When choosing between different types of financing, it can be unclear how the costs compare. Therefore, we’re going to keep it simple (for now). It may not be the most precise analysis, but it will serve as a consistent tool for a quick comparison of options. We will convert all financing options to a simple Annualized Cost Percentage (ACP). Regardless of financing type, having a percentage to work with will create a more apples-to-apples framework for future comparisons.

The ACP helps you understand what percentage of the financing amount you would be effectively paying back on an annual basis. 

For example — if you received funding of $2M and were required to pay back a total of $3.8M over ten years, your Annualized Cost Percentage would be 9%.

If this financing required annual payments, you would be paying $180k a year in cost beyond repayment to use the money. That’s 9% of the $2M funding amount that would be paid each year. 

Every term sheet or financing product may not provide these same inputs. So let’s break down each piece of the equation to understand the moving parts.

FINANCING AMOUNT

This is precisely what you think it is – the total amount of funding you’ll receive—nothing more, nothing less.

PROFIT FOR THE FINANCIER

This is the expected amount of money to be paid above and beyond the Financing Amount. 

The easiest way to calculate this is to find the total amount expected to be paid out to the financier for the deal and subtract the initial funding amount. 

Profit for the Financier = Total Compensation to Financier - Financing Amount

For debt, this is pretty easy to accomplish. First, add up the total amount of debt payments required, and subtract the Financing Amount. 

For equity, calculating this may not be as straightforward. However, you can back into Profit for the financier by understanding the total return that the investor is looking for and subtracting the Financing Amount. Equity investor expectations deserve a post in the future, but if you don’t know the investor’s expectations, we urge you to ask. Given that most early-stage (seed to Series B) equity returns follow a power law, a good rule of thumb is that each investment should have the potential of returning its entire fund.

NUMBER OF YEARS

This is the expectation in years that it takes to repay the capital. 

Most debt makes this easy to understand by giving you a payoff date or a number of months/years required to make payments. 

One of the benefits of taking equity is that there isn’t a time requirement to repay or penalty for not paying anything back. But VCs have expectations of when they would ultimately like to see their return. So you can generally use ten years for the Number of Years for early-stage investors.

In the absence of a defined timeline for repayment (à la more modern products like revenue-based finance), you can run a simple forecast of consistent monthly growth to determine the date the final repayment will be made.

HOW DOES THIS STACK UP

Now that you have a simple framework to compare capital costs, we’ll offer a quick reference guide for different financing options and the relevant lowest Cost of Capital you could expect from a given financial product. The goal here is not completeness, but to provide context for the actual cost of capital of each financing option and inform which path you should choose: