When your startup is ready to grow, you need the right financial tools to help you achieve your business goals. After initial investments are made in your company (including by family and friends), there are broadly two ways to raise capital – equity financing where you sell shares in your company or debt financing where you borrow money. If you want to maintain control and avoid diluting ownership in your own company, debt financing is the better option. This simply means borrowing money from lenders – which can be traditional banks, online lending platforms or specialist early-stage debt providers.
Knowing your options
In order to make an informed choice for your company, it is important to first be aware of some of the key debt financing options available:
Overdrafts
With an overdraft, you can borrow funds up to a pre-defined limit. You will usually pay an arrangement fee and interest on the overdrawn amount. The overdraft will likely be secured by cash and other assets that you already hold with the lender. The key advantage of an overdraft is flexibility for accessing additional funds. The risk with overdrafts is that the lender has the right recall the funds for any reason – at which time you will need to repay the bank on short notice. As such, overdrafts are suitable for managing daily cash flow but may not be the best option if you are looking to borrow large sums.
Committed loans
Committed loans are a much more stable option. With a committed loan, the company pays a commitment fee to the lender to borrow an agreed sum of money, to be repaid on a fixed date. Knowing that the loan cannot be recalled unexpectedly gives you the certainty you need for long-term business planning and strategic development.
This security does, however, come at a cost. The process of obtaining a committed loan tends to be much more complex than with overdrafts but your company will have more of an opportunity to negotiate the terms of the loan arrangement with the lender. Lenders offset the risk of making cash available for a set period by imposing more controls (information, compliance) on the borrowing company.
Of course, fees and the length of legal paperwork also increase with perceived risk. To assess and guard against this risk, it is common for lenders to require your company to go through a comprehensive vetting process and/or to provide security. This can be sums standing to the credit of bank accounts, security over IP, real estate or shares in your company.
Convertible loans
A convertible loan has characteristics of both debt and equity financing. It starts off as a loan and a liability on your balance sheet but will be converted into shares in your company when certain conditions are met, such as a significant new round of funding. This delays the dilution of ownership in your company until further down the line, when it is more established and can achieve a more favourable valuation. Any interest can also be wrapped up to be paid in equity on conversion rather than in cash. This type of instrument requires a lender that is able to take an equity position, which points towards early growth funds.
Which form of debt is best for your business?
Each of these debt financing options offer unique advantages – which one is best for you ultimately comes down to your business’s needs, goals and financial health on the one hand and the immediate cost and availability of the debt product on the other. To be able to choose wisely, it is also crucial that you have a solid understanding of your business’s financial health, including cash flow forecasts and reserves, so that you can accurately assess the business’s capacity to meet any repayment obligations that may fall due.
Negotiating terms that work for you
Before entering any debt financing arrangement, you should always consider whether you can negotiate the terms of the finance documentation so that the outcome is best adapted to your business. Some financial products may be standardised in form but easier to put in place quickly, while others can be negotiated and tailored to your company, which will mean they take more time to put in place.
Whether you are dealing with a traditional bank or an alternative lender, building a positive relationship with your lender can lead to more favourable terms or personalised financing solutions that support your business’s growth and success. Engaging a professional, like a lawyer specialising in debt financing, can also ensure that you put yourself in the best position possible in line with your long-term business strategies.
Article written by Victoria Judd, Counsel, and Max Griffin, Associate, Pillsbury Winthrop Shaw Pittman
