Raising $$: Debt
*This article is part of an on-going multi-part series on venture financing.
Debt. It is a fact of life for businesses and households in the United States. While it may bring strong emotional feelings when brought up, it doesn’t have to be an unspeakable word. In fact, it is part of the fuel that helps businesses, large and small, mature and thrive. However, it must be carefully considered. As Spiderman’s grandfather said, “with great power comes great responsibility.”
What exactly is debt?
Debt is the promise to pay someone in the future for funds or goods received now. Hundreds of millions of transactions in the U.S. happen this way every day. Credit cards, open accounts, and services provided on credit are all forms of debt. In the business context, debt usually takes two forms when used for expansion, growth, or funding.
Straight debt is what most people would think of as a loan. You promise to pay back the money borrowed with interest over a given number of months or years. This benefits you and the business because you get the funds now, but it comes at a premium price known as interest. Interest is generally a set percentage rate that is agreed upon during the negotiations. Many interest rates are determined by the global interest rates or interest rate set by the Federal Reserve in the United States that determines how much it costs a bank to borrow from the government.
Failure to pay this debt on time can lead to serious consequences. In addition to damaging credibility with the lender, it can also lead to a foreclosure on any assets that the debt may have a security interest in. The easiest example of a security interest is when equipment or vehicles are purchased. Chances are that if you don’t pay, the car will be seized by someone authorized to take it. Serious failure to pay debts can lead to the business being brought into bankruptcy court by the creditors in order to get paid. Serious business.
However, those potential consequences can be taken care of by making sure that you accept terms that are appropriate for your business, growth plan, and business model.
Small Business Loans
A subset of traditional debt, small business loans can be a great way to procure good financing for a new business. Backed by the U.S. Small Business Administration (SBA), a small business loan is a commercial loan issued by a traditional lender, such as a bank, but the bank is guaranteed repayment even if the borrower defaults. Because the SBA has a significant interest in the repayment of the loans, applying for a small business loan requires getting approval from the SBA first before going to a commercial lender. This can be a great opportunity to get a business started, but likely will not provide a large amount of capital for scaling a business or for some ventures. Interest rates tend to be lower and many traditional lenders will be willing to work with new businesses knowing that they are going to be repaid for lending. A potential drawback is that many ventures are ineligible for SBA loan programs. Therefore, it is important to see if this financing model meets your businesses goals and industry.
Similar to straight debt is convertible debt. However, it has a very unique feature: it can evolve into equity in the company. There are a number of varieties of convertible debt all with unique pros and cons. The key advantage to this form of debt is that the interest rate during the repayment period is often lower. Generally, this form of debt is used with investors, rather than a lending institution such as a bank. Additionally, convertible debt is considered a security and requires compliance with state and federal securities laws. While this may require additional work upfront, convertible debt can provide a great way to building a relationship to investors who may be able to produce additional financing in the future if the venture has success in reaching milestones. Generally, convertible debt is used in the early stages of a venture. Investors want to see the company perform to a high level before putting funds at risk in the form of equity. Convertible debt provides them the ability to see the company grow and get protection if the end result isn’t as promising as they had hoped. In short, it is a win-win for the investor.
However, if the business is successful and reaches the point agreed upon in negotiations, the creditor can trade the debt for shares of stock or interest in the company. Therefore, convertible debt should only be considered for creditors that could be contributors and provide something worthwhile to the venture as an equity holder. This is especially important because stock dilution can occur. When shares of stock are issued to the debt holder, it means more shares are present but the value of the company has is still the same company. With one “pie” you are cutting it into more pieces and as a founder without careful planning, you could be left with crumbs.
A Line of Credit
Traditional banks and lending institutions have the ability to grant businesses or individuals the ability to borrow money on a standing basis up to a certain amount. Many businesses use these in order to cover expenses that are due now, but they are waiting on payments to come through in a few days. This might come in the form of a bank granting a business a $50,000 line of credit that may or may not be secured by inventory or other property of the business. If a vendor needs to be paid $5,000, but the company does not have the actual cash for it, then the business may use the line of credit to pay it. Lending institutions have different standards for setting the amount that they will allow a business to use before having to reapply. Like credit cards, it is imperative that they be used prudently and are paid back before interest accrues. This will help save the business money and establish a good working relationship with a lender.
How do I determine what’s best for my venture?
Businesses go through different stages and cycle. It is important to evaluate the purpose behind seeking funding. Is it to get off the ground? Scale the business already establish? Or, are you simply having cash flow issues? These inquiries require an honest and candid look at the financial health and future of the company. An experienced attorney and outside counselor can help guide you through this process and determine what financing model would align with the goal of protecting your legal and financial interests.
Debt can be successful tool in growing and starting your business. It can also cause significant problems for both founders and the venture. Make sure debt is the right tool at the right time and contact the SAVaGE lawyers at Chester PLLC.
The SAVaGe Entrepreneur Knowledge Base (“SE-KB”) is part of a series of articles written and published by CHESTER PLLC, a Dallas-based law firm that advises innovation-based entrepreneurs, and emerging companies regarding their core legal issues (www.chester-law.com). Information provided is for informational and entertainment purposes only, and is not legal advice.