Entrepreneural Issues

Chapter 8
The Cost of Capital

Small firms have a difficult time attracting capital to support their investment programs. Owners of small firms are reluctant to sell common shares because they do not want to lose voting control in the company. When shares are sold, many small firms create two classes of shares, such as Class A and Class B. The Class A shares are traded most extensively in the capital markets. Class A shares usually receive a higher dividend than Class B. In contrast, Class B shares, often held by the firm’s founders, have greater voting power than Class A shares. In this way, capital can be raised without losing voting control.

Many firms are so small that it is nearly impossible to raise funds by selling common shares. If shares can be sold, investors will often pay much less for these shares than they would for similar firms that are larger and have their shares traded regularly on an organized exchange or over the counter. Issuance costs for common share sales of small firms may exceed 20 percent of the issue size. As a consequence, the cost of equity capital tends to be significantly higher for small firms than it is for larger firms. Because of the limited access to the capital markets for new equity, small firms tend to retain a much larger portion of their earnings to fund future growth than larger firms.

Similarly, the sources of debt capital to small firms are also limited. Bonds and debentures cannot be sold publicly until a firm has grown to a relatively large size. Before reaching a size that will permit it to sell securities publicly, the small firm will have to rely on the following sources for debt funds:

• The owners’ own funds and loans from friends
• Loans from chartered banks and/or other financial institutions
• Small-business loans
• Leasing companies
• Venture capital firms that normally demand some equity interest in the firm through conversion features or warrants (discussed in Chapter 17)
• Private placements of debt issues with insurance companies and large corporations, often with a conversion feature or warrants

Generally, the cost of both debt and equity capital is significantly higher for small firms than for larger firms. The high cost of capital puts small firms at a competitive disadvantage relative to large firms in raising funds needed for expansion.

Conceptually, computing the cost of capital for a small, closely held firm is no different than for a large, publicly traded firm. The same models of valuation apply to small firms as to large firms. In practice, however, there are often serious difficulties in developing confident estimates of the cost of capital for small firms. Computing the cost of straight debt and preferred shares (nonconvertible and without attached warrants) is relatively easy. However, when debt and preferred shares are convertible or have attached warrants, an analyst must make an estimate about the time and conditions under which these securities will be converted into common shares or when the warrants to purchase common shares will be exercised.

In the case of common shares, there is often no ready market for them. Hence, it may not be possible to make confident estimates of the share price when computing the cost of equity. Also, because many small firms pay little or no dividends, applying the dividend valuation model is more difficult. As a consequence, when computing the cost of equity for small firms, analysts must often first compute the cost of equity for a group of larger, publicly traded firms in the same line of business that have similar financial risk (as measured by the capital structure). Then the analysts must add an additional risk premium reflective of the perceived increased risk due to reduced marketability (liquidity) of the small firm’s shares and any differential in business and financial risk.

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