Debt Management and Financing Obligations: Handling Financial Commitments

Managing Debt and Financial Obligations Effectively

Understanding and optimizing debt as part of capital structure. **Debt fundamentals** Definition: - Borrowing money, obligation to repay with interest - Lender (bank, credit fund) loans money at interest rate - Borrower (company) repays principal + interest Pros: - Lower cost than equity (interest ~8%, equity dilution ~20%) - Keep control (no new shareholders) - Tax deductible (interest reduces taxable income) Cons: - Fixed obligation (must pay even if unprofitable) - Covenants (restrictions on business) - Personal guarantee (founder liable) - Interest cost (8-15% typical) **Debt types** Type 1: Term loan Structure: - Borrow: Lump sum upfront - Repay: Fixed payments monthly for fixed period (3-7 years typical) - Rate: Fixed (8-12% typical) or variable Example: - Borrow: £500K - Term: 5 years - Rate: 10% - Monthly payment: £10.6K (calculated) - Total paid: £636K (interest £136K) Use case: Equipment purchase, expansion, bridge financing Type 2: Line of credit Structure: - Borrow: As needed (up to limit, e.g., £200K) - Repay: Monthly payments on what you owe - Rate: Prime + margin (usually variable, 6-12%) Example: - Limit: £200K - Borrowed: £100K in month 1 - Interest: 10% annually = £833/month - Repay: £100K over 12 months + interest Use case: Cash flow management, working capital, flexibility Type 3: Equipment financing Structure: - Lender: Finances equipment purchase - Collateral: Equipment itself (lender can repossess) - Term: Life of equipment (3-7 years) - Rate: 6-10% (secured, lower rate) Example: - Buy: Servers costing £100K - Finance: £100K over 5 years at 8% - Monthly: £2.4K payment Use case: Hardware purchase (servers, office equipment) Type 4: Revenue-based financing Structure: - Lender: Gives money in advance - Repay: % of monthly revenue until cap - Cap: Usually 1.3-1.5x borrowed amount Example: - Borrow: £500K - Revenue: £100K/month - Repay: 10% of revenue = £10K/month - Total repay: £500K (cap) - Timeline: 50 months (4+ years) - Cost: Implicit interest (£500K repaid on £500K borrowed, but 4 years, =~10-12% annual cost) Use case: Fast-growing SaaS (predictable revenue), no collateral needed **Cost of debt** Interest rate factors: - Credit score (higher = lower rate) - Collateral (secured = lower rate, unsecured = higher) - Loan size (larger = lower rate, economies of scale) - Lender type (banks lower, credit funds higher) - Maturity (shorter term = lower rate, longer = higher) Typical rates by type: | Type | Rate | Notes | |---|---|---| | Bank term loan | 6-10% | Secured, good credit | | Unsecured credit line | 10-15% | Higher risk | | Equipment financing | 6-9% | Secured by equipment | | Revenue-based financing | 10-15% | Implicit (% of revenue) | | Credit card | 15-25% | Expensive, avoid for capital | All-in cost: - Interest: 10% annual - Origination fee: 2% upfront (£10K on £500K) - Admin/documentation: £1-5K - Total: 10% + 2% + fees = ~12% year 1, 10% ongoing **Debt covenants** Definition: - Lender-imposed restrictions to protect lender's interests - Breach = forced repayment (entire loan due immediately) Common covenants: Covenant 1: Minimum cash balance - Requirement: "Maintain £500K cash minimum" - Breach: If cash falls below £500K, full loan due - Impact: Forces company to raise funds or cut spending Covenant 2: Debt-to-equity ratio - Requirement: "Debt < 2x equity (debt ≤ 40% of capital)" - Example: £500K debt, equity ≥ £250K - Breach: If company takes more debt without more equity, covenant breached Covenant 3: Revenue/EBITDA targets - Requirement: "Maintain £1M MRR" or "EBITDA ≥ £100K" - Breach: If revenue falls below target, lender can call loan - Impact: Enforces minimum performance Covenant 4: Limitation on additional debt - Requirement: "No additional debt without lender approval" - Breach: If company borrows from another lender, covenant breached - Impact: Limits flexibility to raise capital Covenant 5: Key person insurance - Requirement: "Key employee insured for £X (if dies, payout goes to lender)" - Impact: Protects lender if key person leaves Managing covenants: - Track monthly (cash balance, ratios, revenue vs target) - Plan (if approaching breach, discuss with lender) - Communicate (update lender if problems brewing) - Renegotiate (may be able to modify covenants if reasonable) **When to use debt vs equity** Equity (investors): - Raises: Capital + expertise + network - Cost: Dilution (15-20% per round typical) - Best: Early stage (need mentoring, network) Debt (lenders): - Raises: Capital - Cost: Interest (10-15% annual) - Best: Predictable revenue (can service debt) Decision framework: 1. Do you have predictable revenue? - Yes (SaaS, recurring): Debt works (can forecast payments) - No (project-based, lumpy): Equity better (flexibility) 2. Can you afford interest payments? - Yes (gross margin >70%, CAC payback clear): Debt viable - No (pre-PMF, uncertain): Equity better 3. Do you need investors for other reasons? - Yes (need board help, mentorship): Equity - No (have operator CEO, experienced team): Debt can work 4. What's the interest rate vs ROI? - Interest 8%, expected ROI 30%: Use debt (20% spread) - Interest 12%, expected ROI 15%: Maybe not (tight spread) Example decisions: Company A: £5M ARR, 70% margin, stable, experienced CEO - Decision: Can use debt (£1-2M to scale marketing) - Structure: Term loan £1M at 8%, 5 years = £20K/month - Use: Scale sales (expect 30% ROI, debt cost 8% = 22% spread, good) Company B: £500K ARR, early PMF, first-time founder - Decision: Equity better (need guidance, pivot possible) - Structure: Raise Series A from VC (equity), get mentor board **Debt monitoring and management** Monthly tracking: | Metric | Required | Actual | Status | |---|---|---|---| | Cash minimum | £500K | £520K | OK | | Debt-to-equity | <2:1 | 1.5:1 | OK | | Revenue | ≥£1M MRR | £1.05M | OK | | Monthly debt payment | £20K | £20K | Paid | Quarterly: - Review covenant status (any at risk?) - Forecast 12 months (will we stay in compliance?) - Plan (if at risk, what actions?) If approaching breach: - Communicate to lender (proactive, not surprised) - Modify covenants (may be willing to adjust) - Refinance (restructure debt on new terms) - Accelerate revenue or reduce burn (fix underlying issue) **Common debt mistakes** Mistake 1: Too much debt - Problem: Monthly payments £50K on £100K revenue (50% of revenue!) - Fix: Debt should be 10-20% of revenue (rule of thumb) - Impact: Over-leveraged (risk of breach, financial stress) Mistake 2: Not understanding covenants - Problem: Covenant breach surprises (cash dropped below £500K, lender calls loan) - Fix: Understand covenants, track actively, communicate - Impact: Prevent forced repayment (cash crisis) Mistake 3: Debt with no plan for revenue - Problem: Borrow £1M with "hope" revenue will grow - Fix: Only borrow if clear path to revenue (PMF proven, CAC payback known) - Impact: Avoid debt trap (can't service debt without revenue) Mistake 4: Ignoring personal guarantee - Problem: CEO personally liable for debt (if company fails, CEO responsible) - Impact: Personal assets at risk (home, savings) - Better: Negotiate to limit personal guarantee