One of the most important jobs for a startup CEO is figuring out how to raise capital for the startup while navigating the ups and downs of business growth. A growing number of growing startups are looking for debt financing rather than equity financing.
Increasing risky debt avoids some of the pitfalls of equity raising and can be more effective. Equity investors who provide significant funding may demand board seats or exercise other forms of control over the company. Their view of the growth and structure of the company may not match that of the founders, leading to conflict. As a result, founders may find themselves with little decision-making control over the business they created.
This type of financing is a way to raise capital without diluting the participation of the founders and early employees. Increasing non-dilutive debt capital can empower founders and delay the need for a roundtable. Historically, startups have used this type of funding to improve their bottom line in subsequent funding rounds. In recent years, debt financing has become increasingly common in early stage funding cycles.
Borrowing has its downsides for startups. There are risks involved in taking too much leverage, especially for a startup with fluctuating financial performance. Lanham Napier is co-founder of the venture capital firm BuildGroup. He notes that while there is a lower cost to raising capital with debt, it can be a risky option for start-ups. “The benefit is incredible, but there can be a significant downside to leveraging your business,” Napier said.
Debt securities involve regular interest payments and repayment of principal. Unlike equity securities, these securities have a fixed payment term. Startups that fund themselves need to have a basic understanding of the terminology associated with debt securities.
At a simple level, debt securities have an issue date, maturity date, nominal interest rate and nominal value. Another name for the coupon rate is the interest rate and can be a fixed or a variable rate. If a variable rate applies, the price is usually the London Interbank Offered Rate (LIBOR) plus some gap. LIBOR is a benchmark interest rate that lenders use for many loans.
Borrowing companies generally pay interest semi-annually. The maturity date refers to the date of repayment of the full principal as well as the remaining interest. Securities with longer maturities often carry higher interest rates.
Debt can be secured, meaning that there is a collateral to back it up, or it can be unsecured. This comes into play in a bankruptcy scenario when the lender asks for repayment of money or other remedies against the borrowing company. Companies can also borrow through different tranches. They can divide these brackets according to the level of risk, returns or other characteristics. For example, it could be senior secured debt, senior lien, or lower senior priority debt.
Non-redeemable financing refers to debt that is not likely to be redeemed before the due date, unless the lender pays a penalty. Once certain thresholds have been reached, the debt may become payable. Some loans are completely non-repayable, which means that the issuer cannot repay them before the due date. However, most debts are repayable and the issuer can repay them once the trigger conditions are met.
Covenants are restrictions that lenders place on borrowers. They limit the ability of borrowing companies to take certain actions or mandate that they operate according to certain rules set by the lenders.
Negative covenants, also called restrictive covenants, describe the various actions that a borrower may not take. Examples of negative liabilities include limitations on the dividends a company can pay to its shareholders, restrictions on entering into transactions with affiliates, and limitations on the borrower’s ability to sell assets. There may also be specific negative financial covenants, such as the requirement to maintain a certain debt ratio.
Positive covenants describe the actions that the lender requires a business borrower to take. Examples of positive commitments include requirements to produce annual audited financial statements and ensure compliance with appropriate accounting standards.
Debt financing can be a viable option for many startups. However, they must carefully weigh the option against the potential risks. If the startup cannot repay the venture capital debt on time or creates unfavorable conditions for the startup, this can create a barrier to the startup’s ability to raise future equity.