The Opportunity Cost of Capital

Back in February 2020 I gave a presentation to the Princeton Entrepreneurship Council called Crafting Your Startup’s Funding Strategy, Funding strategy is a topic we think a lot about at Reformation, so I wanted to resurface a part of my talk here as a short blog post.

To us it’s not just about how to raise VC (nailing your pitch, approaching investors, etc.); it’s about how best to fund your entrepreneurial vision whether that involves VC, debt, alt finance, bootstrapping, or some combination thereof. My partner Andrew Oved recently wrote an excellent blog post on the Alt Finance Landscape that I recommend you check out related to this topic.

The key point from the talk is that for each funding path it’s important to consider not just the visible cost, but also the opportunity cost of capital.

By visible cost of capital I mean the terms on the term sheet. The simplest way to think about it for equity is dilution (valuation), and for debt it’s interest rate. Obviously there’s more to choosing a capital partner than terms. There’s the value-add partner, the network, strategic angle, and opportunity cost, meaning the longer-term trade-off you make by choosing one path over another.

For instance, raising VC may sound great if you dream of building a big business, but at the opportunity cost of not being able to make everyone happy with a modest outcome. Because early stage VCs typically look for a 10x on their investments, an opportunity to sell for 3x — while potentially life changing for your founding team — may put you at odds with your VC who would prefer you be raising at 3x, not selling. See my partner Andrew’s other post on blitzscaling and why it may not be for you.

On the other hand, raising (non-convertible) debt may sound great if you want to minimize dilution, but at the opportunity cost of limiting your ability to change course and therefore potentially sacrifice your ability to service the debt. Many lenders will have operational covenants or availability formulas to protect themselves from the risk of default. These will limit your ability to do things like pivot your product or strategy if it means taking revenue down below covenants. As a general rule, stability of business model is a must for debt providers.

Lastly, bootstrapping is the best way to ensure you completely control your destiny, however limited that destiny may be. If you’re happy building your business to a certain point and want to pay yourself a comfortable wage, or decide to accept an acqui-hire somewhere to continue building with more resources, or to invest in a pivot and temporarily take revenue down to zero, that’s entirely up to you. However, the opportunity cost is that you may never have the balance sheet to really lean into an opportunity, or experiment with some new product or sales angle. Worst of all, better funded competition may beat you to it.

That’s where the following chart can come in handy. Across the top row I’ve listed the major funding types. Down the columns I’ve listed the visible costs, the potential benefits, the opportunity costs, and key considerations as they relate to operational flexibility and the universe of outcomes for the business.

At Reformation we are long-term investors, and as such our goal is to help our companies think through the best funding path for our companies at each stage of their growth taking into account both the near-term visible and longer-term opportunity costs of financing decisions.

We aim to create as much alignment as possible with founders on the best course of action for their businesses whether that involves some, all, or none of the financing options above. Get in touch to learn more!