Considering Debt Capital
Chris Wand, Principal, Mobius Venture Capital
When a business is looking for cash, there are generally two ways to find it – either by securing a loan (debt) or issuing company stock in exchange for cash (equity). Deciding which avenue is best for a business depends on many factors, but for those who believe that debt may be best, the following guidelines may help with this process:
Know the difference between debt and equity. Even though both deliver you cash, issuing debt and issuing equity are not the same, and shouldn’t be treated as such. Sometimes the cost of debt is cheaper than the cost of equity, and sometimes it isn’t.
For instance, a company that takes on debt essentially is making a promise that it will repay a loan, which lowers the risk to the creditor. A business borrows the money and the bank expects the same amount back with interest. A company that issues stock is basically giving away a part of the business. The shareholders understand they own a piece of something that may some day be worthless or very, very valuable.
High-risk businesses that lack operational history may find the cost of equity cheaper than the cost of debt, but if the entrepreneurs who own those businesses believe with some certainty that their companies will indeed be successful, they may find the cost of debt to be less expensive than the cost of equity.
Thoroughly understand the issue you’re looking to resolve with a debt facility. Unlike equity, debt is best deployed and least likely to cause problems when a plan exists to use the borrowed cash for specific purposes rather than for general corporate uses. Typically, a business assumes debt to tackle one or more of the following:
- Finance capital expenditures.
- Bridge a short-term gap as a business awaits cash flow profitability.
- Smooth out cash flow problems resulting from timing issues
Be honest with yourself about your company’s finances and financial abilities. A business that decides to assume debt needs to establish answers to the following questions:
- Does the business have enough assets to make a bank comfortable with extending credit? In the absence of assets, does it have sufficient operating history to demonstrate that the cash flow can support taking on debt?
- Do you have the support of your existing investors?
- Will your prospective creditors feel comfortable that your investors will continue to back your company if it needs additional equity financing?
- Do you have adequate insight into the future of your business? Are your company’s operating and financial metrics consistent enough to give you and your prospective creditors comfort that you can meet the current and future financial and operating demands of a debt facility?
Keep in mind that taking on debt requires establishing and then maintaining a relationship. While relationships can be enriching, they also often come with constraints and requirements, and a business that takes on debt will need to determine if it’s ready. In addition, the entrepreneur needs to embrace the fact that the relationship with the creditor needs to be developed and nurtured during good times, so that it can bear the weight of true burdens should they arise.
- Can you live up to the open communications required to form a strong working relationship with your creditor? Consistent, timely, honest communications are a must in building trust and eliminating surprises.
- Can you deliver on your word? A culture of under-promising and over-delivering is always an effective way to build trust.
- Are you willing to live with the additional scrutiny and potential constraints (i.e., covenants) that come with taking on debt?
- Are you prepared to deal with the consequences of having debt in your capital structure if your company falters? In times of trouble, debt’s “senior position” means that if things don’t go well with your business, your bank could own your company or its prized assets.
Ensure that your company’s infrastructure can support the debt facility. When a business takes on debt, it needs to ensure important components are in place:
- Who in the business will be responsible for managing the relationship with your creditor?
- Does your business already have an auditor? If not, are you prepared to be audited?
- Are you able to meet the additional reporting demands of your creditor, which often include monthly unaudited financials, annual audited financials, annual projected financials, and routine in-person and telephonic updates and communications? Closing the books each month in an accurate and timely manner is also an important expectation.
Know your new credit partner well. When you investigate entering a relationship with a creditor, you need to know more about them than the color of their money. Following are some important issues that you should investigate and be comfortable with before embarking on the relationship.
- How have they behaved with other companies when the going gets tough?
- Have they shown the flexibility to restructure their terms and covenants when they no longer make sense?
- Do they have a commitment to your market segment, geography, etc.?
Taking on debt can certainly be healthy for a company and its sustainability. The keys lie in ensuring that the debt is taken on for strategic purposes and that the organization is ready to manage the important relationship that will result once established.
© 2006 Ewing Marion Kauffman Foundation. All rights reserved.