How to reduce your cost of capital with R&D finance
By: Alex Kepka
Tags: Fundraising, Startup, Finance, Venture Capital, Scaleup

“The WACC is the price that a business is expected to pay on average to finance its assets to everyone that has a security, be it debt or equity. In short, it’s the average cost of the capital you raise.”.

Your cost of capital under equity finance

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When equity funding is the only type of finance available to a company, the WACC will rely solely on the valuation of the business. This means that the less proof of market viability the company has, the more expensive the capital will be. A seed round at a $1,000,000 valuation will have a founder part with 10% of equity for a $100,000 cash injection. Given that the cost of capital reflects the current market price of stock in the company, if the company is valued at $2,000,000 one year later, the cost of the funding received in the earlier round has effectively increased by 100%. This reflects the risk of the early investor but it’s not great news for the founder who has worked diligently to grow the company and cannot make use of 10% of their company’s value anymore.

The alternative here would be debt finance, but most often companies who have few assets or are pre-revenue or low revenue do not have access to debt, as most lenders will want a safe bet. An innovation stands out in this space for companies with a high degree of innovation: R&D finance.

With an R&E loan, a company with minimal assets that is pre-profit or even pre-revenue can still access debt finance by using future government payments from HMRC for the R&D tax credit as security.

What does R&D finance mean for your WACC?

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Given how expensive equity finance is at the start of a company’s journey, it makes sense for the company to take on debt to optimize its cost of capital.

The best way to explain the difference it makes is through an example.

You have a company that is valued at $10,000,000 pre-money at the beginning of the year, and by the end of the year reaches a $15,000,000 valuation. At the beginning of the year, you decide that your funding needs will be $1,000,000 for the year, to cover your runway and ensure you hit your targets. You can either raise the whole round through equity, or you can raise $500,000 through an equity raise where you sell with 5% and the other $500,000 through an R&D tax credit loan you are eligible for at 1.2% interest and a 3.5% facility fee.

If your company goes the traditional route of raising $1,000,000 via equity the total cost of capital as measured by the end of the year will be $500,000. If you choose to mix in the available debt, the company’s cost of capital will be $250,000 for the equity component and $89,500 for the R&D debt, with a total of $339,000.

If the company’s valuation goes up the year after that, the debt funding will have improved in relative cost while the equity gets relatively more expensive as time goes on. At the end of the year in question, if the company takes on the SR&ED facility and complements it with the equity sale, its WACC is reduced by 32% as compared o a full equity round, saving the company $161,000 in value.

In conclusion, for a company that is on a steady growth trajectory, it makes sense to use available debt smartly to optimize its WACC and avoid further erosion of the founders’ equity position.

If you’re curious if you can use SR&ED finance to lower your cost of capital and what this could look like for your company, we’re always happy to have a chat and see if we can help. Chat to us about reducing your WACC.