The Cost of Capital

In any start-up, but especially in a technology start-up, the decision to seek capital from outside investors is often complicated. On one hand, companies can benefit from ready capital by rapidly ramping up research, development, and deployment of products and services. On the sales side the company can quickly add heads to an existing team or assemble a new sales organization to address new markets. The ability to use investment money for inorganic growth is another tempting possibility. Buying components of code can save a great deal of time and bring a product to market faster than the actual development. In addition, the breathing room that a hefty bank account affords is often priceless in the beginning stages of a business where oftentimes, poor decisions result directly from panic brought about by cash flow issues. Ongoing cash flow problems can lead to bankruptcy, dramatically scaled-down business goals or in worst cases a sale ahead of an acceptable valuation or complete dissolution.

Naturally, anyone who has invested time and energy into a venture wants to avoid the problems that shoestring boot-strapping can bring, and this is what makes investment capital seem so wonderful. When it comes in the form of equity, it even strengthens the balance sheet. (Debt, of course, doesn’t look as attractive, but it still provides the cash that helps a CEO sleep at night.)

There’s another side to using other people’s money, though. Ultimately, cash comes with strings. Sometimes the strings represent additional cash flow strains in the form of interest payments or preferred stock mandated dividend disbursement. In many cases, the level of oversight involved can be onerous. Company founders accustomed to complete dictatorial control over every aspect of the business suddenly find themselves answering to the sources of the money, and the money sources are primarily concerned with a return of capital and a return on investment; not necessarily with the company’s overall goals. This isn’t to say that venture capitalists (or other sources) are uninterested in the long-term success of the company. They are constrained, however, by their investment goals, and in many, if not most, cases, these goals involve a relatively quick and secure return of capital more than an ongoing interest in the continued success of the company. Let’s not forget that using external money can sometimes bring both oversight and expense. It’s not uncommon for a fund to require the hiring of a particular employee—salary paid by the company—in order to close the deal and provide an insider to keep them informed on the daily ups and downs in the business.

In my experience, try to grow and operate your company organically for as long as possible. That way, when the time comes for investment money, you’re positioned powerfully rather than weakly enabling you to maximize your valuation and fully embrace the benefits from the capital while minimizing the negatives.

Full Disclosure – Paragon Software Group Corporation was started with a loan from the company founders. Profitable within 3 months of incorporation, PSGC continues to grow organically and is currently the 3rd fastest growing private company in Orange County, California.