Some business owners pay little attention to their cost of capital. The most common form of capital acquisition is usually a bank note; therefore, the cost of capital would be the interest on your bank loan. However, every decision made by an entrepreneur can affect his company’s cost of capital.
Consider a typical episode of “Shark Tank” where 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’s offer to the shark’s bid could be as much as an astounding 370%.
So why is their cost so far apart? The difference is risk. The entrepreneur knows the business and trusts his own ability to make a brighter future. 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 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, they will get nothing 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 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, minus the weighted average cost of capital. Taxability can come into play here as well, but we will keep it out of this theoretical discussion for now.
Growing revenue, profitability, transparency, and management’s reasonable decision-making can make a company more profitable and result in a lower cost of capital. A profitable company is a proven commodity because it speaks of the abilities of management, the business concept, the industry, and much more. An investor in a Blue Chip company is not likely to require nearly as much discount to offset the investment risk as they would if the business were a speculative start-up. However, even proven businesses can come with a high cost of capital. Non-publicly traded companies are 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.
Investors flock to companies that promise to pay investors cash in the future, especially if their history shows they are likely to follow through. Anything that leads an investor to believe he would not be paid a stream of future cash flows raises the discount on investor offers.
William G. Lako, Jr., CFP®, is an Executive in Residence at Kennesaw State University’s Coles College of Business and a principal at Henssler Financial and a co-host on Atlanta’s longest running, most respected financial talk radio show “Money Talks” airing Saturdays at 10 a.m. on AM 920 The Answer. Mr. Lako is a CERTIFIED FINANCIAL PLANNER™ professional.