The cost of capital

Boring!!! Yes - I know. But there is a certain reality that we have (almost) all been ignoring or covering up or something like that. It is the cost of capital - how much you pay for having the cash to succeed (or fail).

Most pro-forma presentations, most investor prospecti, most companies never mention this, and angel investors, even though somewhere in the back of their mind know it, don't ask and let it slide. But there is a very real cost associated with getting funding, no matter how you do it.

Different versions of how it plays out

You know it's the cost of capital when:

Here's an unhappy number. According to my quick review of CEOs going after angel funding, about 1/3 of their time is spent on getting investments while they are in funding rounds. All of that time, is also the cost of capital.

Penny wise and pound foolish

I run A2E, and of course, we charge a fee for companies to "go to angel". The fee is $100, we tell people this as part of the application process, and they agree to it as a condition of applying. We wonder why some of the folks we invite don't every respond to invitations, so we did a little survey of 55 of those who were offered presentations but did not proceed. To be clear, we don't invite everyone. In fact, our statistics show that we decline about 4 out of 5 applications without inviting them. Here's what we found out, and no it's not statistically valid (small sample size):

This last one bothered me, so I asked a few of the respondents who chose to communicate in this regard about it. Here is a sample response sequence (anonymized - my statements italicized):

A few falacies

Before continuing, I want to mention that I really do appreciate the seeming honesty of this person after having the falsehood pointed out. In essence, they admit that they were lying in the original application. And worse yet, they claim that this lie works.

As an aside, my view is that I only want to deal with honest people. The initial lie is enough for me to not want to do business with them because I presume they will lie from now one and I cannot believe anything they say. The claim that the lie works and, in essence, that they must therefore do it to succeed is more troubling. It means that other investors are willing to fund people who lie to them. Perhaps they don't know it's a lie because they don't ask such questions, but it is troubling nonetheless.

Here's another problem with their response. They say they have $200K invested and yet are unwilling to pay $100 of it for an hour or so of the time of several experts who will evaluate their pitch and provide metrics on why they might or might not get funded, and who are willing to work for equity and deferred compensation (none of their cash) if there is mutual interest. If they paid $100 per hour for a whole year full time that would come to $200K - 2,000 presentations.

Here's yet another problem with their response. They must believe they have something better than sliced bread, or perhaps they just don't understand risk and reward, but in either case, there appears to be a lot of ego there. The folks I work with are not big fans of high ego and bad judgment.

Here's another problem with their response. They seem to believe that folks who charge them are frauds - or at least some of them are. Of course a reasonable argument could be made that people who offer you something for nothing are the frauds, but then we give away a lot of free content on our Web ites as well. But in any case, they seem to justify their own lie based on the presumption that we are lying.

I had another company explain to me that they were not allowed to pay to present - as a matter of policy by their parent company. But they were allowed to fly across the country, stay in a hotel, pay for meals, and take 2 days for a 30 minute presentation, as long as the presentation was free. Of course this did not explain why they applied to present where a fee was required, but it shows something about the nature of the beast.

How does this relate to the cost of capital

There are two problems here. One is that startups somehow think that the time of investors and experts is or should be free. However this came to be, I think that investors and experts should stop offering any free services to startups, requiring at least a minimal fee for everything they do. The purpose is to make it clear that you pay for what you get and to create the resonable expectation that there is a cost to capital and expertise.

The second problem is that investors do not require the cost of capital to be listed in financials. As a result, this very real and substantial expense gets ignored or swept under the carpet. This is easy to fix. Whenever there isn't a line item for the cost of capital, investors should ask about it and refuse to invest unless and until it is included. It's a simple matter of due diligence to identify costs. Failure to identify substantial costs doesn't meet the standard of diligence in any real sense of the word.

In summary

The cost of capital is important to understand for all parties. The free ride fiction is problematic because it creates other fictions and fictional financials and because integrity and honesty are fundamental to the trust necessary to justify funding.

Copyright(c) Fred Cohen, 2017 - All Rights Reserved