Klear, Inc.
2021 Fillmore Street
San Francisco, CA 94115
The CEO’s Role in Capital Allocation and Company Value Creation
Founders of growing companies wear a lot of hats. They’re often the visionaries, the technical inventors, the lead sales people and ultimately one of them usually becomes the CEO. When a founder becomes a CEO they have a very specific new set of job requirements. If they raise outside capital, especially from venture capitalists, it becomes even more well defined. A major part of a CEOs job is to decide; to choose what does and what doesn’t get done.
The "E" in CEO stands for executive and the active form is to execute. Hopefully the CEO has meaningful help from skilled and experienced board and leadership teams. But ultimately, the CEO decides. The sum of their decisions are supposed to combine to increase the value of the company. That is the most common metric of execution in scaling companies.
One of the most important of these decisions is how and where to invest. What gets funded? What gets postponed? What gets cancelled? At the end of the day, the investments that get made should result in outcomes like: more competitive or popular products, more revenue, more customers, more marketshare, and lower cost structures so that current and future investors evaluate these decisions and reward them with a higher price per share.
Ultimately, there are many ways a company can acquire the capital needed to fund these investments. Each of them has a cost and a set of rules that come along with those costs and the impact of those costs can be quantified. That is a key job of the CFO and the board.
What Is WACC? Understanding the Weighted Average Cost of Capital
I mention the costs and rules together because they are often related. Each source of capital has a calculable cost (some more obvious than others) and a set of rules that come with the money. I’ll break down costs and rules later when we discuss the capital stack. To set the stage, let’s look at how the math works.
As a CFO (or VP of finance or college roommate that studied econ, or worst engineer on the team - depending on your stage), building and managing the capital stack is a primary responsibility. Each financial tool has a cost and all of the costs and volumes have a metric that is typically the preview analysts, professional investors and financial academics called the WACC.
The Weighted Average Cost of Capital (WACC) is the “hurdle rate” your business must exceed to create value. It blends the cost of equity, cost of debt (short and long term), and working capital financing—weighted by how much each contributes to the capital structure. Managing WACC is about both controlling the numerator (costs) and optimizing the denominator (capital mix) and managing the rules that come with the capital which will limit the decisions you are able to make as a team. Basically, how do you get the right money for the right job at the right time?
Why Most Startups Ignore WACC (And Why That’s a Problem)
Why isn’t WACC a standard tracked metric when building a company? That question brings us to the Capital Stack. We’ve all heard the old adage about the guy with the hammer and all the nails he sees. Startup funding looks very similar. Even post COVID, post ZIRP, post alternative lending frenzy that came with it, most scaling companies are nearly 100% capitalized by equity funding.
Said differently, they raise most of their cash by selling ownership in the company at the current share price to acquire the capital needed to execute and improve the value of the company and achieve a higher share price and then do it again. It makes sense if you have a hammer. This however isn’t all they try to do.
What Is a Capital Stack? A Practical Framework for Startup Funding
One of my favorite stories comes from a Klear customer that has a top tier global enterprise customer base and a 10 year rack record of delivering. They went in to see a tier one bank that was right across the street from their office. They were looking for a working capital loan that would help them expand into the scaling demand of a global F1000 enterprise customer that had repeatedly ordered their product and was implementing the technology across their global footprint.
The bank said “How much cash do you have?” The customer said “We have about $2,000,000.” The bank said “If you deposit the $2,000,000 with us we can lend you up to $2,000,000.” The client was confused. This is how big banks work, for real.
So what are the real choices? What is the relative cost of each and how do they “stack up”? Let’s open our analysis with the hammer, equity and then we’ll look at venture debt, private credit, traditional debt, and working capital.
To keep this blog length instead of textbook length, I’m going to use this framework:
- Who get’s it?
- What do you get?
- What does it cost?
- What are the rules?
- What can go wrong?
Venture Equity: High Growth, High Cost Capital
Who gets it?
Companies that are going to grow 3X-100X in 5-10 years. If your growth forecast has this curve than equity is a good choice. If it doesn’t, then investors can buy public equities that will deliver a competitive return for far less risk.
What do you get?
A slug of cash all at once, usually expected to last 18 months or more and usually, a new board member and a defined UoP (use of proceeds) that dictates where you will be permitted to invest the money.
What does it cost?
This is the rub. An investors expected return is basically your cost in each of these investment vehicles regardless of what the vehicle is. If the investor expects 3X-100X by a certain date then that is the corresponding cost. If we use 5X in 5 years, the cost is 38% per year in expected return. The good news is, if you do that, your remaining stake grows like that too!
What are the rules?
You usually get a board and with the board, a boss. That is not a negative, good governance is critically important and a good board can be extremely valuable but it is important to know the rules of the game you’re playing
What can go wrong?
Most companies can’t do this. That kind of growth is very rare. That’s why VCs expect a high failure rate and play a “power law” game when constructing their portfolios. If you don’t believe you can deliver these results, don’t play this game because you will 1) get deeply diluted after you fail to deliver and lose control of your company or 2) get fired outright and get $0 because of preferences.
Venture Debt: Leveraging Equity with Additional Capital
Who gets it?
Most people don’t realize that venture debt is a “sidecar” to venture equity. It is attached and rides along. Venture debt lenders underwrite your equity round; size, caliber of investors, conviction and likelihood and capacity to keep funding the company. So the people that get venture debt in any meaningful amount are those that can raise tier one venture equity. (see above)
What do you get?
A nice slug of cash that is closely tied to the amount of equity you raised and is typically around 20-30% of an equity round. It is a good tool if you are a good fit.
What does it cost?
Headline coupon rates are typically around 8-12% but there are often additional fees like origination, unused, or termination fees that can and 1-3% more and warrants. Warrants are sneaky forms of equity and all in this increases costs to 10-16% which isn’t terrible.
What are the rules?
Venture debt is often senior secured and creates a different dynamic with investors and boards. It is leverage pure and simple and leverage cranks up the heat. In addition, senior secured means the lender gets paid before anyone makes any money as an equity seller…(see below)
What can go wrong?
…and if things go wrong they can foreclose (translation: take your company). The close ties between venture investors and venture debt lenders means that if they do take your company they will turn to your equity investors to figure out what to do with it.
Caveat: If you are a high growth company with top tier equity investors and you execute, venture debt can be a great source of leverage to turbo charge growth.
Private Credit: Large-Scale Capital for Mature Companies
Who gets it?
Private credit is traditionally awarded to companies with a fairly sophisticated finance capacity, collateral, and the ability to absorb big tickets. If you’ve ever landed private credit, you know the “get out of bed” ticket is around $50,000,000. If you don’t have the above criteria to get them out of bed, skip it. If you do and you’re still reading this, thanks!
What do you get?
A nice slug of cash to enable growth and likely a very well capitalized business partner who can back you on the growth journey if you execute.
What does it cost?
Usually 8-12% with additional fees of 1-3% taking the total cost to 9-15%
What are the rules?
Private credit is very covenant heavy. There are a lot of rules and there are a lot of steps to get it. You usually need to do a Q of E or quality of earnings analysis where they audit the sources of revenue, you may need to issue a personal guarantee or at the very least a bad actor guarantee, you will have significant ongoing reporting requirements and you may get another board member and have to issue warrants like venture debt.
What can go wrong?
Private credit investors are very good and protecting capital and taking action when things go wrong. They will take your company, supersede your investors, fire your leadership team and install a swat team of MBAs to harvest the organize and monetize the corpse.
Traditional Bank Debt: Why Startups Rarely Qualify
Who gets it?
Not us guys! Next!
Working Capital Financing: Aligning Capital with Revenue Cycles
Who gets it?
Companies with a strong customer base, a committed order book, and good financial discipline. If you sell to F1000 and/or government customers you should look very closely and this option.
What do you get?
Capital that is aligned with your order-to-cash cycle, scales with customer demand, is relatively covenant light and is high velocity relative to other choices.
What does it cost?
It usually costs about 10-15% per annum and typically doesn’t come with a lot of other fees. Legacy providers or banks may have rules that limit your options or create operational complexity so it is important to understand how it is implemented. Good working capital is operationally aligned so if your operations are weak or immature, this may not be a great option.
What are the rules?
Underwriting is usually aligned with your order book and different types of account infrastructure is put in place to control cashflow. Typical solutions providers won’t take senior security or ask or personal guarantees but the infrastructure may create operational complexity. Sizing often scales based on customer credit quality so the better and larger your customer base is (F1000 and government customers) the more powerful this solution can be.
What can go wrong?
Working capital solutions can often scale far beyond the “balance sheet” of the business based on the fact that they underwrite customer credit quality. Sometimes customers have a bad quarter, go bankrupt or in the case of governments shut down for extended periods of time due to funding issues or bureaucratic seasonal and budgetary issues. It is important to understand the “recourse” that a working capital solutions provider has to your business and/or your customer base in these scenarios.
There are a lot of solutions out there with a lot of different structures, prices and rules. There is no single tool that fits all jobs. Good teams know how to align the right tools with the right job and match them to the stage of the business and the growth goals that you have committed to.
Final Thoughts: There Is No One-Size-Fits-All Financing Strategy
Like the Swiss Army Knife, good teams have combination of skill, vision, determination and experience. Not all experience however, is created equally especially in the rapidly evolving conditions in the current American Industrial Renaissance. In the next installment we’ll examine the Modern American Finance Professional in this new, dynamic market context.