A Primer On Calculating Your Cost of Capital

When raising debt capital, accurately assessing the cost known as the cost of capital is crucial. The cost of capital primarily includes interest payments and associated fees and can be calculated with the following formula: 
Cost of Debt (YTM) = (Annual interest payment + annualized fees) / Net proceeds of the debt

Where: 

Annual interest payment = Loan principal × annual interest rate 
Annualized fees = (Origination fees + commitment fees + back-end fees) amortized annually over the life of the loan 
Net proceeds of debt = Loan principal − Origination fees and other upfront fees

Example calculation: If your company borrows $1M with an interest rate of Prime + 3% (assuming Prime is 5%), with a 2% origination fee, no commitment fee, and a 4% back-end fee over a 4-year term:

• Annual interest = $1,000,000 × 8% = $80,000
• Origination fee = 2% × $1,000,000 = $20,000
• Back-end fee (annualized over 4 years) = (4% × $1,000,000) / 4 = $10,000 per year
• Net proceeds = $1,000,000 - $20,000 = $980,000

The annualized cost of debt (YTM) would be: ($80k + $10k) / $980k = 9.18%

This calculation provides an accurate assessment of your company's true cost of debt, allowing you to effectively compare offers and make informed financing decisions.

Why it’s important for you to run a competitive process

In any type of fundraising you conduct, having multiple options is key. A competitive process means engaging several lenders simultaneously so you can compare offers and negotiate stronger terms.

When lenders sense competition, borrowers see three positive impacts:

• Better pricing: Interest rates and fees may drop if lenders worry about losing your business.
• More favorable terms: You can reference other offers to push for improvements (e.g., fewer covenants).
• Potential fallback options: If one lender backs out, you still have other options.

So, how do you run a competitive process without spending too much time away from your business?   

It starts with that shortlist of lenders you’ve made. Reach out to, say, 3-5 of them around the same time with your pitch materials and aim to get initial expressions of interest within the same 1-2 week window. Keeping all of your prospects on the same timeline can take some creativity, but letting them know, “We’re speaking with a few potential financing partners and aim to decide by X date” can set the expectation that they should move reasonably fast and put their best foot forward.  
 

As you have meetings, you might find one or two drop off because they’re not a fit or they pass that’s okay, keep moving. With those remaining, you’ll enter more serious discussions and likely get to a term sheet stage.  
 

If you get a term sheet from one lender, and you expect one from another lender soon, you can use the first lender as a benchmark in discussions with subsequent ones. For example, if Lender A gave a 9% rate and you really like Lender B more, you can hint to B, “We have an offer around 9%, but we’d prefer to work with you if you can be in that range.” Be mindful of any confidentiality on term sheets (usually, they’re not confidential like VC term sheets can be), but be conservative you don’t have to show one lender the other’s sheet, just summarize key differences as negotiation points. 
 

Try to keep the lenders moving at roughly the same pace. If one gives you a term sheet super early, and another is still in diligence, you might kindly ask the first for a little time to make a decision. Most lenders know companies will compare offers, and they’d rather stay in the game than give an unreasonable deadline that turns you away. With that said, don’t leave them hanging indefinitely; the quicker you can run your fundraise, the higher the likelihood that you’ll close successfully.

Ultimately, remember that the goal is not just to get the best rate but the one with the best overall fit and flexibility for your company. So, weigh offers on all dimensions cost, covenants, lender reputation, and how well they understand your business. Running a competitive process gives you the visibility to make that choice wisely.