What is Cost of Equity? – Meaning, Concept and Formula
February 12, 2025
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The Fed has decided to raise interest rates steeply. One rate hike has already been announced this year (2018). It is likely that there are many more rate hikes to follow until the year 2020. The cost of capital is likely to go up.
In a high-interest rate scenario, investors typically prefer to invest in debt itself. This is because the returns from equity do not seem very attractive if the returns from debt increase significantly.
In a high-interest rate scenario, the risk appetite of investor is reduced. Hence debt funding becomes more prevalent during such times. It seems like high-interest rates will be the norm for the next few years. Therefore, high-risk investments like venture capital may face a shortage of funds. It is for this reason that the popularity of venture debt is increasing. In this article, we will have a closer look at venture debt.
Venture debt means the wide variety of debt-based financing options that can be used by companies that have already been backed by venture capital firms. Venture debt can be raised from the same firms that provide venture equity funding. However, such companies make debt investments only in very rare cases.
Usually venture debt is raised from banks and other consortiums which have an expertise in making such investments. However, it needs to be understood that like any other debt investment, venture debt is also a loan. Hence, it needs to be paid back
The benefits of using venture debt are as follows:
However, in case of debt, venture firms lend against the already existing cash flows. If a firm has a relatively stable cash flow, it can easily obtain venture funds in a matter of days. However, the management of the firm will have to obtain the permission of other equity investors before venture debt can be obtained. This is because new venture investment also increases the risk of equity investments that have already been made.
Given the changing economic scenario in the future, venture debt may become a necessity for most firms.
The fact that lenders are also willing to lend sends a positive signal about the firm to the market in general. It has been observed that the valuation of the firm increases in the round following a venture debt funding. It may be attributed to the confidence infused by the positive signals. Alternatively, it could also be attributed to the fact that trading on equity increases the return on investment for equity shareholders.
Venture debt provides the opportunity to avoid down rounds. If a startup needs funds, it need not sell equity at depressed prices to raise those funds. In such scenarios, venture debt allows promoters to hold on to their stakes and avoid dilution as well as loss of control.
To sum it up, venture debt is an important tool. This tool is particularly helpful in the era of high-interest rates. Also, if used correctly, it helps firms keep their business running by providing them adequate cash flow at the right time.
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