The 6 mistakes startups make when it comes to Cost of capital
Many startups are cost-conscious, but they also need to take into account the cost of capital. The cost of capital is the interest rate that a company pays on its borrowing. When you’re building your business plan, it’s important to understand how much money you will owe and the cost of those loans or investments.
There are many mistakes that startups make when it comes to cost of capital, which we’ll discuss in this blog post!
1. Not understanding the cost of capital.
Not including enough information in your cost of the capital section can lead investors and lenders to believe you don’t understand how much debt or equity financing will cost your company over time, which may affect their decision on whether they want to invest or lend money to your business!
To avoid this issue altogether, focus on making sure all costs associated with borrowing are included in these sections.
Include things like loan origination fees, annual percentage rates (APR), repayment schedules, etc., so potential financiers have an idea of what expenses come along with lending you money for a certain period. If your cost of capital is high, it may be a red flag to investors who are looking for companies with a lower cost of capital.
2. Choosing a team that doesn’t have complementary skills.
Choosing a team that doesn’t have complementary skills, or choosing to hire someone in an area where you already have a lot of internal knowledge can cost your company time and money when it comes to cost of capital. When building out your financial model, make sure the cost structure is set up so if there are any additional hires needed for specific areas (i.e., Finance), it’s accounted for in the overall plan. In addition, be aware if certain roles require different levels of experience — this will affect salary requirements as well! If you’re adding staffing costs into your plan without being able to justify them with increased revenue from those new employees, investors may not take too kindly to these expenses coming off the top line before growing profits later on.
3. Failing to properly leverage relationships and networks.
One cost that many startups forget about when it comes to cost of capital is leveraging your relationships and networks. If you’re able to find a partner or investor who has connections, insight into the market, etc., outside of what you’d be able to do on your own as a startup without any experience in the industry, this can help reduce costs for all parties involved! In addition to cost savings from things like contacts and knowledge transfer between partners/investors and management team members, these relationships may allow access to funding sources not available otherwise.
4. Underestimating the importance of customer acquisition costs.
Startups often underestimate the cost of customer acquisition. When budgeting for cost of capital, make sure you include costs associated with finding customers and clients (marketing expenses), as well as sales commissions to close deals.
If these numbers are underestimated, your business plan may show that there is too much “margin” between what it cost to acquire a new client or sell one unit vs how much revenue comes into the company from those efforts — this looks unappealing to investors looking at whether they should invest in your startup.
Customers aren’t just important because they drive revenues; if done right, they can help reduce cost of capital! For example: If an investor knows anyone who would be in investing money or lending funds to a startup, they may be more likely to work with you if the cost of capital is lower.
For example: If an investor knows anyone who would be in investing money or lending funds to a startup, they may be more likely to work with you if the cost of capital is lower.
The cost of capital depends on the industry. For example, if you’re in a high cost-of-capital sector like retail or energy, your cost to borrow will be much higher than that of an internet company with large margins and liquidity — which means it can take longer for those businesses to turn around their investments into positive cash flow!
That’s why when looking at cost of capital as part of your overall plan during fundraising efforts (or even applying for loans), make sure you understand what specific factors investors consider before making any financial commitments so there are no surprises later down the road. However, startups should expect some level of uncertainty given this is still early stages; use things like management teams’ track records to mitigate risk exposure until you can prove your cost of capital will decrease over time.
5. Assuming you’ll be able to raise more money than you need.
Another cost of capital mistake startups make is assuming they’ll be able to raise more money than is necessary.
If you’ve done your homework and figured out the cost of raising each round based on what investors are looking for, as well as how long it takes before those investments begin bringing profit back into the company (i.e., payback period), you should have a good idea about what amount will get you where you need to go without too much risk exposure — this also helps reduce cost of capital by showing there’s less financial “slack” during growth phases! This way, if an acquisition opportunity arises or something else happens that requires additional funds beyond original projections, it won’t create undue stress for everyone involved in getting these deals done.
6. Allowing your business model to become outdated too quickly.
Startups should also avoid allowing their cost of capital to increase by not keeping up with industry standards. For example, if you’re a startup in 2021 and your cost of capital is growing as more technologies become available that make it easier for businesses like yours to complete specific tasks or look better from an investor’s perspective, don’t assume those upgrades will be available later on — the cost may be higher! One way to combat this cost-of-capital fear is using cloud technology solutions that can help reduce infrastructure costs versus building servers/computers yourself upfront.
In addition, startups could gain a competitive advantage over other companies just entering the industry through rebranding efforts after going live with new marketing strategies designed around these updated business models — this cost of capital can be spread out over time rather than all at once, making it easier to manage the transition!
Startups should remember change is constant, and the cost of capital changes with every decision made. That’s why it’s important to understand how cost of capital can affect your business plan throughout different stages of development — this will help you make better decisions that won’t end up costing more money than originally expected!
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