Financing Life Cycles & Costs of Capital

Whether you are an entrepreneur starting-up or the leader of an established business, a solid understanding of the available sources of capital and today’s expected rate of return for capital is the fundamental step in crafting a financing and fund raising strategy.

Financing Life Cycles

Sources of capital have different preferences and practices, including how much money they will provide, when in a company’s life cycle they will invest, and the cost of capital or expected rate of return. The available sources of capital change dramatically for companies at different stages and rates of growth.

The graphic above depicts the financing life cycles of firms. It shows the source of capital available over time for different types of firms at different stages of development. It also summarizes, at different stages of development, the available sources of capital and their associated costs.

A key factor affecting the availability of financing is the upside potential of a company. 5% or less of new businesses launched each year achieve growth and sales levels of high potential firms, firms that will exceed $25 million or more in sales. Foundation firms total approximately 10% of new firms. They grow more slowly, but exceed $1 million in sales and grow to $5 to $20 million. Remaining are the stable lifestyle firms. High potential firms have the widest array of financing alternatives, while lifestyle firms are limited to personal resources of their founders and the net worth they accumulate.

The financing life cycle is a useful framework to begin identifying financing alternatives, and when and if certain alternatives are available.

Costs of Capital

As high potential and foundation firms move along their financing life cycle, cost of capital decreases because risk decreases. As revenue, profit and number of employees increase, the un-diversifiable or systematic risk inherent to the company’s entire market decreases.

Systematic risk or company specific risk generally decreases with differentiated and diversified product lines serving large markets, a secure supply chain, a strong patent portfolio, a hard to replicate interdisciplinary technical team, and an experienced and diverse management team without reliance on key persons or founders.

Private Cost of Capital

The Pepperdine Private Cost of Capital Survey7 is a web based survey of tens of thousands of capital providers including banks, asset based lenders, mezzanine investors, private equity groups, venture capitalists, factoring companies, business owners, investment banks, and business valuation professionals. The survey investigates for each private capital market segment, the important benchmarks that must be met in order to qualify for capital – amount of capital typically accessible, required returns for extending capital in the current economic environment, and outlooks on demand for various capital types, interest rates, and the economy in general.

The cost of capital results of the survey released in Spring 2013 are depicted below. The data identifies annualized gross financing costs and represents the required rate of returns for different categories of private capital providers.

Loans have the lowest average rates while capital obtained from angels and venture capital has the highest average rates. As the size of loan or investment increases, the cost of borrowing or financing from any of the following sources decreases.

Private Cost of Capital Model

The Private Cost of Capital model is based on the principal of substitution and mirrors how private capital providers make investment decisions. The relevant market of investors is the market that determines the cost of capital. Discount rates emanate from the return expectations of the relevant capital providers.

Referencing the PCOC model above, the first step in determining the appropriate CAP is to review the credit boxes described in the most current Pepperdine survey. Next, select the appropriate median CAP from the survey results. Then, adjust the survey CAP by SCAPi to reflect the company specific risk based on a comparison between the subject company and the survey. Use the upper and lower quartile returns as a guide to this adjustment. Determine the market value of each CAP and derive the percentage of the capital structure for each CAP. Finally, add the individual percentages to derive PCOC.

Other Cost of Capital Resources

Summarized below is additional cost of capital research data by life cycle stage. While dated, the expected rate of return is in line with today’s PCOC survey.


Precise practices vary between individual investors or lenders in a given category and change with market conditions. Identifying appropriate sources and developing a fund raising strategy to tap them depends on knowing what kinds of investments investors and lenders are seeking. While the stage, amount, and return guidelines outlined here can help, doing the appropriate homework and/or engaging an advisor in advance can save months of wild-goose chases and cash, while significantly increasing the odds of successfully raising funds on acceptable terms.

1Plummer, James L., QED Report on Venture Capital Financial Analysts (Palo Alto QED Research, Inc. 1997).
2Scherlis, Daniel R. and William A. Sahlman, A Method for Valuing High-Risk, Long Term Investments: The Venture Capital Method (Boston: Harvard Business School Publishing, 1987).
3Houlhan Valuation Advisors and Venture One Study on pricing of venture capital investments in technology and life science companies in the United States, January 1993 to January 1996. Note only successful backed VC companies included in this study.
4William Bygrave, Babson College, as quoted in the Expert Report by PricewaterhouseCoopers, Cleas BioLimited Prosepctus and Investment Statement, November 14, 2002.
5Frei, Patrik and Benoit, Leieux, Evaluating the Company: Starting a Business in the Life Sciences – from Idea to Market. Quessen, H. (edt) 42-55 (Edison Cantor, Verlag, Aulendorf, Germany, 2003).
6Seiffer, John. “The Business of Software: The Venture Capital Race o’ Return.” November 21, 2005.
7Slee, Rob and Paglia, John. “Private Cost of Capital Model.” The Value Examiner. March / April 2010.; Pepperdine Private Capital Markets Project – 2014 Capital Markets Report.