I'm Karl Ulrich.

I'm a Professor at the Wharton School and this session is on Debt Financing.

We've talked quite a bit about equity financing in which the investor provides

the capital in exchange for an ownership interest in the company.

Basically, what that means is your investor owns

part of the business with you for better or for worse.

Debt financing is a little different.

With debt financing, you the company,

take on an obligation to pay back principle and interest.

But that's your only obligation, to pay back the principle and interest.

There's no residual ownership interest in the company.

Debt is usually senior to equity.

What we mean by that is that the debt is paid back before investors get any money,

before equity shareholders get any money.

That's what we mean by senior.

Debt is senior, typically, to equity meaning it's paid back first.

To that extent, it's less risky to the investor than equity.

On the other hand, debt is usually secured by assets, and

that's called collateral, just like in a consumer loan.

It's called collateral, when you buy a car, and finance it,

the bank takes an ownership interest, the vehicle itself is the collateral.

Same thing is true of a company.

When you borrow money,

that debt is typically secured by the assets of the company.

Now, here's some examples, and they range from ordinary to somewhat unusual.

The most ordinary and common form of debt is trade debt, which is simply a supplier

who provides you goods and doesn't have you pay them back for say 30 or 60 days.

In effect, this supplier's lending you the money to buy those goods and

you're promising to pay back that debt with then 30 days or

60 days, that's called trade debt.

It's a pretty important source of debt for

companies that need to minimize their working capital requirements.

The second example is a credit card balance.

If you run a credit card balance the credit card companies lending you

money and

you're paying interest on it if you carry that balance over past the payment period.

A third example is equipment financing.

If you buy a machine tool, the lender or finance company will finance that

purchase, and take a collateral interest, take an interest in the equipment itself.

Again, of course, there's banks that will lend to a company in a general

purpose line of credit, we'll talk a little bit more about that in a minute.

There are also government loans that are provided in many jurisdictions,

the United States, many countries in Europe, in Asia, there is often in some

municipalities and states, there are government loan programs.

Lastly, there is a special kind of dept called the convertible note

that I'll spend just a few minutes talking about at the end of the session.

Now, in general, debt is a good thing if things go well.

Basically, it's less costly to the founders than equity,

if you eventually pay off the debt, then you still own 100% of the company and so

debt in that respect, is a pretty nice thing.

On the other hand, debt usually requires that you pay interest and

that you pay interest immediately from the cash flow in the business.

The problem is that most very new businesses don't even have any cash flow

and if they have cash flow, it's usually not even enough to cover their expenses,

let alone to pay interest on debt.

Maybe more significantly for the entrepreneur, in most cases, a significant

amount of debt provided to the company requires that you personally guarantee it.

Which means that if the company defaults on the debt obligation,

the creditor can come after your assets, and that of course,

is a very scary thing for most entrepreneurs.

On the other hand, if you genuinely have significant assets in the company, and

we'll talk about some examples of that, say inventory, or

receivables from suppliers, or equipment.

Then debt can be a very valuable way to finance your business because it

doesn't require that you give up an ownership interest.

In the long run, it can be less costly to you as the entrepreneur.

Let me give a few examples.

Let's say you're starting a new airline and you want to provide

a relatively small jet aircraft to business travelers.

It's going to be very hard for you to raise enough equity

to finance that business because airplanes are really expensive.

On the other hand,

airplanes are a well defined asset that have very clearly defined resale value.

It's possible for you to go to a finance company or

to the manufacturer itself and to get a loan to buy

that equipment because the creditor knows that if you default,

they can repossess that airplane and they can get quite a bit of value for it.

They know, in fact, exactly how much value they can get from it, so they know just

how much risk they're taking in loaning you the capital to acquire that equipment.

If you're involved in a business that has

well understood equipment that is generally valuable in society,

you can probably borrow money to purchase that equipment.

And that can be a very important source of financing

in a capital intensive business like an airline.

The other kind of assets that you can use to

borrow against are working capital assets.

Working capital is the cash you need to operate the business,

even if it's profitable.

Even if your business is profitable,

you need a certain amount of cash just to keep it operating.

Let me give you some examples of that.

If you sell things, you have to generally hold inventory of those things.

That inventory requires you to pay some cash to your suppliers but

you aren't getting any money from customers for that inventory.

It's just an asset that's sitting in your company and

that inventory asset requires cash, even if you're

profitable you have to come up with the cash to finance that inventory.

Similarly, when you extend credit to your customers,

that is when you send them an invoice and give them 30 days to pay the bill,

then you're providing the cash, you're basically lending to your customer.

That's another kind of working capital that's often required to support your

business, even if you're profitable.

Now the good news is that if you have those kinds of assets, working capital

assets and in particular, inventory and receivables, then many times,

banks will lend against those receivables and provide a line of credit

to you as long as you stay within certain covenants of the loan.

Typically, what will happen is the bank will stipulate that you may borrow up

to a percentage of the current amount of inventory and the current

amount of receivables that you're holding on your balance sheet as a company.

That ratio is often around 50 and 80%, often around 70%.

If you have $100,000 in inventory, you might be able to borrow

up to $70,000 from the bank and that helps to meet your working capital needs.

Typically, that still requires a personal guarantee,

that is the bank will typically still require that you, the entrepreneur,

the business owner, sign for that loan personally.

But if you're quite disciplined about not borrowing more than a fraction of

the genuine assets that you have in the company, that can be a relatively

safe bet that you as the entrepreneur can make and may be worth doing.

Let me also note that there are some very specialized financial institutions that

focus on a particular kind of lending, often lending against receivables.

Let's say, for instance, that you're selling to a well-known retailer,

you're selling, let's say, to Walmart, well-known retailer.

You've sold Walmart the product,

you've sent Walmart the invoice, then Walmart is going to pay that bill.

A very a reliable company, they going to pay that bill.

They just aren't going to pay that bill for 30 or 60 days,

depending on what terms they have negotiated with you.

There are specialized financial institutions that will

factor that receivable and that's the term of ours, factor the receivable.

Meaning they will take the receivable that bill to Walmart,

they will take possession of it and Walmart will pay them instead of you but

they will advance you the money that Walmart will eventually pay.

The problem with that is it's usually very expensive.

The interest rates for factoring receivables can be as high

as 24% per year, so very, very high interest rates.

But if you have no other alternatives, or you really don't want to sell equity on

your business, and you have some receivables from very reliable customers,

you can probably go to one of these financial institutions called a factor and

get some working capital that is secured by the receivable.

Let me just speak for a minute about government loan programs.

In the United States, the main government loan program at the federal level

is called the SBA or the Small Business Administration.

What the SPA does is works with local banks and

essentially guarantees the loans that local banks make to small businesses.

Often somebody with limited assets can get an SBA loan on quite

attractive terms from a local bank and it's secured by the federal government.

Now this is for

the U.S., but many other developed countries have very similar loan programs.

I'll talk about the U.S. example but you should check out your own jurisdiction

in order to see what loan programs are available.

SBA loans are typically guaranteed personally.

That is, you the entrepreneur do need to provide a personal guarantee.

But they can be quite popular for people who don't have significant assets.

I've seen instances where a new college graduate who doesn't have significant

assets will get an SBA loan, will signed a personal guarantee.

The downside is that the bank would come after them in the case of

default but because they don't really have any assets at risk,

they don't have much to lose in that scenario.

On the other hand, if you have significant personal assets,

a house let's say, or investment accounts,

you want to be very careful about loans that require a personal guarantee.

Because when you do that, you're effectively loaning yourself money and

it might be better just to do that, just to loan yourself money than to involve

the bank because eventually, the bank will come after you in the case of default

>> Let me just spend, lastly,

a few minutes talking about a special kind of debt, which is the convertible note.

The convertible note is a vehicle for an investor to provide capital to you,

the entrepreneur that the expectation is

that it will eventually convert into equity, but it's structured as debt.

Really, you should think of it more

like equity than as conventional debt financing.

But just for completeness,

I'm going to point out that a convertible note is a form of debt.

But it's really a form of temporary debt that will eventually convert into

equity and is probably best thought of as equity, not as debt.

It isn't typically guaranteed, personally.

It doesn't typically have interest payments, and

the expectation is that it will in the end, convert to equity.

Let me close by saying that the landscape for

debt financing is constantly changing and there are some

institutions that have had pioneered innovative forms of debt financing.

One of them in the San Francisco Bay area, really in the United States more broadly,

is called Silicon Valley Bank.

Silicon Valley Bank has made really their business

providing debt financing to new ventures.

You can check out the SVB website, look at the products that they have,

look in your own region for similar kinds of institutions.

But I point this out, just to say, that the landscape is constantly changing.

There are some interesting innovative new forms of debt that start to look a little

bit more like equity, that don't necessarily have the downside of debt,

that is, personal guarantees,

but that still may be less costly than equity financing.

Debt Financing

Entrepreneurship 4: Financing and Profitability

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