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Compounding Effects of External Capital

January 28, 2013

In real estate, you often hear investors talk about leverage.  Use the bank’s money to get bigger returns.  Instead of using your own capital, put 20% down and get the bank to fund the other 80%.  In a perfect market you actually do get larger returns by using other people’s money, by following this strategy.

The problem with our addiction to cheap capital, is we rarely look at the flip side. What happens in a downturn?  When you are heavily leveraged, your losses are amplified.  Let’s look at an an example.  Let’s say you have a property that’s worth $100,000, which you put $20,000 as a downpayment and you owe the bank the other $80,000.  The market drops 10% so you’re property is now worth $90,000, your equity drops to $10,000 and you still owe $80,000 to the bank.  The 10% drop in the market amplified your losses to 50% loss because of leverage.

What about using this model in venture capital and with angel investors from a purely financial perspective?  The examples are two different types of capital groups, debt vs. equity, but they still can have compounding effects on your return-on-investment.

Let’s say you round up a team of three founders, who own 33.33% each, and build a company worth about $5 million with no outside investment.   The business has started to generate significant revenue.  This year the company will have operating expenses of $1 million and generate $2 million in revenue leaving $1 million in profit.

Operating expenses and revenue  is on track to grow 50% each year for the next 5 years, so by year 5 they would be generating $5 million in profit.  In 5 years, the founders would have pocketed $4.3 million each (if they distributed profits as dividends or did some share repurchase), not to mention the equity that is now built up in the business.

A team of identical founders in the exact same scenario, feel that 50% is not good enough.  They feel if they raised capital they could accelerate beyond 50% growth each year.   They go shop the deal and end up raising $1.5 million at a $5 million pre-money valuation or $6.5 million post-money valuation.  The investors negotiate a 15% option pool.  The company is now structured as the following:

  • Founders: 61.92% (each founder has 20.64%)
  • Investors: 23.08%
  • Option Pool: 15.00%

The founder’s equity gets diluted to an effective pre-money valuation of $4 million because of the option pool.  Not only this, the business immediately puts that $1.5 million to work increasing their operating expenses to $2.5 million in the first year.  Similar to the entrepreneurs in the first group, their revenue is still $2 million which means the business loses $500,000 in the first year.  The operating expenses grow constant at 50% each year.

For this group of founders to get the same type of return as the first set of founders, they would literally need to grow at 92% in revenue each year.  This group of entrepreneurs needs to increase their revenue output an extra 84%, just to walk away this the same amount of capital.

A great post I just came across looked at a few real life examples:

This blog post isn’t meant to stop you from raising capital, but to show you the compounding effects external capital can have on your business.  I want to make sure as an entrepreneur you understand that the capital you raise is truly going to accelerate your business and provide the return you want to your founders and employees.

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