What Is Debt Raising?
Small businesses frequently need money, especially those in the early stages of development.
However, finding cash can be particularly difficult as borrowers typically face tight lending standards and reluctant venture capitalists. In an environment where fundraising is a challenge, there will always be three main capital avenues available to companies seeking funds: equity, debt, or some hybrid of the two.
While equity represents an ownership stake in a company that gives the shareholders a claim on future earnings, the other route the company can take to raise capital is by issuing debt.
What is Debt?
Generally speaking, debt is borrowed monies obtained from a lender that has to be repaid by a particular date and along with a specific rate of interest agreed at the start. This can be a fixed rate or a floating rate, typically based on a benchmark lending rate.
The initial amount of the investment loan is typically referred to as the ‘principal’, where it will need to be repaid at an agreed date in the future. The total payments or instalments to be repaid typically constitute the interest component and part of the notional principal amount, where it commonly dictates a fixed repayment schedule over a specific period, such as weekly, monthly, quarterly etc.
Whether the business makes a gain or loss, the debt will have to be paid back. In instances where the company goes bankrupt, the lenders maintain a higher claim on liquidated assets than equity shareholders.
What is Debt Raising?
Debt raising is when a company raises capital by borrowing from others to fund its operations. Debt raising, also known as debt financing or leveraged financing, can be funded via bank loans, private debt, or by the issuance of bonds or debentures.
Main types of Debt Financing
- Unsecured Business Loans
- Secured Business Loans
- Bond issuances
- Financial Institutions Loans
- Non-Bank Cash Flow Lending
- Recurring Revenue Lending
- Peer-to-Peer Lending
How does debt raising typically work?
There are usually two parties that partake in a transaction, the borrower (the debtor) and the lender (the creditor). During the exchange for capital, the lender will issue a form of a loan or a promissory note to the borrower.
Ordinarily, interest payments are made to creditors on a quarterly or monthly basis, as the principal is paid over a defined extended period. This allows businesses to have steady cash flow while the principal remains outstanding.
Typically, the principal is amortised, which means that it can be paid gradually in installments over the lifespan of the loan, or repaid in full at maturity (bullet maturity).
Debt is usually at the top of the capital structure and in cases of liquidation or bankruptcy, it is the first to be repaid. Debt raising can also entail security features tied to certain assets of the company (the debtor), which avails an even greater level of security to creditors in case of default or bankruptcy.
In the context of venture capital, the most common debt product is convertible debt (also known as convertible notes). This is a short-term loan that matures between 12 to 36 months. In practice, rather than paying interest in the form of cash, which depletes valuable resources from a maturing company, the interest accrues until maturity or conversion.
This process of converting a loan (plus accumulated interest) into equity is usually triggered during a priced equity financing round (known as Series A financing).
Furthermore, to compensate convertible noteholders for the extra risk assumed when investing at an early stage, most convertible notes constitute a conversion price below that of the subsequent financing round via a valuation cap, or a discount on the purchase price.
Valuation caps and discounts are typically mutually exclusive conversion features, hence cannot be applied simultaneously. The documents governing the loan will outline comprehensive provisions of the transaction.
Mature businesses with a larger scale of operations can also look to structure a credit instrument, like bonds or notes, to sell to investors and obtain the funds they require to grow and expand their operations.
In this scenario, where a company issues a bond either via private placements or public bond issuance, usually, banks will get involved to underwrite the primary issuance and help to sell the bonds to institutional investors and private banks, where they will charge a fee to facilitate the whole transaction.
Why do companies choose debt financing?
In contrast to equity financing where shares or ownership interests of a business are sold to raise capital, debt financing lowers the risk of leaking value-creating IP (intellectual property) to competition. Furthermore, it does not require business owners to give up ownership or control.
Measuring Debt Financing: Debt to Equity Ratio
When choosing debt raising, one key metric lenders will scrutinize is the debt-to-equity ratio. This ratio is typically considered a critical indicator of the financial health of a business, its stability and ability to raise extra capital to fund expansion, operations and growth.
In practice, debt to equity ratio demonstrates the relation between assets financed by creditors and assets financed by equity stockholders. This means that it measures the contribution of the creditors and shareholders towards the funds invested in a business, and it is used to derive an understanding of how much of the borrowed capital can be repaid in case of liquidation using the shareholder’s contribution. Investors will typically analyse the company’s debt-to-equity ratio as a financial metric to critically understand the risks involved in investing in a specific business.
For example, if a company’s total debt is $2 million and total stockholders’ equity is approximately $10 million, debt-to-equity ratio is $2 million / $10 million = 1/5 or 20%. This ultimately means that for every $1 of debt financing, there is $5 of equity.
As a rule of thumb, a low debt-to-equity ratio is more desirable than a high one, though particular industries possess a higher tolerance for debt than others.
Other metrics that lenders will look at:
- Current leverage (debt-equity ratio)
- Current fixed costs of the company.
- Interest coverage ratio
- Company credit rating, if any
- Future projected cash flows
- Earnings consistency
- Duration of funds requirement
Advantages of Debt Raising
- Debt financing does not dilute the business owner’s stake or control.
- It offers “cheaper” financing than that dilutive effect of taking on more equity financing.
- Interest rates on business loans are typically lower than the cost of equity.
- The interest paid is tax-deductible, thus giving businesses some tax shielding.
- Loan providers do not have voting rights nor have a say in the day-to-day operations of the company.
- Debt financiers have no claim of excess profits and only need to be paid an agreed fixed rate.
- Debt financing is characterised by predictable cash outflows
- Less back and forth, legalities and formalities to raise debt in contrast to raising equity.
- There is no need for annual meetings.
- Debt repaid is removed in its entirety from the capitalization table, whereas equity remains outstanding unless repurchased by the business.
Disadvantages of Debt Raising
- Businesses have to satisfactorily demonstrate their ability to repay or refinance the loan. This is a challenge as high growth companies typically need all of their capital to fund growth.
- There are payment demands imposed on available cash flow, which, when insufficient, can lead to bankruptcy of the business or the defaulting of the loan.
- Interest payments typically deny a business extra working capital
- A lender may institute covenants on a loan, preventing a business from undertaking specific activities until the loan is paid off.
- Poor loan repayment can cause share value to drop as a loan is a liability that can possibly reduce the overall net worth of a business. However, a loan that helps increase a company’s profits and revenue can help its value to rise.
In essence, debt raising enables business owners to fund their ventures in exchange for future repayment at a premium interest. The key incentive for debt raising is that the borrower will not have to give up their equity.
While debt is a smart way to finance your company, you might want to avoid being completely debt-financed since lenders may demand personal guarantees and collateral. As long as a business owner has a sound plan to service the interest and repay the principal, lenders will largely stay out of your business.
Director, FX Algorithmic Trading
For the past decade, Ashli has accumulated diverse work experiences in the banking and finance industry. Prior to joining Salzworth, she served as the COO for a Forex brokerage, and co-managed a consultancy firm advising on fund management structuring and trade signal provisioning.
With her wealth of experience, Ashli is focused in expanding Salzworth’s corporate and institutional partnerships. Ashli heads the Salzworth FX team and manages the Salzworth Global Currency Fund which aims to deliver double-digit absolute returns for investors.