By William H. Payne

Debt financing is generally considered to be an inexpensive source of capital for business, especially when compared to equity, which involves giving up part of the ownership of the company.

Unfortunately, very little debt financing is available to early-stage entrepreneurs, because lenders expect loans to be paid back in a predefined and timely manner with interest. Furthermore, lenders expect borrowers to demonstrate their credit-worthiness by providing collateral, which in essence guarantees repayment. When buying a car or house, the asset itself is the collateral. Due to their inherent high risk and lack of liquidity, early-stage companies are not considered sufficient collateral for debt financing.

Loans from friends and family are often used as preseed capital for startup ventures. This debt is attractive because it often is available without interest and entrepreneur is not required to repay loans on any pre-arranged schedule. While particularly useful in the initial stages of a company, this source of funding is usually only available in small quantities, that is, less than $25,000.

HIGH GROWTH, BIG BORROWING.  Credit-card debt is available to many entrepreneurs and is collateralized by the earning capability of the borrower. This debt has the advantage of minimum repayment schedules that can be spread over months and years. This form of debt, however, is generally very expensive and is also normally available only in total volume of less than $25,000 for each individual.

Many high-growth companies require more than $100,000 of capital to achieve the positive cash flow necessary to grow on internally generated funds. For these entrepreneurs, the primary sources of capital are equity investments, which requires giving up partial ownership of the venture in exchange for the funds necessary to grow the company.

The most common sources of equity capital are angel investors and venture capitalists. (I myself am an "angel," having invested in some 25 early-stage companies, after selling my own company, Solid State Dielectrics to E. I. DuPont Nemours in 1982).

However, we often hear about two other forms of debt financing for entrepreneurs, namely, convertible debt provided by early-stage equity investors, and bank loans to venture-backed companies. What follows is an examination of each of these sources of capital.

Convertible Debt from Equity
It is common for equity investors to structure early-stage investments as convertible debt. Since the conversion from debt to equity is almost always at the option of the lender, most entrepreneurs consider this a form of equity investment and therefore an expensive source of capital.

Convertible debt has all the rights of debt financing, requires reasonable interest payments (often deferred), and can be converted to common or preferred stock, depending on the structure of the deal, at the pleasure of investors, usually upon triggers signaled by the success of the company. The value of the company at conversion is predetermined and is often based on a modest discount to the pricing of a future round of investment. Conversion is often triggered when the company closes a substantially larger round of equity investment, usually from venture capitalists.

Investors insist upon, or agree to, convertible debt financing for a number of reasons. Debt is a lower risk investment than equity, that is, in the case of the liquidation of the company, lenders are ahead of shareholders for repayment. All debt generally must be repaid prior to any liquidation to shareholders.

Convertible debt instruments allow lender/investors to enjoy a modest return on investment as interest (often deferred) with all the upside opportunity of shareholder after conversion. Structuring a convertible debt financing is relatively easy -- hence, legal fees for completing this form of investment are substantially lower than conventional equity investments. Much of the legal expense is deferred until the time of conversion, which is usually at the time of the closing of a subsequent round of equity investment.

Bridge loans are often structured as convertible debt. Bridge loans are debt usually funded by earlier investors to provide the entrepreneur with sufficient cash to "bridge" the time gap between running out of earlier raised capital and the closing of a round of new funding for the company. Since new investors prefer that all new funds be used to grow the company (and not to repay debt), bridge loans are often converted into debt at the closing of the next subsequent round of equity financing.

Compromise and Convenience
In general, convertible debt is often a compromise between entrepreneurs and investors, when they can't agree upon a valuation for the company at the time the loan is closed. In this case, the investor believes the company is worth less than does the entrepreneur. They agree to a convertible loan, which is priced at the closing of the next subsequent round of equity investment and a discount, usually 10 percent to 30 percent of the valuation of that next round of investment.

Some angel investors prefer this form of investment, as they fear investing at too high a valuation, only to see a subsequent institutional investor price their deal at a lower valuation, resulting in very unfavorable dilution to the earlier stage investor. These can also be considered bridge loans to the next round of investment.

Convertible notes are also a convenience to investors, since they generally remove the risk of equity investments at valuations that prove to be too high. However, in many cases, pricing the conversion at a small discount to the next round can be unfair to the early-stage investor, when closing the next round takes much longer than anticipated, or when the valuation of the company is growing rapidly. One could conclude then that convertible debt limits both the downside risk and upside potential for these investors.

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