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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.
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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.
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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.
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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.
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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.
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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.