Balancing the Capital Stack & Lowering Your Overall Cost of Capital

Equity and debt are two sides of the same coin. However, raising equity in exchange for shares in your company is not the only way to fund a business. As the business matures, applying the correct dosage of debt into the capital stack can help lower the overall cost of capital, get shareholders the best return on the company’s assets, and minimize unnecessary dilution in the process.

Your Company’s Capital Stack

In economics, money is the classic example of what they call a “fungible good,” i.e., cash is cash, and my $50 bill is worth the same as yours. However, even though money is fungible and easily interchangeable, not all investors allocate their money the same way – debt and equity investors have different risk appetites that are not fungible. Companies from Dropbox to Zendesk know this well as they scale and mature their businesses. They continuously manage the capital stack with the right mix of debt and equity to lower the overall cost of capital to scale the business efficiently. Smart CFOs continuously optimize the company capital stack with the appropriate dosage of equity and debt and understand how to seek the right capital and time from the right capital provider. The benefits of doing so ensure that the company’s balance sheet is right-sized, and the shareholders minimize dilution and increase valuation in between any funding rounds.

Finishing The Race (Debt) Versus Winning the Race (Equity)

In simple terms, equity investors deploy the highest form of “risk” capital to secure a slice of the ownership pie and seek to “win the race.”  Equity investors can generate significant capital returns to compensate them for their risk, but they also can be the last to get their money out. This requires patience, conviction, and an acceptance that you may lose it all. On the other hand, debt investors directly lend their capital, hoping that borrowers can “finish the race” and repay the debt. Thus, debt investors function as lenders, contributing capital based on predefined terms and a fixed rate of return - there is rarely any upside beyond the interest rate earned. Therefore, the debt investor is content if the borrower can finish the race, but the equity investor needs the company to get placed in the race to cover the risk incurred. In our experience, all too frequently, some founders forget that pitching debt investors is different from pitching equity investors but remembering this subtle nuance can help ease the capital raising burden time and effort required.

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A Changing Field of Debt Providers

Over the last decade or more since the global financial crisis of 2008, several “alternative” credit funds and traditional private equity firms stepped into the market to provide debt, where many banks retreated.  At the very top end of the market, the traditional PE buyout funds like Carlyle and Blackstone now have well over 20% of their overall funds deployed into “Credit” strategies showing the growing market of debt availability for companies.

A recent report by Pitchbook illustrates this well. It outlines the drivers of this stemming from persistent low-interest rates, subdued default rates, and a continuing appetite from investors for yield in alternative asset classes. The findings further point out that over the past decade, venture debt has emerged as a significant alternative source of financing for high-growth startups that have traditionally opted to fund their business solely with equity. For example, more than $20 billion has been loaned to VC-backed companies in the US during the past three years, and the number of debt financings for VC-backed companies has grown at a higher rate than the VC market overall. In Europe, the venture debt market is starting to catch up with the US but still lags the US in the availability of funds.

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Not All Debt Providers Are Created Equal

Since the beginning of 2014, a new wave of alternative lenders have emerged powered by FinTech  from Lending Club and Funding Circle to more recent debutants such as Pipe. We believe this is an evolution of the original P2P lending model , where liquidity is primarily provided by institutions seeking yield. The benefit is that debt capital is being democratized for start-ups, the downside is that we are seeing an increasing trend in the number of sharp pricing practices in conveying the true cost of debt financing to founders. Therefore, it is important when picking a funding partner to choose a long-term partner and one that provides capital through the peaks and the troughs, the highs and lows, and who takes the time to deeply understand your sector and your business model as intimately as you do.  

Summary

Building the right balance sheet and capital stack of debt and equity is one of the most important jobs the CFO must undertake as the company evolves and matures. Of course, not all capital is created equal, and selling shares in exchange for cash is not the only way to finance a fast-growth business. Just as important as choosing the right equity and debt partners for your business, those who have conviction in your sector and understand your quickly changing needs. We frequently read about the big fundraise or the big exit headlines but rarely hear about whether the founders and their families achieved the right return for their efforts. Used correctly, debt and, more precisely, venture debt can be a cost-effective component of your capital stack as a non-dilutive supplement to venture capital in funding growth.

If you would like to understand if venture debt is the right fit for your business, Talk to Us and schedule a chat with our finance experts.

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