People who know me know that the concept of cost of capital is near and dear to my heart, so I read with great interest this new practical guide to measuring it from the financial mind of Michael Mauboussin. The whole thing is worth reading, but the first eight pages are particularly good at clarifying what can be a very abstract concept. 

All things being equal, a company should prefer a lower cost of capital to a higher one because it lowers the threshold return a company needs to generate in order to create value. The catch-22 of that is that the cost of capital from an investor goes down alongside the investor’s perceived riskiness of the investment. In other words, if you’re able to somehow guarantee an investor a return, they won’t ask for much of one. This is why bank debt backed by assets is relatively cheap (i.e. has a lower interest rate) compared to what a VC will ask for to provide funding to a money-losing start-up.

The reason I think that’s a catch-22 is because the more you guarantee an investor in order to lower your cost of capital (in loans these guarantees are called covenants), the less flexibility you have to run your business, which increases all kinds of hard-to-quantify costs. If you have to pay the bank, for example, you may not be able to hire a team to pursue a greenfield project.

Moreover, as Mauboussin points out, having investors with senior claims on cash flow increases the odds of financial distress even if the objective cost of capital is low. Put another way, if you take on too much low cost capital (i.e. debt), you will end up increasing your cost of capital because the more guarantees you make the less likely you are to satisfy them all.

So what’s an optimal capital structure? That depends on what you’re optimizing for. 

If you’re optimizing for near-term returns, the answer is as much low cost capital (i.e. debt) that a business can tolerate without tipping it into distress (which is why traditional private equity closes levered transactions). But if you’re optimizing for the very long term, I think the answer is very little to no debt at all (which is what we do). The reason is then you have maximum flexibility and the opportunity to allocate capital that while more expensive, has the chance to go into ideas and opportunities where the spread between what the capital costs and what it might return is highest. 

We call this creating variance and while it makes some investors (like banks) nervous, that’s why they get really cheap capital (customer deposits) and prefer to earn lower returns.

– By Tim Hanson

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