Some business owners pay little attention to their cost of capital. This may be for good reason since the most common form of capital acquisition comes in the form of a bank note. If that is the case, cost of capital would be the interest required on your bank loan; however, many things can affect the cost of equity and that cost affects the value of your business.
You don’t have to watch Shark Tank for more than fifteen minutes to see what I mean here. The entrepreneur offers 10% of his company for $300,000. The “sharks” begin bidding the same $300,000 for a 33% equity stake. In mere seconds, the entrepreneur’s hard work; blood, sweat and tears, is reduced from $3,000,000 to $900,000, a 70% decline in value. Investors are looking to buy a stream of future cash flows. When they project the operational outcome of the business forward, the next step is to bring those cash flows back to the present value. Without getting too technical, the discount value used in this calculation is the cost of capital, both debt and equity. In the example given above, the difference in the cost of equity from the entrepreneur offer to the shark bid could be as much as an astounding 370%.
So why is their cost so far apart? In one word, the difference is RISK! The entrepreneur knows the business. They trust their own abilities to make their future brighter. They also have a vested interest in the value of their company, as it rises, so does their wealth. The “shark,” on the other hand, just wants cash flow. This business could make them richer too, but it could also be a total loss. They don’t often know the full history of the company or the owner. They will not likely control operational decisions, including the decision on when they will receive cash flow since non-controlling equity owners are generally guaranteed nothing in the way of a return. If the business fails to make a profit, and many small businesses are not profitable, they will get nothing for their investment. If the business is profitable, they may be rewarded for their investment.
Now to the point of this thought exercise: What will make your business more valuable? Many things come into play, including growth, profitability, and cost of capital. The last two of which are closely related. Economic profitability is considered to be the amount of return generated on the capital invested in excess of the cost of that invested capital. Put mathematically, it is the return on invested capital (ROIC), minus the weighted average cost of capital (WACC). Taxability can come into play here as well, but we will keep it out of this theoretical discussion for now.
Focusing on the cost of capital, there are many items that could affect this cost. Success lowers the cost. Think of this from the investor’s perspective. A company making a profit is a proven commodity. It speaks of the abilities of management, the business concept, the industry and much more. An investor in 3M is not likely to require nearly as much discount to offset the risk of their investment as they would if the business was an unprofitable start-up. Start-ups are better known to most investors as speculations and for this reason, the risk is higher.
Even proven businesses can come with a high cost of capital. Any non-publicly traded company is considered to have liquidity risks. Ease of transfer of ownership lowers the discount required by investors. Companies where the investment is without any hope of control will be considered riskier than one where the investor is buying a controlling share. Corporate governance can also make a big difference to investors. If the owner runs the business like a personal piggy bank, paying himself an above-market wage and flying all over the country in the company’s airplane, many investors will shy away from investing.
Although a valuation analyst could fill this page with calculations, it could be argued that it’s just this simple: Growing revenue, profitability, transparency, and management’s reasonable decision-making can make a company more profitable. Investors flock to companies that promise to pay investors cash in the future, especially if their history shows they are likely to follow through. This heightened attention often raises the price investors are willing to pay for the privilege of ownership. That being the case, every decision made by an entrepreneur or manager can impact the company’s cost of capital. Anything that raises the perception of risk of the investor not being paid that stream of future cash flows also raises the discount on investor offers.
If you have questions regarding the cost of capital for your business, the experts at Henssler Financial will be glad to help:
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- Email: experts@henssler.com
- Phone: 770-429-9166.
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