan, the entire document, or review a plan that you already have.

Why does this matter? Well the right combination of debt-to-equity is important from a strategic perspective. Setting a capital cost structure and understanding the balance will help your organization make sound business decisions moving forward. Knowing the cost of your capital will allow you to accurately measure your ROI and evaluate the profit margins on revenue you otherwise would not have generated had it not been for the capital acquired.

Leave a Reply

Your email address will not be published. Required fields are marked *