Risk and the Costs of Financial Capital
Bank debt is very likely your cheapest source of financial capital. Ownership equity, despite having no contractual requirement to pay interest or dividends, is certainly your most costly. Why is this?
When a bank makes a loan to a company, the bank takes little risk. Banks are regulated with a view toward protecting the depositors. For starters, a bank’s lending officer and credit review committee must be persuaded that the company will have sufficient profit and cash flow to cover the interest charges on the loan (normally 3 or more times the interest the expected interest expense) plus the ability to repay the loan. Only if they are satisfied on these points will the bank go to the next step of considering collateral and personal guarantees of the owners (joint and several. When the loan is made, there probably will also be covenants restricting things like compensation and dividends to the owners and thresholds of ratios that will serve as red flags, and could trigger the calling of the loan, if broken. The bank will also be senior to all other creditors in the event of bankruptcy. In effect, the bank simply does not take risks, and because of the low risk, its charges for loans will be the lowest you can expect to get.
At the other end of the risk spectrum is owner equity. As an owner, you have no contractual protections (beyond limited liability) and no guarantees of any income from interest or dividends. You are at the bottom of the totem pole regarding recovery of your investment in the event the business fails. If the company is privately owned, you, as an owner, have little chance of being able to sell your position. That is, unlike being a stockholder in a public company, there is no market for your ownership position. Your only hope for some kind of financial compensation is that some day, perhaps in the distant future, the company might get acquired or go public. Well, it is also possible that at some point, when the company slows it growth sufficiently (to a crawl) it might be in a position to start issuing dividends. But, the future is uncertain for an equity owner. The road to success is a long one and is littered with the corpses companies that simply did not make it. Factually, the vast majority of companies do not survive to the point of reaching critical mass and self-sufficiency.
So, as an owner/investor, how much ultimate compensation is enough to entice you to take the risks and remain illiquid for an unknown period of time? Let’s say the bank charges 6% for its very secure loan. And, history tells us that we can anticipate about 10% total return annually, on average, by investing in the biggest public companies. If we invest in smaller public companies we would reasonably expect, on average, around 13%, a higher return to compensate us for the higher risk we take by investing in smaller, less established, companies. If we consider investing in some of the smallest public companies, with annual sales of, say, $25 million, we would rationally do so only if our expected total return were over 13%, probably in the range of 15% to 20%. That is, in the absence of a dividend, we would expect the value of our investment in a very small public company to grow at a rate of 15% to 20% per year while we own it.
Now consider being an owner of a small company that is not publicly-traded. There is no market to sell into if you decide you want out. How much more compensation would you need to entice you into such an opportunity as an owner? The answer, widely accepted by the IRS for valuation purposes, is about a 30% premium over what you would require for an investment in a publicly traded company. For example, if you would expect an 18% ROI for a similar company that is publicly traded, you would need 23% from a private company to fully reflect the risk and inflexibility of illiquidity for your investment.
Effectively, the “cost” of equity capital is what investors expect to receive, over time, to compensate them in a competitive market for the risks they take as equity investors. This is why equity capital is the most costly form of capital.
Most entrepreneurs are shocked when the first start seeking equity investors when they hear their first proposal. They have to be willing to give up a shocking amount of their ownership in order to get co-investors. For a relatively new venture, figure that the early investors will have to visualize around a 30% ROI to be willing to go in. This is a real quantification of the risks involved in the early stages of even the greatest-sounding idea. You do not want to give away equity ownership for good reasons, including the fact that if the business succeeds, the equity owners, including you, stand to gain wealth in proportion to the risks that have been taken by all who invest with no contractual expectation of financial reward or even beng paid back. This is the financial lure of entrepreneurial onvesting.
The costs of other forms of financial capital fall somewhere between bank debt and straight equity. The list of possibilities is as large as the imaginations of those involved.
Samuel W. Norwood III
© 2014
