The difference between WACC, or Weighted Average Cost of Capital, and the investors’ return confuses many entrepreneurs, especially those with very little finance knowledge. Both are important valuation concepts and will definitely come up in your fundraising process. In this article and the corresponding video, we will learn what they are, how they differ from each other, and how to calculate them.
Measure of risk:
WACC is a measure of risk. Therefore, it is highest for riskiest ventures, such as early-stage startups, and is lower for less risky ventures, such as later stage startups. It is even lower for publicly traded companies. It is lowest for publicly traded companies that are stable and with a very large market cap.
WACC is also a rate used to discount the company’s cash flows (i.e. how much cash it generates for its investors) from the future to the present to determine the value of your company.
As a startup, you will typically accept your first investment in the form of equity or in the form of debt. Following the logic above, WACC for an equity investment is higher than WACC for a debt investment because equity is riskier than debt.
Debt is less risky when it is collateralized by another asset, such as real estate or land. Further, when debt is issued by a bank, your company needs to satisfy certain financial criteria in order to qualify for a loan.
The financial requirements are lower for convertible debt, when it is issued as a form of startup investment by venture capital firms. However, it is still less risky than equity, because it may need to be repaid under certain circumstances, unlike equity which never HAS to be repaid.
WACC = Debt / Total Capital * Cost of Debt + Equity/ Total Capital * Cost of Equity, where Total Capital = Debt + Equity
Cost Of Debt
The cost of debt is calculated as follows:
Cost of Debt = (Interest Rate) X (1 - Tax Rate)
The interest expense is tax deductible, and you are thus able to reduce the cost of debt by your tax rate.
Cost Of Equity
Cost of equity for publicly traded companies is determined based on the capital asset pricing model. This model does not apply to early-stage companies. So instead, we are forced to simply use a range. This range is between 50% and 70%. The riskier your company is, the higher your cost of equity would be in that range.
Investors’ Return And Why It’s Different From WACC
WACC is the minimum investors’ return that investors require to help fund your company in the form of debt or equity.
On the contrary, the investors’ return is the desired return. The startup success rate is so low that investors typically look for a 10x to 20x return on their investments in early-stage ventures in order to be able to make money on their portfolio.
For more information on valuation concepts, check out Course #3: Valuation Models For Early Stage Startups.
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