Raising Debt The Right Way — 5 Guidelines
This is a follow up to previous articles dealing with cap table and raising non VC capital.
My experience of debt as both a cofounder and a VC is startups pay considerably less attention to debt than they should. So here are some guidelines to help illuminate your journey and avoid common mistakes (mine very much included!).
1) Why Not To Raise Debt
There are plenty of reasons to not raise a debt, the obvious one is that you have a loan hanging over your head that you are paying an interest on. The less obvious one is that having debt can give you a false sense of security and not force you to run the startup as lean as you would have otherwise. In general I believe startups should raise more debt at later stages when their cash flow is more stable and when equity becomes even more precious. Most startups raise 20%-30% of the round as debt so if you are raising more beware of over-leverage. A good lawyer / lender will also help draft terms in such a way that the outstanding loan gets converted into equity or refinanced in the case you are unable to pay the principal, say if you fail to raise the next round in a timely fashion. This may be the least harmful solution but it will still hurt and is definitely an overall situation to avoid.
2) Why To Raise Debt?
There are many reasons to raise debt — you don’t want to dilute your equity, you expect to have enough cashflow to cover the interest, you want to have an option to draw extra reserves in the future, you are contemplating an acquisition, you want to market a round as a larger number which could help in partnerships or hiring. Make sure you are clear in your own mind what is your particular motivation. A very common strategy that entrepreneurs use is to raise debt and leave it aside as contingency, operating the business solely on the equity.
3) Shopping Around
Diligence and terms for top VCs can take 1–3 months but for lenders the process is usually much faster and shopping around for best terms is expected. Most entrepreneurs will reach out for debt when they have a lead term sheet ie there is enough substance in the round to make a credible case to the lender. If you are unsure of which lender to work with then ask your VCs for recommendations — getting them on board is a requirement anyways for raising the debt and chances are the VCs will have a much better pulse on the debt market. Most lenders are essentially sources of capital but some go beyond in helping you with introductions for hiring and partnerships, so it’s a good idea to validate their reputation.
Debt covenants are agreements between a company and a creditor usually stating limits or thresholds for certain financial ratios that the company may not breach. Maybe goes without saying but be sure to understand what those covenants are before signing the debt, you definitely don’t want to have unexpected surprised when you actually need the money. Another question to ask is how and who will assess your creditworthiness. Chances are you are getting debt from a large institution like a bank, where they are multiple groups, and the folks extending the debt to you might be different from those assessing your company later.
Warrants are actually a form of equity but they are often issued alongside debt which is why I am listing it here. A warrant, much like an option, is simply a contractual right of the holder to buy a certain security during a certain period of time and for a certain price. Warrants are typically attached to a startup’s security such as preferred stock or convertible note, rather than being standalone, and do not carry voting rights. If you are issuing warrants alongside your debt you are essentially making it more attractive for the lender ie you can use it to negotiate better terms. You can also attach special / unusual provisions to warrants such as guaranteeing the holder a certain percentage of the company. My caveat is keeping financings as simple as possible minimizes unintentional loopholes, you are dealing with enough uncertainty running a startup as is.
Got any other handy guidelines for raising debt? Comment away. As always appreciate any likes!