The Cost of Capital: Growth ❌ Value
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In this edition of our newsletter, we cover:
The Cost of Capital and How Growth Can Destroy Value
Trivest Partners Q&A with Jay Vasantharajah
Fellow Deal Maker Perspectives
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The Cost of Capital: Growth ❌ Value
The record COVID bull market ushered in an unprecedented period of growth for many businesses. Ultra-low interest rates have given way to the “growth at all cost” mentality.
But the tides have changed; interest rates have risen and may continue to rise in the near future. Given this, it’s the perfect time to discuss the cost of capital and how growth can destroy value.
How Growth Can Destroy Value
We all know the obvious ways that growth can destroy value, like unprofitable business models or negative gross margins. We’ve all heard the stories of capital being burned on businesses that just didn’t make sense.
But profitable growth can destroy capital too.
This occurs when incremental capital invested in growth initiatives creates a profit but doesn’t exceed the business’s cost of capital. Many business owners don’t even consider their cost of capital before pulling the trigger on growth initiatives. But understanding the cost of capital of your business is critical since it literally makes up your business DNA. Cost of capital dictates which direction a business should head in, the strategies and initiatives it should pursue, and ultimately, the value that will accrue to owners.
For example, let’s take a software company that’s considering investing $500k in R&D to develop a new feature. The company estimates that this new feature will generate an extra $75k per year in EBITDA. This growth initiative appears profitable, it has a 15% expected return on investment ($75k EBITDA / $500k capital). But what if the company’s cost of capital was 20%? If this was the case this company would actually be destroying value, even though the growth appears profitable. The company would need to find better growth initiatives that yield a higher expected return, exceeding 20%+. Otherwise, the company would earn a higher rate of return by simply returning the capital to debt/equity holders.
The most common way to calculate a business’s cost of capital is the Weighted Average Cost of Capital formula (or WACC). This formula takes into consideration the cost of both debt and equity in a business.
Businesses Are Not Always Rational…
Reinvesting capital into projects that clearly exceed your cost of capital sound great on paper. These formulas and calculations can easily be put together in an Excel sheet. But in practice, it almost never works this perfectly.
Here are some of the reasons why businesses often reinvest capital into projects that return less than their cost of capital:
Growth’s Gravitational Pull
Businesses have a gravitational force to reinvest into growth, no matter if the returns exceed their cost of capital. And for many businesses, this is what often leads to their demise (and permanent capital loss for owners).
Poor Incentive Structures
Management and employees are often incentivized for some sort of growth, usually revenue or profit targets. It’s rare that they are compensated for maximizing net returns on invested capital. An incentive structure that doesn’t include a hurdle rate, to consider the cost of capital, is a poor one.
It’s difficult to predict returns on growth initiatives. It’s not often that businesses have a strong reinvestment moat, meaning, they’re able to consistently reinvest capital and generate a predictably high return.
In this current macro environment, the cost of capital may continue to increase for business owners/operators. Growth, even if profitable, has the potential to destroy value. Now is the time to stress test your capital reinvestment decisions, and effectively analyze your cost of capital.
Finally, if you run a software or tech-enabled business that may be a fit for Atlasview, feel free to reach out. Atlasview has ample dry capital and LP relationships excited to invest alongside us!
Q&A w/ Atlasview Equity
Last week, Jay Vasantharajah sat down with Tony Hill of Trivest Partners, as part of a Q&A for their Independently Sponsored series. The interview covers Atlasview’s origin story, our firm’s value prop/thesis, and where we are seeing opportunities today.
Give the full interview a read: here
Preferred Investment Criteria
We look for the following characteristics in our partner companies:
Industry: Software and tech-enabled businesses
Business Profile: Sticky B2B customer base
Size: Minimum $1m EBITDA or $5m ARR
Geography: The US & Canada preferred
Whether you’re a business owner interested in working with us, or an intermediary with a deal to share, always feel free to reach out and get in touch with us!
Deal Maker Perspectives
An interesting take on the SVB situation:
Silicon Valley Bank Explainer:
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Atlasview Equity is a private equity firm specializing in software and tech-enabled businesses. We combine patient capital with proven operational strategies to deliver predictable results for our stakeholders.