Balancing the Capital Stack: How to Reduce Your Overall Cost of Capital

Giving up equity in exchange for cash is not the only way to fund your business. As your business matures, adding the right amount of debt into your capital stack can lower the overall cost of capital, get you the best return on your company’s assets, and minimize unnecessary dilution to you and your shareholders.

Your Company’s Capital Stack

In economics, money is the classic example of a “fungible good.” In other words, cash is cash, and my $50 note is worth the same as yours. However, even though money is fungible, not all investors allocate money the same way. Debt and equity investors, for example, have different risk appetites that are not fungible. 

Companies from Dropbox to Zendesk know this well. They continuously optimize the balance sheet with the right mix of debt and equity to lower the overall cost of capital as they scale. Just as a chef works with seasonal ingredients to produce the best flavors, you want to optimize your capital stack with the correct dosage of equity and debt at different times with different providers. 

This ensures your company’s balance sheet is right-sized, you don’t cause unnecessary dilution, and you increase the valuation in between any funding rounds.

Your company capital stack should change as you scale.

Finishing The Race (Debt) Versus Winning the Race (Equity)

Debt investors want you to finish the race while equity investors want you to “win”.

If you want to secure the right capital at the right time, you need to understand the difference between equity and debt investors. Where an equity investor wants you to “win the race,” a debt investor simply wants you to “finish the race,” which means adjusting your investment pitch to suit either one. 

For example, equity investors deploy the highest form of “risk” capital to secure a slice of the ownership pie. They can generate significant capital returns when you “win”, but they can also be the last to get their money out. This requires patience, conviction, and accepting they might lose it all. 

On the other hand, debt investors lend their capital hoping that borrowers can “finish the race” and repay the debt. Debt investors function as lenders, contributing capital based on predefined terms and a fixed rate of return – they rarely gain any upside beyond the interest rate earned. 

In other words, while the debt investor is happy if the borrower can repay their debt (finish the race), the equity investor needs the company to increase in value (win the race) to cover the risk incurred at the outset. 

A Changing Field of Debt Providers

Since the 2008 global financial crisis, several alternative credit funds and traditional private equity firms have stepped into the market to provide debt where many banks have retreated. At the very top end of the market, the traditional PE buyout funds like Carlyle and Blackstone now have over 20% of their funds deployed into “Credit” strategies showing the growing availability of debt for companies.

But what’s driving these changes? According to a recent report by Pitchbook, the main drivers appear to be persistently low interest rates, subdued default rates, and investors’ continuing appetite for yield in alternative asset classes. The findings further illustrate that over the past decade, venture debt has emerged as a significant alternative source of financing for high-growth startups that have traditionally opted to fund their businesses through equity alone. 

For example, more than $20 billion has been loaned to VC-backed companies in the US during the past three years, and the number of debt financings for VC-backed companies has grown at a higher rate than the VC market overall. In Europe, the venture debt market is starting to catch up with the US but still lags in the availability of funds.

A breakdown of private debt fund value by fund type (courtesy of PitchBook)

Not All Debt Providers Are Created Equal

Since 2014, a new wave of alternative lenders such as Pipe and eCommerce Lending has emerged, powered by FinTech. Instead of giving up equity in exchange for investment, you can instead convert recurring revenues into upfront cash, which means debt capital is finally being democratized for startups and less mature companies. 

Nevertheless, it’s important to choose a long-term funding partner that provides capital through the peaks and the troughs, and who takes the time to deeply understand your sector and your business model as intimately as you do. 

Selling shares in exchange for cash is not the only way to finance a fast-growth business – you need a healthy mix. Building the right balance sheet and capital stack ratio of debt and equity is critical as the company evolves and matures. 

Like a good chef, you should partner with good quality producers who provide the right ingredients from the right suppliers in the right season. Chose debt and equity investors who have conviction in your sector and understand your quickly changing needs.

We frequently read about the big fundraise or the big exit headlines but rarely hear about whether the founders and their families achieved the right return for their efforts. Used correctly, debt can be a cost-effective and non-dilutive component in balancing your overall capital stack mix and funding your growth.

The content on this site is not intended to provide legal, financial or M&A advice. It is for information purposes only, and any links provided are for your convenience. Please seek the services of an M&A professional before any M&A transaction. It is not Acquire’s intention to solicit or interfere with any established relationship you may have with any M&A professional. 

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