Cost of Capital : The Real Cost of Equity

 

As a Tech startup founder, raising capital through equity financing is a common way to fuel growth. However, the real cost of equity goes far beyond the percentage of ownership given up in exchange for funding. While equity financing provides much-needed capital without requiring regular repayments like debt, it comes with significant long-term consequences that founders often overlook. Understanding the true cost of equity—especially in the context of growing tech companies—is essential for managing dilution, controlling your company, and achieving long-term success.

This article is part of our ongoing series on the cost of capital for Tech startups, where we dive deeper into the implications of financing decisions. In this piece, we’ll explore the hidden costs of equity, how Investor Internal Rate of Return (IRR) plays a crucial role, and why it’s critical for Tech founders to understand the long-term financial impact of equity financing.

For more in-depth understanding, read our previous articles on Tech Valuation Multiples and Essential Metrics for Swiss Tech. These topics provide valuable context for understanding the financial frameworks and benchmarks that play a role in equity financing decisions.

 

The Classic Cost of Equity Approach (CAPM)

The Capital Asset Pricing Model (CAPM) is a widely used approach to calculate the cost of equity for established companies. The basic formula for CAPM is:

CAPM assumes that the cost of equity is determined by the systematic risk (market risk) a company faces, which is captured by beta. It is commonly applied to publicly traded companies that have stable, predictable earnings and a long track record of performance.

CAPM works well for mature, publicly traded companies with stable earnings and established market positions. However, it doesn't apply to tech startups mainly for the following reasons (among others):

1. Private vs. Public Equity: Tech startups are private companies without public stock prices, making it impossible to estimate beta (volatility relative to the market), which is central to CAPM.
2. High Growth vs. Stability: Startups typically experience high growth and uncertainty rather than the stability of mature companies. CAPM assumes steady, predictable cash flows, which don’t reflect the volatile and high-risk nature of tech startups.
3. Risk-Taking Capacity: Startups are willing to take on more risk to disrupt markets and scale rapidly. CAPM doesn’t capture this entrepreneurial risk or the potential for massive, non-linear growth.

 

Investor IRR: The Real Cost of Equity

When a founder issues new equity in their business, they are essentially selling a percentage of the company’s potential future value. Over time, this decision carries costs, not just in terms of dilution but also in terms of the return investors expect to achieve. The IRR reflects this expected return, and the more equity sold, the greater the investor's potential gain (in absolute terms), but also the greater their potential loss if the business underperforms. While this risk-sharing aspect can provide a safety net for founders during uncertain times, it often comes at the expense of the founder’s long-term financial rewards when the business is successful.

Key Variables to Consider:

• Equity Issued (X%): The percentage of ownership the founder gives up in exchange for funding.
• Exit Valuation (Y): The company’s valuation at the time of exit (e.g., acquisition or IPO).
• Years to Exit (T): The number of years the company takes to reach an exit.
• Raised Amount: The amount of capital raised by the company in exchange for equity.
• Exit Event: This can either be an acquisition or an IPO, but it represents when the company’s value is realized.

We will break this down further with an example to illustrate the hidden cost for Tech founders. Let’s assume the following:

• The Tech startup is raising $2 million at a $8 million pre-money valuation, increasing its Post-Money valuation to $10 million.
• Investors obtain 20% of the company in exchange for $2 million in funding, diluting 20% of every existing shareholder.
• The company grows for 5 years, and at the time of exit, the company is valued at $100 million.

Calculate the IRR

To calculate the IRR, we use the formula for compound interest:

Substitute the values into the formula:

In this scenario, the new investor has acquired  20% of the company for $2 million, netting a 58.49% IRR over 5 years. Given the high-risk, high-reward nature of such investments, if the company fails to become a successful and profitable business, the company will not owe anything for the capital provided by investors. However, if the startup succeeds and the company achieves a successful exit, the company will have effectively paid a 58.49% annualized return to the investor over the 5-year period. This valuation increase might seem high, but it aligns with early-stage VC investors' expectations of achieving at least a 10x return on their investments.

You can use our calculator to calculate your own Cost of Equity:

Understanding the Hidden Cost of Equity

Besides the monetary cost, raising equity has hidden costs that extend well beyond the percentage of ownership given up in exchange for investment. While equity financing provides much-needed capital, it comes with significant long-term implications.

In one of our previous articles, we explored the pros and cons of different funding alternatives to help you choose the option best aligned with your company goals.

The Impact of Dilution

The most obvious cost of equity financing is dilution. When a founder sells equity to investors, it is effectively reducing its ownership stake in the company. While this may seem like a fair trade-off for the funding received, the long-term consequences can be substantial.

Dilution can become particularly problematic as the company grows and raises additional rounds of financing. With each new round, if the company's valuation is not sufficiently high, the founder may lose an increasingly larger percentage of the company. This compounding dilution can eventually lead to founders owning a minority stake in their own company, diminishing their control and financial returns at exit as well as undermining their ability to raise further equity rounds.

Loss of Control

In addition to the reduction in ownership, equity financing often leads to a loss of control. By bringing in external investors—especially venture capitalists or angel investors—the founder agrees to share decision-making authority over critical aspects of the business. These decisions can range from strategic product direction to key hires or even the decision to sell the company.

Investors typically demand some level of control, particularly in companies with high growth potential. As they often have significant experience and resources, their input can be valuable; however, divergent visions between the founder and investors can create friction. Even if the founder maintains a majority ownership stake, the influence of investors can steer the business in directions that might not be fully aligned with what the founder thinks is best.

Preferred Stock and Complex Financial Structures

For companies that raise capital at high valuations, the real cost of equity becomes even more complex due to the introduction of preferred shares. Preferred shares typically grant investors special rights, such as liquidation preferences and anti-dilution protections, which can dramatically alter the financial outcome at exit.

In a scenario where a company is sold for a substantial exit value, the presence of preferred shares can significantly affect the founder's share of the proceeds. Preferred shareholders may have priority in receiving their portion of the exit proceeds before common shareholders (founders). This can lead to the founder receiving a smaller share of the exit value, even if the company’s success was largely driven by its vision and leadership.

 

When Does Equity Make Sense?

While the cost of equity can be significant, there are scenarios where raising equity financing is the best option for a Tech startup. In particular, equity funding can make sense in “winner takes all” scenarios, where the company operates in a market with rapid growth potential and a high chance of dominating the market.

In such markets, equity funding is often necessary to fuel rapid expansion and secure a dominant position before competitors can enter. In these cases, the potential for massive returns from dominating the market outweighs the dilution risk, making equity financing an attractive option.

 

Mitigating the Hidden Costs of Equity Financing 

To effectively manage the hidden costs of equity financing and ensure the long-term viability of their business, Tech founders should focus on two fundamental factors:

Comprehensive Evaluation of Company: Before opting for equity financing, it is essential for founders to conduct an in-depth analysis of both their company’s internal dynamics and the broader market environment. This includes assessing the company’s current and projected growth, its competitive position, and its capacity to deliver on its value proposition. By understanding whether equity financing is the most suitable option—given the company’s financial health, scalability, and risk profile—founders can avoid unnecessary dilution. A thoughtful evaluation of market conditions and business strategy ensures that equity financing aligns with the company’s goals and reduces the risk of over-leveraging ownership at an early stage.

Strategic Rounds Approach: A well-defined rounds strategy is key to minimizing dilution while optimizing funding. Founders should avoid seeking excessively high valuations in early funding rounds, as this can result in unsustainable expectations from both investors and the market. Instead, a reasonable rounds strategy focuses on raising capital incrementally, tied to clear milestones and growth achievements. This approach not only helps preserve the founder’s ownership stake but also positions the company for future success with less pressure to raise funds at inflated valuations. It ensures that equity financing is executed at the right time, based on performance and growth, rather than external market conditions.

It’s also important to note that down rounds, where a company raises capital at a lower valuation than in previous rounds, can result in significant dilution and negative signaling. This challenge will be addressed in a future article, where we will explore strategies to avoid or mitigate the effects of down rounds.

 

Conclusion

Investor IRR is what founders will pay. The real cost of equity is not just about the percentage of ownership you give up; it’s about understanding the long-term financial and strategic implications. Dilution, loss of control, and the complexity of preferred shares can significantly affect both the founder's financial returns and decision-making power.

By carefully evaluating whether equity financing aligns with the company’s growth goals and adopting a strategic funding approach, founders can mitigate the hidden costs of equity and retain greater control over their business.

Stay tuned for future articles in this series, where we will explore additional aspects of the cost of capital, including debt financing, and provide further insights to help Tech founders navigate the complexities of financing.