Is more money always good for your business? This may sound like a trick question but from a financial perspective the answer is not as straightforward as you might think. Looking at capital value through the lens of cost benefit analysis, this blog post suggests that capital can hurt businesses as well as help them.
Given the fact that a significant amount of the business world runs on money, most people who want to do business have a natural tendency to believe that the more capital that can be obtained the better.
This is often particularly true for people who are just starting out in business and take the understandable view that concerns about long-term shareholder value creation should take a back seat to the need to keep a business up and running. Yet despite all its potential positive uses, capital is actually capable of destroying business value. This is something that people setting off on the search for funding should keep in mind right from the start.
The Cost of Capital
The simple reason why money can actually be bad for a business is that all capital, regardless of its source, has a direct or indirect cost. If we take out a loan from a bank to develop a real estate project, for example, the money of course is not provided for free – we have to pay it back with an agreed amount of interest. If the interest we pay exceeds the project’s financial return, in nominal financial terms the use of the capital is obviously hurting the firm rather than helping it. This is true even if the project in all respects turns out to be a great commercial success. A situation in which the financial cost of capital outweighs its financial benefit is known as negative leverage.
Capital Cost and Equity
This is all clear enough with debt capital, but the relationship between capital value and firm value can be a lot harder to see in connection with funds that are raised in the form of equity.
Some entrepreneurs might take the view that equity capital actually does not have a cost, because it is generally not legally required to be paid back by the firm shareholders even if the investor loses money. In reality, however, the cost of equity capital is not determined by an abstract legal obligation but rather practically by the sum total of all the amounts that the shareholders of a company are required to pay to a new equity investor over the lifetime of the investor’s investment in the company. This is typically comprised of the dividends that are paid to an investor plus the investor’s share of any funds that are generated from a sale of all or part of the company in the future.
Capital Return Assymetry
To take a simple example of returns on capital, let’s say that you sell 80% of your company to an investor for $1,000,000, do not pay out any dividends and then sell the company in 5 years for $10,000,000. In return for an investment of $1,000,000, the investor would receive $8,000,000, representing an annualized return before taxes of 140%. Most people would consider this to be by any measure an extraordinary return, particularly for a passive investment where the investor’s time and effort can simultaneously be spent on other value generating activities. The hidden value of passive investment positions is something we will look at in another post.
For the original shareholders that built the company, however, the return picture does not look as rosy. From a purely monetary perspective, the return of the investor is based on the relationship between the amount they invested in the company and 20% of the proceeds from the sale of the company that they will receive – $2,000,000.
$2,000,000 is without question a significant amount of money, but let’s assume that the company has two founders and that they spent a total of 8 years building and then selling the company. If they invested $500,000 of their own money in the company to make it run successfully, the annualized return before taxes would be 9.3%, a small fraction of the investor’s return.
When considering the return for the original shareholders, we also have to keep in mind that the two original shareholders would likely have worked very long and hard hours for 8 years in order to cause the company’s value to increase so dramatically. If the reasonable value of this work was added to the $500,000 in capital that the founders invested, it is very likely that the development and sale of the company would have constituted an overall financial loss. If we throw in the value of indirect financial costs that the founders had to bear along the way the return picture would look even worse.
Flexible Capital Cost and Benefit Analysis
Given this, when entrepreneurs or businesses are looking for capital it is very imporant to carefully consider capital costs as well as benefits. On the cost side, this requires considering not only the direct financial cost of capital but also the reasonable value of what is contributed by the founders of a company to the business. In addition to the value of time that is expended, this includes other indirect costs, such as opportunity costs.
Flexibility is also required on the benefit side of the analysis. In addition to the financial return shareholders receive, there may be numerous benefits that come from successfully running and selling a company. Apart from the insights that are gained from managing a company and steering it through the many obstacles that can cause it to fail, a successful business can strengthen the reputation of the founders and generate many new business contacts, clients and opportunities, all of which can create significant amounts of value for the shareholders in the future, regardless of the capacity in which they are utilized.
None of this is of course easy, because at the time of seeking an investment the shareholders of a company will not be able to predict with certainty what the future benefits and costs will be. Despite this limitation, with a better understanding of capital costs and benefits, companies can better set their own required rates of return in connection with new business initiatives. Depending on who the company is and what their objectives are, these required rates of return can vary widely, but trying to ensure that capital actually creates value can set in motion many other things of important corporate and economic value.