How should I think about the cost of capital of venture equity?
When early-stage software entrepreneurs begin to think about raising money, the field can seem overwhelming at first glance. There are a variety of capital options out there, each with different benefits. Cost of capital is one extremely important consideration for early-stage software entrepreneurs thinking about raising money.
Cost of capital is the return on investment an investor or investment firm receives. This return can come in many forms, whether via a traditional interest rate for bank loans, stock value for traditional venture equity, or, in the case of revenue-based financing, a monthly royalty on sales.
When considering the cost of capital of venture equity, there are a couple considerations for an entrepreneur. The benefit of traditional equity is that companies do not need to return funds to a venture equity firm until an exit – whether that’s through selling the company, going public, or other similar options. However, the cost of capital of venture equity rises as a company’s valuation increases.
As a comparison, the cost of capital of revenue-based financing remains flat, regardless of your company’s value. Revenue-based financing requires ongoing payments, though, and the amount of capital may not be as high as an equity firm can provide.
As an example, in 2010, Slack raised $8.1M during their Series A. In 2019, those Series A investors’ positions grew to billion-dollar-plus holdings, translating to an internal rate of return (IRR) of 90% and a 376x return on invested capital.
There are many aspects to consider when deciding between capital options, cost of capital being only one. However, cost of capital must be evaluated in the context of your business’ needs, metrics, and overall financial strategy.