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If you are a startup founder seeking to raise money, you may have come across the principle of the time value of money (TVM). This is particularly relevant for investors looking to invest in your business. In effect, TVM says that money right now is worth more than it is in the future. TVM has important implications for how much investors will provide your startup right now. This article will further explain the principle of the time value of money and its relevance to startup financing.
What is the Time Value of Money?
The time value of money (TVM) refers to a general financial rule that the money you hold now is worth more in the present than in the future.
This may seem counterintuitive, but consider this thought experiment: Would you agree to loan another of your startup’s cash for free? Unless you are being generous, the answer is no. This is because we all expect our money to “work” for us. The money you lend to another business could be used instead to invest in another project. Therefore, you would charge your borrower an additional amount on top of the loan amount to compensate for the “opportunity cost” of lending cash to this particular business.
This “additional amount” will also factor in the inflation rate and the risk that the borrower will not pay you back. It may take the form of interest charged on top of the loan. Alternatively, you may require the borrower to repay you a larger sum than what they borrowed at the end of the loan period.
An alternative arrangement is where your business receives shares in the borrower’s business. These shares entitle your startup to dividends whenever your borrower declares a profit. This is the premise behind an investor participating in equity financing.
Time Value of Money and Return on Investment
The three factors that determine how an investor puts a price on the time value of their money are:
- opportunity cost — i.e. how much would the investor’s money grow if they invested it in another similar venture?
- risk — how likely does the investor perceive the chance that its investment in your startup will not grow as expected?
- inflation — inflation describes the effect that time has on the price of goods, which is that £1 buys more now than it does in the future. Higher inflation rates lead to higher interest rates to control inflation, which increases the cost of borrowing. Investors seek higher returns on their investments in high inflation markets because the real returns have to outstrip the pace of inflation.
All three of these factors determine how an investor sets their expectations for a return on their investment.
Similarly, investors invest in businesses that have promising growth potential. This reflects the fact that successful startups can generate returns on investment considerably higher than other investment opportunities. For instance, successful startup equity investments can produce returns over a few years of at least 30%. This massively outstrips the returns investors can get from government bonds.
Finally, we are currently in a high-inflation/high-interest market. Accordingly, investors can obtain more competitive returns investing in debt than in low-interest markets. This may mean that investors prefer investing in debt rather than equity.
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Return on Investment and Investment Structure
Investors view debt as less risky than equity because a startup must repay its creditors before shareholders can participate in the business’ profits. Therefore, investors such as banks and loan noteholders usually require less return on their investment than equity investors looking for shares. In other words, equity investors expect a higher return on their investment because it is riskier.
Discount Cash Flow Valuations and Return on Investment
Investors analyse a business’ current and expected performance to determine how much to invest in the startup. Specifically, investors use cash flow models to determine the future value of the cash the business generates throughout the investment period. The sum of these cash flows is then “discounted” by the minimum expected rate of return. This is typically how investors arrive at a valuation for your business.
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Key Takeaways
The time value of money (TVM) is a financial principle that states money is worth more in the present than in the future. This principle is important when raising money for a startup because it determines how investors will value your business and their investment. TVM accounts for factors such as opportunity cost, risk, and inflation to determine their expected return on investment.
Since investors view startups as a high-risk investment, they expect higher returns to offset the risk. Discounted cash flow valuations are commonly used to determine investment amounts and quantify the investors’ expected returns on investment.
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Frequently Asked Questions
The time value of money is crucial in startup financing. It highlights how money in hand today is more valuable than the same amount in the future. Understanding this principle helps startup founders and investors determine appropriate investment amounts, interest rates, or equity stakes. It enables investors to assess the potential returns they expect to earn from their investments and account for factors like opportunity cost, risk, and inflation. Startups, being high-risk ventures, need to offer higher returns to attract investors who consider the time value of money in their decision-making.
The time value of money plays a significant role in shaping the investment structure in startups. Debt investments, such as loans or bonds, are perceived as less risky compared to equity investments. Creditors, including banks and loan noteholders, generally require lower returns on their investments because they have priority of repayment. On the other hand, equity investors take on more risk and, therefore, expect higher returns. The time value of money affects the valuation of startups through discounted cash flow models, which consider future cash flows and the minimum expected rate of return. This valuation process helps determine a startup’s investment structure and the balance between debt and equity financing.
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