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Gearing refers to using debt to fund your startup’s long-term capital structure. Gearing is a common tool used by businesses worldwide, including certain startups. However, startups have certain objectives and limitations that may limit your ability to use gearing. This primarily relates to the limited sources of debt financing available for many startups. Likewise, where your startup can access sources of debt financing, the terms of the debt may limit the advantages of gearing. This article will explain these practical considerations for gearing and startups.
What is Gearing?
Gearing describes the use of debt in a startup’s long-term capital structure. A business that uses gearing means that at least a portion of its total capital is not equity.
The benefit of gearing is that under certain circumstances, it can be cheaper for your startup to raise financing through debt than equity. This is because a company can deduct interest payments from its pre-tax profits, whereas dividends to shareholders incur corporation tax. As a result, provided your startup can generate sufficient operating profits, the value of shareholders’ investments may increase using gearing compared to a 100% equity-financed capital structure.
The disadvantage of gearing is that it increases the risk that your startup may not meet its debt obligations. If this happens, shareholders stand to lose the value of their investment. This is especially true if your company defaults and creditors seek to place your startup in insolvency proceedings.
Practical Considerations For Startups Using Gearing
Gearing is a form of financial engineering that can increase shareholder value under certain circumstances. However, these advantages are purely theoretical if your startup cannot meet certain conditions.
Namely, to benefit from gearing, your startup needs access to:
- sufficient levels of debt financing at competitive interest rates; and
- debt financing that does not give the debt investors the right to convert their debt to equity.
1. Access to Competitive Sources of Debt Financing
Most startups raise debt through bank loans or loan notes to specialist investors. In both cases, these debt investors must be reasonably satisfied that your startup’s credit risk is low.
However, the fact is that most startups, particularly those in their earlier stages, have inherently high credit risk. This is for several reasons:
| Reason | Explanation |
| No proof of concept. | If your startup is still developing its product and has not taken it to market, lenders are unlikely to loan you financing under a traditional debt financing arrangement. This is because you will not have any sales to service the debt. |
| Inadequate cash flow. | Even if your product has entered the market and you generate some sales, lenders may feel your sales are insufficient to service the debt. Alternatively, your expenses may be considerably higher than your revenue. |
| Lack of valuable tangible assets. | Nearly all substantial startup debt financing obligates the startup to grant security over its assets. If your startup defaults, the lender can claim your assets and sell them to recover its loan. Many startups today have few valuable tangible assets to serve as sufficient collateral for a secured loan. For instance, if your startup is developing a payment platform, the bulk of its assets may be intellectual property. Lenders will likely struggle to value this property sufficiently to justify a substantial loan. |
| Concerns about existing finance arrangements. | Lenders may not lend to you if you have any other financing arrangements in place that function like debt, for instance, borrowings issued to directors. |
For these reasons, you may find that your startup simply cannot borrow money. Alternatively, a lender may be prepared to loan to you. However, the lender may demand an uncompetitive interest rate that may saddle your startup with inefficient debt levels. Even if you can meet these interest payments, there may be very little, if any, cash left over to reinvest in your company.
2. Convertible Debt
Convertible debt is a common kind of debt startup issue. In short, it describes debt financing that allows lenders to convert the outstanding debt amount to equity. For example, your company may borrow £1m under a convertible loan note series. Noteholders may have the right to convert their note value into an equivalent of 50% of their total share capital. At this point, the existing shareholders will have their equity diluted by this amount.
This essentially defeats the purpose of gearing, which is to keep the equity pool untouched. Your startup’s earnings per share decreases because the total number of shares in issue increases upon conversion. This means the aggregate value of the pre-existing equity is worth less.
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Key Takeaways
While gearing can benefit startups in principle, your startup may face specific practical challenges that make gearing pointless. This is mainly because startups have a high amount of credit risk, which makes it hard to access debt financing. Even where your startup may obtain debt financing, the terms of the debt financing may be uncompetitive and increase your cost of capital. Alternatively, the debt may have a convertible option that allows lenders to convert the debt to shares in your startup. However, this dilutes your startup’s existing equity as a conversion will drive the price down, defeating the critical advantage of gearing.
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