Advantages and Disadvantages of Debt

‍Advantages of using debt

Utilizing debt in conjunction with equity can help a business achieve a more capital efficient path to profitability and scale.

1. Cost of capital

• Debt is typically non-dilutive against the equity of the business.
• Interest costs translate to significantly less expensive working capital compared to equity.
• Principal and interest payments often are classified as expenses and enjoy beneficial tax treatment.

2. Lower Interest Rates

Although it can be challenging to comprehend, this benefit of debt financing can actually be incredibly useful. Your overall tax rate may be impacted by tax deductions. There may frequently be a tax benefit to taking on debt. You can calculate the following if your bank is charging you 10% interest on a business loan and the government is taxing you at a 30% rate: The result of multiplying 10% by (100-30%) is 7%. You will pay a 7% interest rate rather than a 10% rate after your tax deductions. It's a financially advantageous decision that enables you to both receive the funds needed to expand your firm while also lowering your tax rate.‍

3. Flexibility of capital

• A wide variety of products such as lines of credit, warehouse facilities, and more provide a solution for every need.
• Entering into a lending agreement is typically a multi month or year (but non-permanent) commitment, unlike many equity decisions which are permanent
• Typically faster than equity financing.

Disadvantages of using debt

Utilizing excess or inefficient forms of debt can create unintended consequences for a company, reduce capital efficiency and erode profitability and scale. Debt used to accelerate an unsustainable business model could lead to the creation of existential risk for the business. 

1. Obligations

• Debt arrangements typically carry significant and complex reporting requirements.
• Interest and principal payments, and covenants can cause businesses to engage in behavior that conflicts with their core principles and strategies.  
• Debt is fundamentally an obligation to repay

• Adequate capital must be preserved or generated to cover the future obligation 
• Debt is senior to equity in a company’s capital stack and friction can emerge between parties in downside scenarios.

2. For startups, interest payments may accelerate burn rate.

A few topics to think through when raising credit capital

• Source of the Capital: lenders without permanent capital or a deep and committed source of capital could cause problems. If interacting with a fund, ask what fund the team is deploying out of and what the remaining investing period of the fund is. You don’t want a lender’s problem to become your problem. Try to get confidence that the individual PM or team who executes the transaction with your company will be around for the life of the transaction.
• Excessive Dilution: while it is common for early stage lenders to ask for warrants in your business, it is not normal for more than 1-3% to be given unless there is a specific reason. Make sure there are no hidden conversion clauses (except for Convertible notes where the purpose is for the note to convert)
• Raising Excessive Amounts of Capital: lenders use a wide variety of different structural tools to incentivize borrowers to utilize their line. (Remember: lenders who are deploying out of a fund structure will most likely be paid on deployed/utilized capital, therefore, higher usage = higher compensation). There is a balance to strike between finding a lender that can scale alongside a growing business and not agreeing to overly restrictive terms. COVID presented a reminder that businesses do not always grow in a straight line up and to the right, when there are hiccups (and there most likely will be hiccups), you want to ensure that the lending structure isn’t going to be completely inflexible. 
• Early Prepayment Penalties: often stipulations will apply if a borrower wants to return capital early. Credit investors have underwritten the deal to a certain economic return and amount of time outstanding. Try to negotiate these down if there is a likelihood of plans changing - owning the option to refinance or change plans is usually extremely valuable to startups. 
• Negative Covenants: Covenants will most likely be the most heavily negotiated topic. Be certain that you can comply with covenants and avoid highly restrictive covenants around your business raising additional debt or equity.
• Reputation: It's crucial to consider their previous and present investments when choosing which venture lender to deal with. If you can, look up case studies on their website or call references to get further insight from previous investors and see how the company handled itself while dealing with other businesses.
• Ability to Repay: Have a look at your balance sheet to see if you have any valuable asset that can be used as collateral. Also, analyze your cash flow and profit margin and try to answer the question: do you have the ability to repay the debt in the future?

Remember, raising debt is both an art and a science. A businesses tolerance for these different potential pitfalls will change as the business grows and evolves. Often, a borrower will not be able to get exactly what they want with each of these points, deciding which to push for, and which to give in on is essential.