How to reduce your cost of capital with R&D finance
One highly successful technology entrepreneur once described to me the role of a founder as consisting of two things, and two things only:
“Hiring people and ensuring cash flow.”
Though hiring will certainly make or break the company in the longer run, cash is indispensable for the company even getting to the long run. The simple truth is: a company operates on cash and a founder needs to find ways of providing it. The issue that many tech entrepreneurs run into is that before their idea is proven in the market, the company has a weak negotiating position when it comes to raising money. Even if you’ve convinced your friends, family and first employees of the brilliance of your plan, investors will take a cold hard look at your assets and are less swayed by the story. Your valuation will grow proportionally to how well you can stick to the narrative you’ve laid out, but there is necessarily a difference between what you know the company and the technology can be worth and what it is worth to the investors now. If the company is not revenue positive from the start, and in some industries that’s just the nature of the game, your funding journey will likely consist of several rounds of selling equity for cash.
As an entrepreneur, you are probably familiar with the concept of your weighted average cost of capital (WACC). This measure is the price that a business is expected to pay on average to finance its assets to everyone that has a security, be it debt or equity. In short, it’s the average cost of the capital you raise.
“The WACC is the price that a business is expected to pay on average to finance its assets to everyone that has a security, be it debt or equity. In short, it’s the average cost of the capital you raise.”.
Your cost of capital under equity finance
When equity funding is the only type of finance available to a company, the WACC will rely solely on the valuation of the business. This means that the less proof of market viability the company has, the more expensive the capital will be. A seed round at a $1,000,000 valuation will have a founder part with 10% of equity for a $100,000 cash injection. Given that the cost of capital reflects the current market price of stock in the company, if the company is valued at $2,000,000 one year later, the cost of the funding received in the earlier round has effectively increased by 100%. This reflects the risk of the early investor but it’s not great news for the founder who has worked diligently to grow the company and cannot make use of 10% of their company’s value anymore.
The alternative here would be debt finance, but most often companies who have few assets or are pre-revenue or low revenue do not have access to debt, as most lenders will want a safe bet. An innovation stands out in this space for companies with a high degree of innovation: R&D finance.
With an R&E loan, a company with minimal assets that is pre-profit or even pre-revenue can still access debt finance by using future government payments from HMRC for the R&D tax credit as security.
What does R&D finance mean for your WACC?
Given how expensive equity finance is at the start of a company’s journey, it makes sense for the company to take on debt to optimize its cost of capital.
The best way to explain the difference it makes is through an example.
You have a company that is valued at $10,000,000 pre-money at the beginning of the year, and by the end of the year reaches a $15,000,000 valuation. At the beginning of the year, you decide that your funding needs will be $1,000,000 for the year, to cover your runway and ensure you hit your targets. You can either raise the whole round through equity, or you can raise $500,000 through an equity raise where you sell with 5% and the other $500,000 through an R&D tax credit loan you are eligible for at 1.2% interest and a 3.5% facility fee.
If your company goes the traditional route of raising $1,000,000 via equity the total cost of capital as measured by the end of the year will be $500,000. If you choose to mix in the available debt, the company’s cost of capital will be $250,000 for the equity component and $89,500 for the R&D debt, with a total of $339,000.
If the company’s valuation goes up the year after that, the debt funding will have improved in relative cost while the equity gets relatively more expensive as time goes on. At the end of the year in question, if the company takes on the SR&ED facility and complements it with the equity sale, its WACC is reduced by 32% as compared o a full equity round, saving the company $161,000 in value.
In conclusion, for a company that is on a steady growth trajectory, it makes sense to use available debt smartly to optimize its WACC and avoid further erosion of the founders’ equity position.
If you’re curious if you can use SR&ED finance to lower your cost of capital and what this could look like for your company, we’re always happy to have a chat and see if we can help. Chat to us about reducing your WACC.
