Start thinking about your Non-Monetary Cost of Capital

Founders and executives are very concerned with valuations and interest rates, but hardly anyone devotes adequate attention to the non-monetary costs of funding. My goal is to help make better decisions in fundraising.

In my last post, I gave a brief introduction on how young companies and startups should think about cost of capital.^[1] While that post was concerned with monetary costs, I now want to talk about non-monetary costs.

To reduce complexity, let's only look at venture capital (VC), venture debt, revenue-based financing (RBF), and classic bank loans. We will further reduce complexity by not considering the many stages, funding rounds, and situations a company can be in. In addition, some of the points I will make do have an impact on a company’s cash and are, strictly speaking, monetary. But I decided to add them anyway, because in my experience many founders limit their thinking to direct costs like interest rates and dilution.

In order to apply the following to your individual situation even better, I recommend to first dig a bit deeper into the basics of general finance and how the interaction of risk and return^[2] creates different terms and forms of funding for startups and growth companies

But now, let’s look at our simplified list of forms of funding and illustrate the respective non-monetary costs:

Bank loan

On a basic level, banks have to make sure that their investment risk is low in order to match their limited return potential from a fixed interest rate. The simplest way banks reduce risk is by investing only in companies that are already substantial in size (e.g., revenues of >20m and several years of consistent reporting history) or that are profitable. This means in almost all cases that, unless those investments are subsidized by the government, banks simply do not invest in startups or young companies. And that makes sense.

If they do invest, banks manage risk by reduction, i.e., by adding more security to their investments. The usual way to do that is to demand collateral and/or covenants and adhere to strict rules and processes:

1. Collateral effectively seizes assets of the company from the founders and shareholders. In case the company experiences financial distress, the bank will assume those assets to reduce its loss, in effect increasing the loss of the founders and shareholders. In some cases, founders and executives even have to accept personal financial liabilities.
2. Covenants usually work by contractually forcing a company to achieve defined financial key performance indicators (KPI). For example, the company might be obliged to not exceed a certain burn rate. Therefore, covenants effectively limit entrepreneurial freedom of decision-making. For example, if a company decides to pursue a business opportunity for which it would have to increase the burn rate, it might be forced to seek approval from the bank.
3. Banks are highly regulated which forces them to implement extensive and strict processes and rules. This makes a lot of sense from a macro-economic and societal point of view. But those rules and processes also influence the way banks deal with their borrowers and investees. Consequently, there is less flexibility and perceived understanding for the entrepreneurial challenges of a young company.

Use Case: If the business is already big and stable with, e.g., more than 20M in predictable revenues, and if its internal organization, processes, and management are capable and willing to cope with the standards and requirements of banks, then they can offer low cost of capital.

Revenue-Based Financing

1. RBF may only invest smaller amounts than venture capital because its capped return doesn’t allow for very high investment risk. Therefore, it is less suitable for companies with a high cash burn.
2. RBF demands cash repayments from day one, as opposed to venture capital which demands repayment in a distant future in case of an exit. However, some RBF investors structure their investment in a way that minimizes cash repayments for the first 6-18 months, e.g., by postponing a part of the repayments.
3. In some cases, RBF investors also require collateral (see above).

Use Case: In most cases, RBF is used to extend ‘runway’ in preparation for a larger equity funding round, meanwhile accelerating growth and optimizing valuation without any dilution; or to complement concurrent equity funding round to minimize dilution of ownership and control. But RBF can also be an alternative by providing growth capital for companies which do not want or are not (yet) a fit for classic venture capital.

Venture debt

1. Venture debt in the form of term loans often has comparable properties to bank loans, i.e., comes with collateral and covenants (see above) to reduce risk according to the lower return potential from the interest rate.
2. Furthermore, it usually requires venture capital / equity investment from a top-rated venture capital investor in close temporal proximity. The intention is to reduce risk by having additional shareholders on board who (a) provide a supposed ‘hallmark of quality’ and (b) are expected to invest further equity if the company should get into trouble. Therefore, it is very hard for founders and shareholders to get venture debt funding without also accepting venture capital funding.
3. And to increase the return potential and make risk and return match, at least on average, options on equity / warrants or other forms of additional return are an important part of the investment. That means that in most cases, venture debt is dilutive.
4. The combination of venture capital and venture debt provides even more cash to make the company grow even more. This makes a lot of sense for highly scalable business models which can get really big in the end. But if it is not the right time for that, or if a company simply does not have such outstanding prospects, this adds a lot of financial risk which might get the company in trouble down the road. However, many responsible investors acknowledge this and invest very selectively.

Another way to think about venture debt is that it is a financial leverage on venture capital with all the good and bad implications that come with it. But in almost all cases, it is a bad substitute for venture capital.

Use Case: Venture debt works well for providing high-growth companies with a lot of cash in addition to a large equity funding round to accelerate strong growth even further.

Venture Capital

Venture capital can cope with very high risk because it also expects the highest return (at least 3x, up to 10x of the investment).

1. Venture capital investors try to manage risk by assuming some control of the company. Usually, this is achieved by transferring major decisions to a board with voting seats for the investors or by contractually requiring key managerial decisions to be approved by investors.
2. Venture capital may reduce funding options in the future. The reason is, again, that venture capital demands high returns. To illustrate: the first investors will want to make 5x-10x return on their investment which can, in most cases, only be achieved by adding more venture capital in the next funding round. The new investor might have slightly smaller return expectations, but still maybe 3x-5x. Those expectations can only be met through more exceptional growth which demands more venture capital, and so forth. This implies increased operational risk. And leaving this path is very hard. Again, this can make sense for highly scalable companies or for “land-grabbing” scenarios in which a lot of cash is needed to move fast or push competitors out of the market.
3. Finally, investors not only add capital and (hopefully) value, but there is also shareholder risk. A million things can happen if you deal with other human beings who have something to say in your organization. For example, your sponsor at the investment firm might leave and you will be left with others that do not see your business as favorable; the company that invested in you may decide to change its strategy, maybe discontinuing all investment activities; the internal dynamics of the investor might lead its representative on your board to change his attitude towards your company; or you might simply get involved in a personal dispute with your investor. The list of problems that may arise from shareholders is virtually endless.

Use Case: Venture capital can invest large amounts of cash at any stage and in any situation, even pre-revenue or without ever expecting any meaningful revenue at all. It is the right kind of funding to make companies become very big very fast and go for an ‘exit’.

Although I could go on and add a lot more detail and specific cases, it is best to stop here. Of course, there are many hybrid forms of funding. And I can almost hear my fellow investors complain that their individual way of investing is different from the archetypes above.

But my goal was merely to provide some food for thought and basic insight. Most important is to keep in mind the importance for founders, executives, and shareholders to think about and factor in all non-monetary costs of capital.

If you would like to read more about monetary cost of capital, you may have a look here.^[1]

Disclaimer. Christian Stein is an investor at Riverside Acceleration Capital. The content of this article reflects his personal views. The analyses and conclusions contained in this article include certain statements, assumptions, estimates, and projections that reflect anticipated results and have been included solely for illustrative and informational purposes and do not reflect actual events. This is not an offer or sale of, or a solicitation to any person to buy, any security or investment product or investment advice.

[1] How growth companies and startups should think about Cost of Capital via riverside.ac

[2] How Risk and Return create different terms and forms of funding for startups and growth companies via riverside.ac