The real cost of equity for startups
Ideas are cheap, they say. True, but financing one is damn expensive. Funding for early-stage startups, if any, comes almost exclusively from VC funds. Media covers extensively which startup raised how much. However, there is limited talk about the actual cost. Unlike debt, the cost of equity is neither known upfront nor visible on the income statement. The cost of equity is an opportunity cost for the founders. VCs provide money today against a share of an unknown amount in an unknown time frame. It’s important to realize that. Even if the entrepreneur and the investor agree on a valuation today, this number is relatively meaningless. No one knows if the company will survive or die. If it survives, will it reach $100M or $1B and how long will it take. The valuation of an early stage company is similar to forecasting the weather in 5 years. The goal of this article is not to give a precise answer but give a range. We will look at three different sources, and derive an estimation from them.
Source #1: VC math
VC funds invest money on behalf of rich individuals, mutual funds, pension funds, etc. Those investors have expectations about their investment performance. A typical fund will promise to repay investors five times (5x) their investment in ten years, or 25% IRR over a fund lifetime. This return is the fund average performance across a portfolio of investments. In a typical VC portfolio, returns follow a power law distribution. This is just a statistical fact — a law of nature. If a VC fund makes ten investments, the returns will come from only 1–2 investments where they will generate 10–100x on their original investment. Bottom line, theoretical cost of equity is about 25% IRR with a low probability that’s its much more expensive and high probability that it’s much less expensive. The more successful the investment, the more expensive the equity.
Source #2: Simulation
Suppose a startup raised $5m in a series A in exchange for 15% ownership, that’s $33 M post-money valuation. What’s the cost of this equity round? Let’s suppose the startup went public or got acquired five years later for $100 M. Under all those assumptions, the series A investor would get back $15 M. That’s 3x investment return or 25% IRR. That’s the cost of equity for the entrepreneur.
Source #3: IPO data
Another way to look at it, it’s to look at empirical data based on companies that go public. A company going public will disclose their ownership structure. We often also have the total of the amount raised so we can make an estimate. If a company had multiple rounds of funding, we don’t know how much an investor invested in each round. It’s a sort of weighted average cost. That being said, it’s informative.
Let’s analyze two typical SaaS:
- New Relic: founded in 2008, raised a total of $215M, and went public end of 2014. Benchmark Capital invested $3.5M in their series A round and ended up with 22% ownership, 9M shares, at the time of IPO. New Relic IPO price target was $23. If we do the math, Benchmark invested $3.5M in 2008 and got back $207M six year later. That's 60x investment return and 100% IRR. This number is a guesstimate because Benchmark invested in later rounds, they didn't sell all their shares at the IPO target price, etc. However, it's illustrative.
- Tableau: founded in 2003, raised a total of $15M, and went public in 2013. New Enterprise Associates (NEA) invested $15M in their series A/B round and ended up with 38% ownership, 20M shares, at the time of IPO. Tableau IPO price $31. If we do the math, NEA invested $15M in 2006 (assume one round between round A and round B to keep things simple) and got back $620M seven years later. That’s 40x investment return and 86% IRR. Like for NewRelic, this number is a guesstimate.
Conclusion
Raising an equity round is expensive, especially if the company is successful. It doesn't mean that it's not useful. It's just important to realize it and ponder the pros and cons. If other sources of funding are available, consider them as well.
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