Cost of Capital

Understanding the total cost of capital when evaluating competing term sheets can be difficult, especially when they are riddled with complicated provisions—e.g. warrants, convertible caps, drag-along rights, preferred liquidity rights, and pro rata rights to name a few. We’ve taken a stab at addressing some of the most common provisions, so you can better understand what the cost of your capital is outside of the headline numbers: dilution, discounts or interest, and fees.

One important note before we dive in: this is not financial or legal advice. Before you sign a term sheet you must understand the provisions (and rights) that your potential investors expect—do not agree to terms that you do not understand or have not discussed with your council.

Overview on the total cost of capital for startup funding

Startups raise capital for a variety of reasons including runway extension and the acceleration of their growth. The traditional vehicles for capital raising: venture capital and venture debt—have their advantages and drawbacks, the largest being the lack of transparency around the total cost of the capital. While these forms of financing give startups the necessary capital injections to jumpstart their business and they seem relatively inexpensive at the time, they can mean the difference between millions or billions of dollars in the pockets of the founding team. There are a multitude of factors that go into determining the total cost of capital, hence the need for this guide.

A few words on dirty term sheets

Recently, we have seen an increased number of dirty term sheets provided to founders—primarily due to the changing funding environment. Dirty term sheets, also known as predatory term sheets, are riddled with one-sided provisions and terms that are not in the founding team’s favor.

They are often provided to startups with inflated valuations or those with a short runway who are in a vulnerable position and are based on an internal rate of return mechanic other than price such as—price-in-kind dividends or guaranteed multiple hurdles.

Dirty term sheets can be dangerous, because they create a misalignment of interests between the investors and operators, as investors may focus on pushing the startup to pursue a liquidation event, even if it is premature, to recoup their capital. If you are presented with a dirty term sheet, please know that you likely have other funding options.

A roundup of the most common types of startup capital

There are virtually hundreds of different types of startup funding, each with its own benefits and drawbacks. That said, all fall under one or more of the following classes: debt, equity, and alternatives. Ultimately, the ideal capital stack varies based on how quickly a startup wants to grow and how comfortable it is with the restrictions that are associated with the various forms of financing.

• Bullet loan - is a debt vehicle that comes with lower monthly payments, a higher interest rate, and a required lump sum payment at the end of the loan's term.
• Bridge loan - a debt vehicle that is typically taken out for a period of 6 to 12 months for “holding over” a company until they can secure longer-term financing or they can receive significant cash inflows from a signed deal. 
• Convertible note - is a debt vehicle used by early-stage investors to invest in a startup that doesn’t have a valuation—it starts as debt and transforms into equity upon certain milestones being achieved. 
• Crowdfunding - is a form of financing that is gathered from a large group of individuals, typically through the internet—there are three types of crowdfunding: donation-based, rewards-based, and equity crowdfunding.
• Forgivable loan - is a form of debt that is “forgiven” or considered satisfied, after a while or a specified repayment milestone (often 80% of the loan value). This is typically used by small business owners, in tandem with small business loans. 
• Mezzanine financing - a hybrid form of debt and equity financing, similar to a SAFE or convertible note, except that it gives the lender the right to convert its debt position into an equity interest in the company in the event of default. 
• Revenue based financing - a form of non-dilutive and non-debt financing in which a company sells rights to their future projected revenue streams at a discount.
• SAFE note - is a form of financing used by early-stage startups (typically seed stage) to raise capital from investors.
• Equity Financing - is a form of financing provided by angel groups, angel syndicates, or venture capitalists, that funds the growth of early-stage organizations through the exchange of capital for equity (aka ownership) in the business.
• Venture debt - is a form of financing provided to venture-backed companies that involve principal (the amount borrowed) and interest (the amount paid more than the principal).

An overview of some of the common contractual provisions (and investor rights) in a term sheet

Each term sheet or debt agreement you encounter will likely be structured differently based on how they assess the risk profile of your business and the state of the macro environment. The number and complexity of the agreements are inversely related to the state of the economy—in a seller's market, the startups set the terms; in a buyer's market (e.g. economic downturn) the investors set the terms. That said, even in tough times you can negotiate most of these provisions with the proper legal counsel. Before you sign a term sheet you must understand the rights that your potential investors expect—do not agree to terms that you do not understand or have not discussed with your counsel—onto the provisions.

• Anti-Dilution Protection - also known as an anti-dilution clause, subscription right, subscription privilege, or preemptive right, is used by investors to protect their investment in the event of a down round, or a significant dilution event, such as the issuance of new shares for a round of equity financing, or the conversion of a convertible note.
• Covenants - provisions in a debt agreement that protect lenders from borrowers defaulting on their obligations due to financial actions—when breached, covenants trigger compensatory and other legal actions. 
• Conditions Precedent - requirements in a deal for a condition or an event to occur before a right, claim, duty, or interest arises. If the condition precedent is not met, neither party is obligated to perform.
• Contingency - the requirement of a deal, that if not satisfied results in the other party being released from its obligations. 
• Conversion Rights - give investors the right to convert their preferred stock into common stock in the business. 
• Exclusivity Rights -the limitation of the seller's ability to solicit an offer from or negotiate with a third party during a specified period. It can also refer to the term in the contract that restricts one party from working with or selling to a competing party.
• Information Rights - outlines the information a company must provide its investors beyond what state law requires. 
• Kickers - rights, exercisable warrants, or other features that are added to a debt instrument to make it more desirable to potential investors by giving the debt holder the potential option to purchase shares of the issuer.
• Liquidation Multiplier - a term that allows investors to receive a multiple of their liquidation preference in the event of a liquidity event.
• Liquidation Preference -a 2x liquidation preference means that all holders of that series of preferred stock will receive a 2x return on their initial investment before any holders of junior preferred stock or common stockholders receive a return on their investment. 
• Lock Up Period - the period following an IPO of a company when investors or other shareholders are not allowed to redeem or sell shares. The typical lock-up period is 180 days, but it can last for over a year.
• Major Investor Rights - define the threshold required to be considered a “major investor” and the associated rights that an investor receives for being considered as such. E.g. information rights, pro-rata rights, co-sale rights, the right of first refusal…etc. 
• Mandatory Conversion - occurs when a key event takes place, such as an IPO, acquisition, or merger—results in the preferred shares of a company being converted into common shares. 
• Most Favored Nation (MFN) Clause - gives early investors the same rights and benefits received by later investors, if those rights and benefits are more favorable than those originally agreed to. 
• Negative Covenant - restrictions placed on a borrower that restricts certain actions or behaviors. 
• Participating Preferred - During a sale, holders of preferred stock get preferential treatment and are typically paid first before holders of common stock. 
• Personal Guarantees - represent an individual’s legal promise to repay credit issued to a business for which they serve as an executive or partner. 
• Protective Provisions - Protective provisions ‘protect’ an investor's rights such as their ability to veto a decision or action that they do not agree with—e.g. the issuance of more stock, the liquidation of the company, or the acquisition of the company. 
• Pro-Rata Rights - enable investors to maintain their equity stake and their voting power even when new shares are issued, without the obligation to invest in later rounds.
• Redemption Rights - give investors that hold preferred stock the right to require that a company repurchase their shares after a specified period. 
• Registration Rights - The term ‘registration right’ refers to the ability of an investor (who owns restricted stock) to require a company to go public so that the investor can sell their shares. 
• Representations and Warranties - the set of assurances given by both parties in an agreement. 
• Right of First Refusal - also known as a “preemptive right” refers to the ability of an investor to take the first “at bat” in the event of a potential liquidation event, sale of equity, or another relevant trigger. 
• Right to Audit - an investor's (or board member’s) right (but not obligation) to audit the books, balance sheet, user base, code base, or another centralized record of their portfolio companies that are directly related to its business operations and performance. 
• Veto Rights - give a company’s board of directors the right to refuse to approve a proposal, thus preventing its enactment. 
• Voluntary Conversion - the exchange of a convertible type of asset, such as a convertible note, into another type of asset—usually at a predetermined price—on or before a predetermined date.
• Voting Rights - give board members the right to vote on topics discussed in board meetings, such as a funding round, the issuance of new stock, the initiation of mergers and acquisitions, and more. 
• Warrant - give the holder the right (but not the obligation) to purchase stock at a specified price within a specific period. 
• Warrant Coverage - an agreement between a company and an investor, where the company issues a warrant to the investor allowing them to acquire shares at a predetermined price.

Calculating the total cost of capital from debt instruments

The total cost of debt capital is typically easier to calculate than the cost of equity financing. A few of the metrics needed for the baseline calculation: 

• Principal - the amount that you borrow.
• Interest (or discount) rate - the amount you pay to access the funds.
• Payback period - the amount of time you have to pay it back in.

These items are usually included in the amortization schedule provided by the lender and illustrate how the total cost of capital changes based on the factors above, it may also be referred to as the “risk-free rate”. Once you’ve determined the baseline or average cost of capital, the next step is to read through the contract to find the various provisions included.

Calculating the total cost of capital from equity capital

Calculating the total cost of capital from taking on an equity investment from a ​​venture capital firm or other investor is not as straightforward as debt capital. It involves understanding how each of the provisions may be invoked, or triggered as a result of an event, the initial dilution incurred from taking on capital, future dilution from taking on additional equity capital, and the ultimate exit valuation of the startup. Generally speaking, the more contractual provisions there are, the higher the cost of capital is going to be. Let’s look at a very basic example to see how this plays out.

Say startup ABC raises a $5M seed round from a single investor for 5.25% of the equity pool at a $100M post-money valuation. There are no previous investors, so the only members of the cap table currently are the founders and the employees.

If there are no contractual provisions and the company exits at $1B, the investor would receive $52.5M and the remaining cash would be distributed to the founders and the employees.

Now let’s say the investor has a liquidation preference and a 2x liquidation multiplier. If the company is sold for $1B million, the VC firm would receive its initial investment of $5 million back, plus an additional $47.5 million (to satisfy its remaining equity), plus an additional $52.5M dollars (thanks to the 2x liquidation multiplier). The founding team and employees would receive the rest.

Now let’s say the same investor has a liquidation preference, 2x liquidation multiplier, and redemption rights. The company is running low on funds and is forced to take a down round at a $50M valuation for 20% of the company. The initial investor can invoke its redemption rights and force the company to pay them back the $5M (from the initial investment), plus an additional $5M thanks to the liquidation multiplier—which effectively would drain the company of the $10M it just raised in the down round.

Strategies for lowering the cost of capital

Lowering your cost of capital is essential for maximizing the outcome of your startup, as each percentage point of ownership, could mean the difference between millions or even hundreds of millions of dollars in the event of an exit (e.g. in the case of Facebook, Amazon, Apple, Google, and Netflix).

There are a few strategies that founders can use to lower their cost of capital. 

1. Consider pursuing an alternative source of financing, such as revenue based financing, if you generate revenue. These sources of capital come with the fewest restrictions and are non-dilutive, they also provide more favorable terms than traditional lenders. 
2. If you’ve recently raised a round of equity capital and are thinking about raising more, consider venture debt instead, which will likely result in less dilution.
3. If you are lucky enough to receive more than one term sheet (and even if you only received a single term sheet) negotiate the required provisions and conditions.
4. Try to improve your financials (revenue per employee, growth rate, cash flow, burn…etc.) so that your startup is more “attractive” to investors.

A few more general tips:

• Start early, particularly in this market: the best time to raise capital is when you don’t need it. This puts you in a position of strength to negotiate the best terms possible. 
• Valuation is important, but it isn’t everything: if you receive multiple term sheets or a single term sheet, consider compromising on your valuation for more favorable terms.
• Know who you’re marrying: the reality is that when you take on investors, you’ll be tied to them for the next 3, 5, and maybe even 10 years, so pick wisely.

Resources: cost of capital calculators

Calculating the total cost of capital for a startup can be a difficult task. Fortunately, several online tools can help founders do this and compare funding opportunities, here are just a few: Calkoo, Educba, and GoodFinance.

Final thoughts on the total cost of capital

The cost of capital is an important metric to consider when fundraising for your startup. In the beginning, it might be tempting to finance your operational expenses via your personal credit cards, but as the business grows this becomes unsustainable. Instead, you may turn to venture firms or banks for financing terms, that better fit your needs. When evaluating these offers, make sure to take into account the weighted average cost of capital (WACC) so you understand exactly what the implications are both in the short and long term. Also, make sure to consider how each of the provisions in your term sheet and the seniority of the debt you take on, impact your capital structure. Your ultimate goal should be to maximize the efficiency of your capital stack so that you can grow sustainably, without sacrificing the upside of all your hard work.