June 28, 2018 0

Founders guide to Debt Financing

Founders guide to Debt Financing

Equity financing can be a bittersweet pill that many founders are reluctant to accept.  This is understandable considering the effort that has gone into creating an entity. And founders with a vision to take their businesses forward will certainly not be interested in a trade-off where they raise funding and give away part of their control. The silver bullet that can give founders an option of funding without having to sacrifice control is debt financing. This can be uncharted waters for founders who have not worked out the best way forward. Here is a little guide that can help you get started on a strong note.

When is the ideal time to seek Debt Financing?

Debt financing needs to be timed right. Take a loan too early and you run the risk of finding yourself in repayment mode, when you could actually do with a little more liquidity. Take a loan too late and you run the risk of not being able to use it when it was required the most. The perfect time to seek debt financing will be after the equity financing. This means that you need to be looking at debt financing just after Series A/B/C funding, which will straddle Phase #2,3,4 &5 below.

  • Concept/Research Phase
  • Product Development Phase
  • First Commercial Deals
  • Operational Phase
  • Expansion Phase
  • Getting ready for IPO

There are startups that have availed debt financing alongside equity, to have greater leeway in business expansion plans. Depending on your actual needs and plans, you need to take a call on the actual timing – post equity or with equity. This needs to be carefully assessed, because of the repayment and expenses balance that you need to factor in.

How much exposure to debt financing can a startup itself to?

Three parameters will determine the extent of debt that a startup can seek. One, the debt financing will typically be a percentage of the equity raised. Two, the debt repayments should not cross a particular threshold of total OpEx. And three, the value of debt should not exceed a certain proportion of the company’s value. The amount you seek as debt should fit into these three parameters, which will ensure that the financial health of your company is maintained.

  • Debt financing should be below 30% of equity raised
  • Repayments of debts should not exceed 1/4th of OpEx
  • Value of debt should be lesser than 1/10th of company value

Which startups will find debt financing more suitable?

It is now time to see which startups will find debt financing to be more viable. Yes, you read right. Not every startup will find the going easy with debt financing. It is more suitable for certain operations. The thumb rule that is applied here is the revenue receipts, or rather the nature of revenue inflows. Effectively this means that if your startup has a higher and more credible forecast of revenue by virtue of the nature of services or products offered, it will be more suitable for debt financing. Institutions that lend need to limit their exposure, and therefore find it easier to extend loans to startups that have a robust revenue projection, through recurring or subscription based accruals. Startups that are likely to experience fluctuating revenue inflows may not be the most attractive to lenders. If market forces are likely to have a very strong impact on revenues, the startups will not be viewed as attractive options. This will push loan costs higher, in addition to various other factors that determine the loan costs.

What needs to be taken into consideration before looking for debt financing?

This form of financing involves interest rates, a maturity date and security.  In other words you will be seeking a secured loan against assets of your startup – physical, revenue inflows and intellectual rights. If your company is established, it would be easier to fulfill the obligations of providing assets as security, or have a healthy cash flow. Alternative debt financing options are available to help startups find a way out of this traditional mindset. Here is what you need to consider before you walk down the debt financing path.

The amount you plan to seek as loan. Consider the runway effect of the loan – the manner in which it will help your startup.

The costs that you will need to bear towards repayment. Consider your operational expenses – if the loan repayment will affect other aspects of operations.

The period of repayment. Consider the phase of repayment – if the repayment phase is in conflict with other expansion phases.

The security that will be used to avail the loan. Consider the value of the security that you will be using for the secured loan – are you willing to forego the assets, if the unfortunate happens?

The criteria that a lender will look for while assessing the loan requisition. Consider if you are close to fulfilling the criteria – to keep your loan costs low and loan availability high.

Fallback options. Consider if you are willing to permit an equity stake in the company by the lender as a fallback option.

Debt financing needs to be regarded as an option for business expansion, and should not be viewed as an alternative or a stop gap arrangement. The loan needs to be availed by taking into careful consideration all of the above, and not in a manner to urgently meet some requirements, without considering the possible fallouts in the future. The whole plan needs to be put in place early on during the planning phase itself, as this will help in charting out the right path to business glory.

The high yield success of a large number of ventures that have availed debt financing, has helped to re-write the narrative with more and more financial institutions willing to extend financing to startups. Stakeholders are now regarding this as a viable option in their portfolio. Startup founders will do well to have a plan in place, that will help them to seek and avail the right levels of debt financing at the perfect time, for maximum positive impact on their business growth.

 

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