The Cost of Capital: More Than Just Equity – Options For Financing your Startup

Like the alien plant in Little Shop of Horrors that was always demanding “Feed Me, Seymour”, technology startups constantly gobble cash. The CEO’s top priority is to continually feed this beast.

This means that overriding the operation of any tech startup is the every-present need for more money. As illustration, let’s run through the finance options for a technology startup:

  • Bootstrapping – common, but difficult and suppresses growth
  • Debt – offers greater control over business, interest is deductable as a business expense
  • Equity (Angel funding, Venture Capital) – suited for high risk businesses, no repayment or interest obligations, loss or profit accrues to investors, brings advice, experience, and contacts

While cash is always available somewhere, it comes at a cost. The truth is business financing is always cheapest when you don’t need it. So, sometimes that cost can be higher than you think.

For example, people in the technology industry in Canada often believe equity is their only option for financing business growth. If you live in Silicon Valley, this may be true because there’s more of it and the Bay area is geared toward supporting startups. Further, there is significantly more merger and acquisition activity to fuel the investment cycle in the Valley.

Here in Canada, it’s a different story. The cost of equity is much higher than in Silicon Valley. There is a more conservative approach to startup equity funding and a much smaller pot of gold to dip into. Therefore, equity comes at a higher price in terms of shareholder dilution and eventual cost. Because of this, other forms of financing are also commonly used by Canadian technology entrepreneurs. 

The real cost of financing

As an entrepreneur, do yourself and your business a big favour by ensuring that you understand the full spectrum of financial options for your company and pick the best mix for you.
Just as important, understand the real cost of that money.

  1. Cash in your personal bank account is the cheapest and is the primary source of funding in bootstrapping.
  2. Revenue from customers is the next cheapest because, other than operational costs, there are no costs attached to it. This is also used in bootstrapping.
  3. Next comes purchase order and export financing from corporations such as Export Development Canada. Purchase order financing frees up cash for critical business expenses. In a sense, financing SR&ED claims is a form of purchase order financing combined with debt financing.
  4. After that comes traditional debt, which has some costs, but, as explained above, are deductable from taxes. Of course ,too much debt is always risky.
  5. Finally, there is equity, the most expensive and intrusive form of capital. Taking on too many equity infusions can place unnatural pressures on growth, as well dilute existing shareholders.

So, before you take that cheque, ask yourself: Is this truly the best source and cost of capital, at this stage of my company’s evolution?