Debt Financing for Startups: An Overview of the Terminology
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One of the most important tasks for a startup CEO is to figure out how to raise capital for the startup while navigating the ups and downs of the business’s growth. An increasing number of healthy growing startups are pursuing debt financing instead of equity.
Raising venture debt avoids some of the pitfalls of raising equity financing and can be more efficient. Equity investors who provide large amounts of financing can demand board seats or exert other forms of control over the company. Their vision of how to grow and structure the business may not align with that of the founders, leading to conflicts. As a consequence, the founders can find themselves with little decision-making control over the company they started.
This type of financing is a way to raise capital without diluting the ownership stake of the founders and early employees. Raising non-dilutive debt capital can empower founders and delay the need for equity rounds. Historically, startups used this type of financing to boost their balance sheets during later-stage funding rounds. In recent years, debt financing has become increasingly common in earlier-stage financing rounds.
Borrowing has its drawbacks for startups. There are risks to taking on too much leverage, particularly for a startup with fluctuating financial performance. Lanham Napier is a co-founder of the venture capital firm BuildGroup. He notes that although there is a lower cost of raising capital with debt, it can be a risky option for early-stage startups. “The upside is amazing, but there can be a significant downside to leveraging your company,” Napier stated.
Debt securities involve regular interest payments and repayment of principal. Unlike equity securities, these securities involve a fixed term for payments. Startups that take on financing should have a basic understanding of the terminology associated with debt securities.
At a simple level, debt securities come with an issue date, maturity date, coupon rate, and face value. Another name for the coupon rate is the interest rate and may be a fixed or floating rate. If a floating rate applies, the price is typically the London Interbank Offered Rate (LIBOR) plus a certain spread. LIBOR is a benchmark interest rate that lenders use for many loans.
Corporate borrowers usually pay interest semiannually. The maturity date refers to the repayment date of the the entire principal amount as well as the remaining interest. Securities with a longer timeframe until maturity often carry with higher interest rates.
Debt can be secured, meaning there is collateral to back it up, or it can be unsecured. This comes into play in a bankruptcy scenario where the lender seeks repayment of the money or other remedies against the corporate borrower. Companies can also engage in borrowing via different tranches. They can divvy up these tranches by risk level, yields, or other characteristics. For example, there could be senior secured, first lien , or junior priority debt.
Noncallable financing refers to debt that is not subject to call before the maturity date unless the lender pays a a penalty. Upon meeting certain threshholds, the debt may become callable. Some borrowings are completely noncallable, meaning the issuer cannot redeem it until the maturity date. However, most debt is callable and the issuer can redeem it once the trigger conditions are satisfied.
Debt covenants are restrictions lenders place upon borrowers. They limit the ability of corporate borrowers to undertake certain actions or mandate that they operate under certain rules set by the lenders.
Negative debt covenants, also known as restrictive covenants, outline the various actions that are the borrower may not take. Examples of negative covenants include limitations on the dividends a company can pay its shareholders, restrictions on entering transactions with affiliates, and limitations on the borrower’s ability to sell assets. There may also be specific negative financial covenants like a requirement to maintain a certain debt-to-equity ratio.
Positive debt covenants outline the actions the lender requires a corporate borrower to undertake. Examples of positive covenants include requirements to produce yearly audited financial statements and to ensure adherence to proper accounting standards.
Debt funding can be a viable option for many startups. However, they must carefully evaluate the option against potential risks. If the startup cannot repay the venture debt on time or creates unfavorable terms to the startup, it can create an obstacle to the startup’s ability to raise future equity.