This record bull market ushered in an unprecedented period of growth for many businesses. Ultra-low interest rates have given way to the “growth at all cost” mentality.
But the tides are changing; the market is turning and interest rates are rising. Given this, it’s the perfect time to discuss the cost of capital and how growth can destroy value.
How Growth Can Destroy Value
We all know the obvious ways that growth can destroy value, like unprofitable business models or negative gross margins. We’ve all heard the stories of capital being burned on businesses that just didn’t make sense.
But profitable growth can destroy capital too.
This occurs when incremental capital invested in growth initiatives creates a profit but doesn’t exceed the business’s cost of capital. Many business owners don’t even consider their cost of capital before pulling the trigger on growth initiatives. But understanding the cost of capital of your business is critical since it literally makes up your business DNA. Cost of capital dictates which direction a business should head in, the strategies and initiatives it should pursue, and ultimately, the value that will accrue to owners.
For example, let’s take a software company that’s considering investing $500k in R&D to develop a new feature. The company estimates that this new feature will generate an extra $75k per year in EBITDA. This growth initiative appears profitable, it has a 15% expected return on investment ($75k EBITDA / $500k capital). But what if the company’s cost of capital was 20%? If this was the case this company would actually be destroying value, even though the growth appears profitable. The company would need to find better growth initiatives that yield a higher expected return, exceeding 20%+. Otherwise, the company would earn a higher rate of return by simply returning the capital to debt/equity holders.
The most common way to calculate a business’s cost of capital is the Weighted Average Cost of Capital formula (or WACC). This formula takes into consideration the cost of both debt and equity in a business.
Let’s take a closer look at each.
The Cost of Debt Capital
Debt typically has a hard cost attached to it: the interest. Whether the interest is paid monthly or accrued to the loan balance the cost of debt is generally well defined. I know there are different flavours of debt, with warrants and other mechanisms, but for simplicity’s sake let’s focus on standard interest-bearing loans.
One of the benefits of getting into real estate investing early in my career is the use of debt taught me a lot about the cost of capital. For any project undertaken or investment made, I always knew the absolute minimum return needed to be in order to exceed the cost of debt. It enabled me to objectively assess and underwrite opportunities.
I’ve also borrowed via operating businesses as well, where the cost of debt was far less favourable than with real estate. But, much like in real estate, it taught me to quickly determine the floor for returns needed to successfully generate value with the borrowed money.
If you don’t have any debt in your business, consider applying for a loan periodically. Even if you don’t need it or accept it, it will give you a better sense of what debt capital costs for your business. This will help you to evaluate growth projects and opportunities.
The Cost of Equity Capital
Compared to debt, the cost of equity is a lot more subjective and is typically based on expected returns. In some cases, there are hard costs associated with equity, like preferred dividends. Let’s take a look at 3 different types of equity financing for a business.
Venture Capital
Venture capital firms invest in high-growth startups where the variance in outcomes is quite large. Most startups fail and result in complete, or near-complete, capital loss. This means that the few startups that succeed need to make up for all the losses. As a result, VCs invest in each startup with the expectation that the business will return many multiples of the capital invested.
For example, let’s say a VC invests $1m across 10 startups with the expectation of returning $5m after a decade (~18% IRR). If 8 startups fail, the 2 that survive, each need to turn the initial $100k investment into $2.5m in value. In this case, the cost of capital for each startup in the VC portfolio is roughly 38% per year over the course of the decade.
The markets pursued, strategies implemented and initiatives selected must have the potential to deliver extremely high returns, in order to exceed the high cost of VC capital. It’s classic high risk, high reward.
Private Equity
Private equity firms invest in mature businesses, often taking control positions. Since these businesses operate with proven business models over a long operating history, the variance of outcomes is quite narrow.
Similar to VC firms, PE firms expect to generate returns between 15% to 25% on their portfolio as well. The difference is that each business in a PE portfolio is expected to perform at the same rate, with no failures, and no outsized returns. So the cost of capital for each PE-backed business is roughly the same as the PE firm’s expected portfolio return: 15% to 25% per year.
At, Atlasview Equity, we take the cost of capital very seriously. From day one, we take a preferred dividend, which sets the floor for the capital cost of our equity. From there, our default capital allocation move is to return the precious capital back as quickly as possible. Reinvesting in growth will always be carefully evaluated, compared to and fighting against our default position of returning capital back.
Bootstrapped
When a business is bootstrapped (no outside equity capital), the cost of capital is very subjective. This is because it ultimately comes down to the owner’s opportunity cost and capital allocation abilities. A good benchmark for your opportunity cost is the S&P 500, which has historically returned around 9% per year. Any business growth initiative you allocate capital to should return at least 9% compound earnings growth per year. Otherwise, why not just allocate that money to a low-cost S&P 500 index fund and generate better returns?
But if you believe you possess superior capital allocation abilities and can generate a much higher return on your money, then your business’s cost of capital is quite high!
I really enjoyed the approach to cost of capital outlined by Buffett in this video.
Buffett knows he has superior capital allocation abilities, so the opportunity cost of his capital is very high. As a result, he charges his businesses a hard cost for taking his capital. It turns the subjective “expected returns” cost of equity, into an objective hard cost. “Paying back Buffett, and avoiding his costs” will always go into a manager’s consideration when evaluating new initiatives or projects for the business.
Businesses, Like Markets, Are Not Always Rational
Reinvesting capital into projects that clearly exceed your cost of capital sound great on paper. These formulas and calculations can easily be put together in an Excel sheet. But in practice, it almost never works this perfectly. Here are some of the reasons why businesses often reinvest capital into projects that return less than their cost of capital.
Growth’s Gravitational Pull
If you’ve ever operated a business, you’d know that everyone wants your business to grow. From your employees to your customers and even your vendors. They all, generally speaking, gain from your business getting larger. Growth motivates those within your organization and also attracts outside talent to your organization. Growth is exciting and fun and feels like the right thing to do.
Cutting budgets, shutting down projects, and sucking cash out of the business, to deploy elsewhere, is never fun or easy to do. Though from a strictly mathematical perspective it might be the most optimal thing to do, employees, customers, and vendors don’t care about your cost of capital. It’s hard to retain employees if your business isn’t constantly reinvesting into growth, and just stagnating (though this is partly due to incentive structures, discussed in the next point).
Businesses have a gravitational force to reinvest into growth, no matter if the returns exceed their cost of capital. And for many businesses, this is what often leads to their demise (and permanent capital loss for owners).
Poor Incentive Structures
Management and employees are often incentivized for some sort of growth, usually revenue or profit targets. It’s rare that they are compensated for maximizing net returns on invested capital. Constellation Software is one of the rare ones. Here is an excerpt from an interview with CSU management where they describe their employee incentive structure:
An incentive structure that doesn’t include a hurdle rate, to consider the cost of capital, is a poor one. This is why Buffett charges businesses for his capital. It forces managers to think like owners and understand that money costs money.
Objectively Difficult
It’s difficult to predict returns on growth initiatives. It’s not often that businesses have a strong reinvestment moat, meaning, they’re able to consistently reinvest capital and generate a predictably high return.
From my experience, reinvesting into growth capex or even opex often has unpredictable results. Things always look better on paper. This makes exceeding the cost of the capital hurdle rate objectively difficult for business owners to determine.
This is why I respect exceptional capital allocator-operators like Bob Dhillon of Mainstreet Equity. It’s a unique skill set to be able to run the operations of a single business and consistently keep reinvesting an increasingly larger pool of capital effectively.
Final Thoughts
As interest rates rise, the cost of capital will continue to increase for business owners/operators. Growth, even if profitable, has the potential to destroy value. Now is the time to stress test your capital reinvestment decisions, and effectively analyze your cost of capital.
Hi there! I’m Jay Vasantharajah, a Toronto-based entrepreneur and investor.
This is my personal blog where I share my experiences managing my portfolio of real estate, stocks, and private companies. I write extensively about allocating capital and building businesses.
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