Is this Debt Right for Me?
Considerations when exploring a debt arrangement
Businesses using debt to fuel growth hit historic highs in 2022. This trend continues to grow rapidly year-on-year and the extent of the take up is perhaps much greater than the levels being reported.
Debt capital raises are rarely publicised, typically not offering the same buzz and perceived status as a like-for-like equity raise. Although maybe they should?
Debt can be a valuable funding tool to help a business achieve its financial objectives. It can be complementary to equity funding to help businesses support their growth and allows business owners to avoid greater dilution of their ownership. Recent industry reports show that 1 in 4 Australian VC’s recommended venture debt to at least one of their portfolio companies last year.1Some of the benefits to debt include:
- Taking advantage of growth opportunities
- Avoiding greater equity dilution
- Extending cash runway and managing cash bottlenecks
While a debt offering may seem simple to understand, it is vital that business owners are well across all the specifics and T&Cs before entering into a debt agreement. Failure to do so can be detrimental to the business and potentially, have personal implications…
So, what are the most relevant considerations that you (a potential borrower) should nail down when exploring or negotiating a debt agreement to see if this is right for your business?
The repayment term affects your total cost and the size of your monthly payments.
A longer repayment period can lower your monthly payments but will increase the overall cost of the debt due to the accumulation of interest over time.
On the other hand, a shorter repayment period can result in higher monthly payments but a lower overall amount of interest to repay.
Based on what you intend to do with the funding, you might benefit from a shorter repayment period, leaving you paying less overall interest on the debt.
Cost of funding:
The cost of funding can fluctuate based on a fixed or floating interest rate. Fixed rates have the benefit of being locked in when you sign up to the debt, meaning that you know exactly how much you will need to pay each period.
In a rising interest rate environment, a floating interest rate debt will have increased monthly interest costs and could make it challenging to service the loan payments.
Usually, the cost of your debt is predominantly reflected in the interest component BUT it is important to be aware of other costs involved in the financial arrangement that may mean your overall cost is higher than you think:
- Legal costs associated with negotiating and reviewing the documents for the debt
- Establishment fees that need to be paid upfront
- Ongoing administration fees
- Charges for early and late repayment
- Broker fees paid to people who introduce you to the lender
How do you pay back the lender?
Depending on the financial arrangement, the monthly repayments may be fixed or fluctuate based on future revenues. If you find it helpful for your budgeting to know exactly how much will be paid to your lender, fixed payments may be of benefit to you.
Any security interest?
The lender may require collateral as security for the loan. Security can take many forms and effectively adds extra comfort to the lender that you will repay your loan, or that if you don’t manage to repay, that they can rely on the collateral that you provided to recover some / all the money they lent you.
As a business owner, you should ensure that the collateral offered is reasonable and that you understand and are comfortable with the potential consequences of default.
Restrictions on taking other capital?
In some cases, you may be prohibited from taking on other debt, regardless of whether there is a security interest or not.
It is vital that businesses owners are aware of this as it can restrict the business from having the ability to raise additional funding when needed and potentially limit the business’s growth potential.
What happens if you want the option to repay the loan before its due date?
Often, lenders will require that you pay them a minimum return for lending you the money. This is called a repayment penalty or “make whole” requirement. You are essentially required to pay a premium or “make-whole” amount to compensate the lender for their lost interest from the loan being retired early.
This amount is usually calculated based on a formula that takes into account the remaining term of the loan, interest rate, principal amount or an IRR multiple.
This provision can be a complex and a controversial issue in debt negotiations, so it is important that you fully understand the terms and implications before signing.
Any restrictive covenants?
Covenants are conditions placed on you and on the business operations that you must fulfill during the loan term.
Covenants can be restrictive or difficult to comply with, which can limit your ability to operate the business and achieve its strategic goals. Examples include:
- Limitations on business operations – i.e. restrictions on hiring, investing in new ventures etc.
- Financial ratios – requirements to maintain specific ratios or other financial metrics
- Reporting – onerous reporting requirements or regular audits that can be defocusing
- Limitations on dividend payments or salaries to key executives
- Limitations on management changes or ownership changes
You get the drift… understand these!
Are there warrants?
Warrants are financial instruments that give the lender the right to purchase a specific number of shares at a predetermined price within a specific time. Warrants are a way for lenders to increase their potential return on lending to you and give them the ability to get some ownership in your company if you do well.
For business owners seeking to retain the ownership of their business, warrants should be considered very carefully because they represent a real cost of the debt, and potentially could be worth a substantial sum to the holders.
As with everything in life, the devil is in the detail, so it’s important that you understand the debt arrangement you are entering. Would you purchase shoes without checking the size?
We hope you’ve now got a few more considerations in your toolkit when taking on a debt arrangement. At Fundabl, we believe our fast and flexible funding adds tremendous value to our clients, so if our capital is right for you, please get in touch!
The State of Australian Startup Funding 2022. rep., p. 68.