The topic of debt is extensive. There is a considerable amount of information to cover and understand, including whether or not a company should hold debt on its balance sheet (see our previous blog posts here and here). At a bare minimum, there are necessary points to understand about raising debt — if entrepreneurs are not aware of them, they should be. In this blog, we will address some of the more common sources of debt financing as well as their strengths and weaknesses.
Convertible Debt: This is a hybrid security between debt and equity. The purpose is that it allows the ultimate protection for the investor, even if a company ends up going bankrupt or closing its doors before a sale. These securities vary in multiple formats, but they all contain the following key features:
– An agreed upon valuation of the company that will be the basis of converting the debt value into an equity stake.
– A discount to the valuation that the noteholder may participate in when future rounds of financing are achieved. For example, if a company is valued at $10 million during a capital raise, a noteholder with a 20% discount allows him/her to convert the debt to equity as if the company has an $8 million valuation. This is meant to reward the noteholder for his/her early participation in the company’s funding history.
– If a company ultimately goes bankrupt, the noteholder gets protection as a debt holder during the liquidation process.
– There is often an interest component to this, which is usually accrued over time and included as part of the value to be converted to debt by the noteholder.
A SAFE note (Simple Agreement for Future Equity): This is a type of convertible promissory note that streamlines the time that an entrepreneur takes to raise their initial rounds of capital. Initially, this option is great since it avoids the awkward conversation between the investor and the owner/entrepreneur. However, the lack of specificity in the SAFE can ultimately lead to problems down the line. For example, if there is a discount on the conversion feature, does it apply to ONE round of financing or ALL rounds of financing? There is also the possibility that, if there were more than one SAFEs out there, the founding entrepreneur could potentially dilute his/her equity interest and lose control of the company. It is important to keep track of the potential impact of these securities in the immediate future to ensure that there are no “surprises” down the road.
Cashflow Financing: This is the most expensive form of financing because it is contingent upon the future operating cash flow of the company. It is usually fairly short in duration (3-15 months) and generally used to fill a short-term gap without losing any equity. However, companies that use this type of financing are usually cash strapped to begin with and will likely end up more harming their business in the short-term rather than helping it. This form of financing is popular in real estate investments and construction b/c of the short-term nature of the borrowing and the need to complete projects quickly as possible in order to finalize the transaction.
The financing options described above are the most popular forms of debt securities (and we haven’t explored credit card spending which is also a type of debt financing). It is very important to consult with financial and legal advisors while going through this process in order to avoid crippling, and potentially losing control over, your company.
Takeaway: AcceleratingCFO has many years of experience helping companies recapitalize, finance, and raise capital for its clients. For a free review of your capital structure and ways to optimize cash flow for your business, please contact us at firstname.lastname@example.org.
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