Table of Contents
As a startup founder, you may appreciate that using debt to fund your startup’s long-term financing needs is an important consideration. Using debt in this way is known as leverage, sometimes called gearing. While leverage can increase shareholder value, not all startups can leverage their capital structure. This is because they may be unable to access debt financing or obtain it on competitive terms. Alternatively, the terms of the debt financing may entitle lenders to convert the debt to shares in your startup. This can erode any benefits you obtain from the initial leveraging of your capital structure. This article will explain these practical considerations for leverage and your startup.
What is Leverage?
In the context of startup capital raising, leverage describes using debt to fund a portion of your startup’s long-term capital structure. Businesses use leverage because it can boost shareholder returns. This is because interest payments on debt financing are tax deductible.
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.
LegalVision’s Startup Manual is essential reading material for any startup founder looking to launch and grow a successful startup.
Practical Considerations for Leverage and Startups
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.
Let us consider the following practical points.
Limited Access to Debt Financing Markets
Banks and loan notes are the most common forms of debt financing for startups. Both require your startup to prove that its business can afford to take on the debt.
Unfortunately, the fact is that many startups have an inherently high credit risk. This is for several reasons:
| Inadequate proof of concept | 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. |
| Limited cash flow | 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. |
| Insufficient collateral | 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. |
| Pre-existing financing concerns | Any other debt or debt-like agreements will make it difficult to borrow. For instance, a shareholder or directors’ line of credit may preclude your startup from borrowing. Likewise, onerous contracts that function like debt can hinder your ability to obtain a loan. |
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.
The Nature of Convertible Debt
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 £1 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.
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.
Continue reading this article below the formCall 0808 196 8584 for urgent assistance.
Otherwise, complete this form and we will contact you within one business day.
Key Takeaways
In theory, leverage can increase shareholder value in theory. However, many startups face challenges accessing debt financing or obtaining favourable terms. Likewise, many startups struggle to access debt financing due to their inherently high credit risk. Lenders often require evidence of sales and proof of concept, sufficient cash flow, and valuable collateral, making it difficult for startups to borrow substantial sums or secure competitive terms that cannot evidence this. Separately, convertible debt, a common form of financing, allows lenders to convert debt to equity, eventually diluting equity for existing shareholders. These factors may limit the benefits of leveraging and impact a startup’s ability to preserve its equity pool.
If you need help with your startup, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.
We appreciate your feedback – your submission has been successfully received.
