Debt financing from others

 

In addition to loans and lines of credit new businesses might get from banks, there are other potential sources of debt financing. Other sources of financing include friends and family, angel investors, the founders, leasing companies, venture debt funds and factoring/invoicing companies.

Loans/convertible debentures

Founders, family, friends and early angel investors may provide financing through loans or convertible debentures. They are secured against the business assets and, in some cases, against the founders’ personal assets. Equity investors tend to require these loans be converted to equity as a term of their investment. Alternatively, they may impose protective provisions to limit security rights and prevent repayment of these loans for a period of time or until certain business conditions are met. Equity investors do not usually permit companies to repay debt to early shareholders from the proceeds of the investment round.

Demand or short-term loans

Demand or short-term loans tend to be the first type of loan that start-up companies qualify for and private investors permit. Loans provided by alternative financing providers are similar in structure to bank loans and are also available for liquid assets, such as tax credits and accounts receivable balances. Alternative financing solution providers may also finance the production of inventory and customer payment cycle for a specific contract. Some providers will finance current year tax credits as they are earned under certain conditions, rather than waiting until year end when you’ve filed tax returns. Interest rates vary with the level of risk and are generally higher than banks. Equity investors tend to support these types of loans for early-stage companies where the funding will extend the company’s cash runway and enable them to raise additional financing.

Term loans and venture debt funds

Term loans are usually repaid over time in installments. The lender has the right to accelerate the entire loan balance if one or more specified events of default occur. These types of loans are available to companies close to or generating operating cash flow or earlier if the business has received substantial venture capital investment. Venture debt loans are usually secured by all the company’s assets, although the terms may permit your business to also have a small operating loan for specific receivable assets financed by a traditional lender. Equity investors tend to view venture loans as a reasonable alternative to complement an equity round at a later-stage of a company’s development. However, investors may become concerned when equity investments are used to repay the venture loan and its interest amount.

Leasing

Leasing effectively spreads payments for your capital equipment over a number of years as a long-term rental in exchange for interest built into the lease payments. Leasing arrangements are available through banks, dedicated leasing companies or divisions of equipment providers. Some non-traditional leasing companies will offer leases to earlier-stage companies with sufficient equity investment to ensure cash flow for a minimum amount of time—12 months during good economic times and longer during times of less accessible credit. Equity investors tend to accept lease arrangements as the security for a lease is usually limited to the equipment financed under the lease.

Factoring and invoice discounting

Factoring and invoice discounting are variants on receivable financing where the lender provides cash payment on a specific invoice for your customer receivables in exchange for a security interest in that specific invoice receivable amount. Under this arrangement, you would notify your customers to direct payment for the invoice to the factoring company. Interest rates for factoring are usually much higher than accounts receivable financing loans and are commonly used for a bridge period. The high interest rate makes these loans less attractive to equity investors except under specific circumstances (e.g., providing cash to fund a short period to the closing of the next financing round or an exit event).

References

Houston, T., Johnson, A.,& Smith, E. (2006, September 15).Technology Startups: A Practical Legal Guide for Founders, Executives and Investors. Retrieved April 9, 2009, from Fraser Milner Casgrain website at http://www.techstartupcenter.com/

Canadian Banker’s Association. Retrieved April 9, 2009, from http://www.cba.ca.
Canada Business Services for Entrepreneurs. Retrieved April 9, 2009, from http://www.canadabusiness.ca.
Royal Bank of Canada. Retrieved April 9, 2009, from http://www.rbcroyalbank.com/business/financing/small_bus_loan.html.

Tags: debt, loans