True Cost Of Capital

“While There is Never Any Absolute Rules When It Comes To Pricing Money, Here Are Some Things To Consider When Trying To Understand The True Cost of Capital For Any Particular Application”

When seeking capital funding for any business venture, there can be a lot of different trade offs to consider with the different sources of capital that may be interested in funding a particular deal.

The most common forms of business capital come from debt and equity financing sources. And even though equity equates to ownership, there is still an implied cost of capital that needs to be factored in before accepting this type of money.

The most common problem business owners have when seeking capital is trying to locate money at a cost that does not likely exist. The second biggest problem is not properly comparing different forms of business capital when deciding on how to fund the business.

With problem #1, the business owner or manager does not understand the market and continually rejects potential offers to finance at rates above their target rate. There is nothing wrong with this approach provided that the target rate actually exists for the deal or will appear before the business runs out of time.

In order to avoid being in this situation, a more realistic perspective needs to be established. Remember that the cost of money always has to do with risk and supply with risk and supply typically being inversely related (as risk goes up, supply goes down).

As an example, its not uncommon for a business owner to seek unsecured business capital from private lenders at 10% interest or lower because they can’t secure anything from a bank and they have no assets to leverage. The proper perspective is that private lenders can lend their funds (and do) all day long on real estate and be fully secured and still lend at 10%+ interest rates.  so why would they take on a higher risk (unsecured debt financing) for the same cost of capital?

With problem #2, the business fails to properly make an apples to apples comparison with different forms of business capital and defers instead to self created rules or assumptions.

For example, when a business requires business financing capital in a risk range that could be funded through debt or equity the costs and trade offs between the two forms need to be properly weighed.

Higher risk deals can command debt financing rates in the high teens. Most equity investments want a similar return or higher. Yet when a business owner sees an 18% interest rate as an example, many will immediately believe that’s too high and turn to an available equity solution that could actually be higher over time.

With debt, the best things about it is that you retain ownership and if you pay it back you retain control of the business. With equity, unless there is a buy out provision structured at the start, there may be no easy or cost effective way to pay out the investor as the business grows, creating a very expensive source of capital. Even with a structured buy out, the true cost of capital, if anyone spent the time to figure it out, could be substantially higher than the original debt financing solution.

If the cash flow is available to service the debt, the high interest rate loan option should not automatically be dismissed.

The search for capital often times tends to be left too long so business owners are forced into taking what they can get. But when choices are available, being realistic on your expectations, and crunching the numbers to better understand the true cost, can mean a tremendous saving in the long run.

Click Here To Speak With Business Financing Specialist Brent Finlay

About the Author Brent Finlay