Working out the cost: non-dilutive Vs equity capital

Start-ups can use both equity and non-dilutive capital raises throughout their growth journey – one does not preclude the other. However, given their differences, they can be hard to compare like-for-like when it comes to cost.

At first glance, repaying capital over time plus fees, as is the case with non-dilutive capital, might not seem so appealing to start-up founders. But it’s essential to consider the cost of the alternative – which is selling equity to investors, and how much that equity is likely grow over time.

In this article, we’ll show you how to compare the different costs of capital, and how your run of the mill $1.5m ARR start-up could save over$1.7m by utilising non-dilutive capital instead of selling equity, even once.

Equity capital versus non-dilutive capital

Equity capital has been available and often used by start-ups since the birth of tech as we know it today. It involves selling equity in the business to investors, like VCs and Angels, who anticipate a significant increase in value over time.

Founders run equity raises roughly every 1.5 to 2 years, and this typically leads to giving away (or ‘diluting’) ~20% of the company each time.

Although there can be tens of thousands in legal fees, there’s no explicit fee for equity capital itself. Instead, the cost is the future value of those shares sold. Founders often overlook the true cost, or future value, of these shares and therefore leave themselves with an uncapped opportunity cost.

On the other hand, non-dilutive capital is obtained without giving up any equity in the business, and usually comes in the form of grants or loans.

Since grants are usually free, let’s focus on start-up loans, like traditional venture debt, and more recent revenue-based finance and recurring revenue finance solutions.

Despite the differences among these types of loans, all involve borrowing funds, which are to be paid back over time with some sort of premium.Premiums might be by way of fees or interest on the amount allocated.

Some providers also take warrants or options, which give them the right to buy equity in the future, in which case they’re not truly non-dilutive.

To compare both sources’ costs, let’s examine strictly non-dilutive capital (i.e. capital that charges a fee or interest only, with no warrants or options).

Comparing the cost of equity to non-dilutive capital

A non-dilutive capital provider determines their fees based on a start-up’s financial health, risk profile, and expected performance.

Using the example of a vanilla software-as-a-service (SaaS)start-up, a non-dilutive capital provider might charge a 13% fee on the amount borrowed, repayable over the following 12 months.

So, if $500k is borrowed at a 13% fee, their total fee over12 months would be $65k, which represents the entire cost of funds over the 12-month period. It’s that simple.

Let’s now compare this $65k fee to the cost of raising $500kin equity capital.

A vanilla SaaS company borrowing $500k might be making ~$1.5mARR and growing at 50% year-on-year (YoY), and therefore mean current shareholders (founders, employees and investors) would give up 6.3% in return for the $500k investment.

This 6.3% is calculated by the following logic: Given current revenue multiples of ~5x for SaaS companies, that would imply a $7.5m pre-money valuation for a $1.5m ARR business. With a $500k equity raise, the post-money valuation (i.e. after receiving the $500k cash injection) would be$8m (i.e. $7.5m pre-investment plus $500k investment). Therefore, the $500k equity capital is worth 6.3% ($500k on $8m) of the company. See diagram below.

Now, let’s work out what that 6.3% equity would be worth in the future.

Assuming this company continues growing at the same rate of 50% YoY for the next five years, it would reach $11.4m ARR, resulting in a $57m valuation using the same revenue multiplier (5x ARR).

Typically, a company growing at this pace will have completed about three equity raises within that five-year period. And assuming each round dilutes shareholders by 20%, the initial 6.3% given away would be diluted down to 3.2% in five years (i.e. 6.3% * [1-0.2³]).

So, in this case, the cost of the initial $500k equity round is equal to 3.2% of the $57m valuation, amounting to $1.8m. In other words, the $500k given away in equity would have been worth $1.8m in five years.

Now let’s reflect on the cost of that $500k loan again, being $65k. By taking on non-dilutive capital in that case:

existing shareholders would have saved themselves more than $1.7m!

 Keep in mind that this example only considers using non-dilutive capital instead of equity capital just once. Repeating the exercise can increase the difference many times over.

Conclusion

In sum, when it comes to funding a start-up, founders can utilise both equity and non-dilutive capital throughout their journey.

Using a mix of both can dramatically reduce the overall cost of capital for shareholders, and thereby offer a more sustainable method of funding a start-up’s growth over the long run.

We think speaking with a finance professional is the best way to fully assess viable options, but hopefully this article helped equip you with the basic tools and concepts to get started 

If you want to know how much non-dilutive capital is available to your start-up, try our funding calculator to get an indication on the spot.

And, if you want to know more, our team will be glad to help. Simply contact us.

Disclaimer

This article is for informational purposes only, is general in nature and does not consider your specific situation. It is not, and should not be relied upon for, financial, tax, legal or investment advice.