LegalVision’s Startup Manual is essential reading material for any startup founder looking to launch and grow a successful startup.<\/p>\n <\/div>\n \n\nDownload Now<\/a> <\/section>\n <\/div>\n\n\n\n\n Leverage may be a valuable way to increase shareholder value. However, suppose your startup cannot access debt financing or under such terms as to make it worthwhile. In this case, it may not be suitable for you.<\/p>\n\n\n\n Let us consider the following practical points.<\/p>\n\n\n\n Banks and loan notes are the most common forms of debt financing<\/a> for startups. Both require your startup to prove that its business can afford to take on the debt. <\/p>\n\n\n\n Unfortunately, the fact is that many startups have an inherently high credit risk. This is for several reasons:<\/p>\n\n\n\n For these reasons, you may find that your startup cannot access debt financing. Alternatively, a lender may be prepared to loan to you but on uncompetitive terms. For example, you may face substantially higher interest rates. <\/p>\n\n\n\n Convertible debt is a common form of debt that startups often use as part of their financing strategy. In simple terms, it refers to debt whose terms give lenders the option to convert the outstanding debt into equity at a later point. For example, suppose your company borrows \u00a31 million through a convertible loan note programme. The noteholders may have the right to convert their note value into an equivalent of 50% of the total share capital. Consequently, this would lead to equity dilution for existing shareholders as the total number of shares in issue increases upon conversion.<\/p>\n\n\n\n This aspect of convertible debt defeats the purpose of leverage, which is to preserve the equity pool so that shareholders have a claim on a higher percentage of the earnings your startup generates. With the conversion of debt to equity, your startup’s earnings per share decrease, ultimately reducing the overall value of pre-existing equity.<\/p>\n\n\n\n\n\n Continue reading this article below the form\n <\/i>\n<\/a>\nPractical Considerations for Leverage and Startups<\/h2>\n\n\n\n
Limited Access to Debt Financing Markets <\/h3>\n\n\n\n
Inadequate proof of concept<\/strong><\/td> Lenders often seek evidence that your startup has made sales. Sales require a proof of concept. Therefore, proof of concept is necessary to raise debt financing.<\/td><\/tr> Limited cash flow<\/strong><\/td> Even if your product has entered the market and you are generating a degree of sales, lenders may feel that your sales are too low to service the debt.
Alternatively, your expenses may be considerably higher than your revenue. This will also decrease lender confidence in your ability to repay the loan.<\/td><\/tr>Insufficient collateral <\/strong><\/td> If your business has limited real assets such as property, machinery, or valuable bank accounts, a lender may not feel it can take security over sufficiently valuable assets. This may mean you cannot borrow substantial sums. <\/td><\/tr> Pre-existing financing concerns <\/strong><\/td> Any other debt or debt-like agreements will make it difficult to borrow. For instance, a shareholder or directors\u2019 line of credit may preclude your startup from borrowing. Likewise, onerous contracts that function like debt can hinder your ability to obtain a loan. <\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n The Nature of Convertible Debt<\/h3>\n\n\n\n
However, a leveraged capital structure means your startup incurs more credit risk. The primary concern is that your startup will be unable to service its debt and struggle to meet its debt obligations. In severe cases, if your startup defaults on its debt obligations, its shareholders may lose the value of their investment.<\/p>\n\n\n
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