WACC vs Investors’​ Return

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.

Discount rate:

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.

Definition:

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.

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.

Victoria Yampolsky, CFA, is the President and Founder of The Startup Station, a comprehensive financial resource for early stage startups. She evaluates the financial feasibility of business models and specializes in the financial modeling and valuation of pre-revenue companies. She also created a finance curriculum for early stage founders and launched The Startup Station’s educational program in 2015. Since then, more than 1,000 founders have attended her online and in-person finance classes and learned the basics of financial modeling, valuation, and startup financing.

Previously, Victoria worked for the Deutsche Bank Research Department and performed IT consulting for CapGemini’s Financial Services Division. Victoria holds a Bachelor’s Degree, Cum Laude, in Computer Science, with a minor in Mathematics, from Cornell University and an MBA, with honors, from Columbia Business School. Victoria is also on the Advisory Board of the Computing and Information Science (CIS) Department of Cornell University.