How Much Does Capital Cost You?

cost-of-capital

When starting a company, capitalization is one of the primary concerns. Often, founders put savings and seek help from friends and family to get started. For technology companies (or any research and development based company, for that matter) it can be very tempting to seek angel investors, venture capital, or private equity and debt. Over the last twenty years, a great many books such as Robert Kiyosaki’s Other People’s Money (Kiyosaki and Lechter, Warner 2004) have suggested that leveraging money from other sources is the fastest and best path to wild success in business.

money-and-capitalTo some extent, the advice is sound. Start-up companies can benefit when the resources are available to instantly ramp up development of new technologies and spend what’s necessary to introduce those technologies to the marketplace. There’s also something to be said about sleeping at night without worrying if payroll will be met next week. Cash is truly the lifeblood of a startup company, and capital to achieve the company goals is a welcome sight.

There’s a dark side to using other people’s money, though. First of all, it’s easy to ignore fundamental business problems when they don’t have a visible operational impact. When all the bills are paid and there’s no risk of the lights going out, it’s hard to realize the company is failing, even when the financial reports scream that reality. Without a real incentive to profit, the urgency to restrain spending and increase productivity can often disappear.

The cost of money is also a consideration. The more the money is required for survival, the more expensive it will be. The old adage that money is loaned to people with money is fully applicable here. If a company is desperate for capital, that very state makes it a riskier investment. Risk usually defines the cost of capital, so it’s more expensive to get it when you need it as opposed to when you don’t. The best companies will seek capital for expansion after demonstrating operational stability. That’s the “magic” point at which capital is less expensive and most useful.

Oversight is another issue. When a firm makes a substantial investment into a business, that firm expects a level of input into the operations of that business. Sometimes it’s only an irritation, but oftentimes it can change the focus of the company from long-term goals to short-term, capital-preserving aims that benefit the goals of the investor more than the operation as a whole. This is understandable behavior, and it again relates to risk. The more capital at risk, the more likely an investor will want to protect that capital with interference in the business operations.

The best strategies for start-ups involve growing an enterprise on the most limited budget available until the organic growth has developed the company so that it represents the lowest risk possible for outside money. At this point, traditional credit facilities can be used to manage cash flow ups and downs and capital can be reserved for actual capital expenditures.

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