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Debt vs. Equity: Which Way Should Startups Go

July 30, 2019

Is debt or equity fundraising smarter for startups?

There is more than one way to fund a new business venture and fuel its growth. For almost all, it is going to require bringing in outside money at some point. Even if that is only to multiply what is working or to create a source of emergency capital. The two primary options are to either leverage business debt financing or fundraise for equity investors.

Each method can carry its own pros and cons. It is vital for entrepreneurs not to blindly follow the herd just “because everyone else is doing it.” Discover which is best for you, at your stage in business, and stack the most advantages in your corner.

Once you have decided the course of action and have a lead investor covering at least 20% of your financing round you would typically also include in the pitch deck the form of financing in which you are raising the capital.

Debt Financing

We’re all familiar with debt. At some point, we’ve all probably at least had a student loan, signed up for a mobile phone contract, had a credit card, or an auto loan or lease. Debt means you are borrowing. Often, you will have to repay in monthly installments, over a fixed period of time, at a predetermined rate. Though this can vary depending on whether you are raising debt from investors, are using lines of credit or working capital loans, or even new hybrid convertible notes.

While non-recourse corporate financing is always preferred, some new entrepreneurs may also have to decide whether they will use their personal credit to get off the ground.

The Pros of Debt Financing

The biggest and most obvious advantage of using debt versus equity is control and ownership. With traditional types of debt financing, you are not giving up any controlling interests in your business. It’s all yours. You get to make all the decisions and keep all the profits. No one is going to kick you out of your own company.

Another big pro is that once you’ve paid back the debt your liability is over. With a fluid line of credit, you can repay and borrow just what you need at any time, and will never pay more interest than you need to. Looking at the big picture, using debt can ultimately be far cheaper.

One major benefit that is frequently overlooked is that business debt can also create more tax deductions. This may not have a big impact at the seed stage but can make a huge difference in net profits as you grow and yield positive revenues.

The Cons of Debt Financing

The most significant danger and disadvantage of using debt are that it requires repayment, no matter how well you are doing, or not. You might be burning cash for the first couple of years, with little in the way of net profits, yet still have to make monthly debt service payments. That can be a huge burden on a startup.

If entrepreneurs have not separated their personal and business credit, they may also find their entire life’s work and accomplishments are on the line if they default on the debt. Your home, cars, washing machine, and kids’ college fund can all become collateral damage.

It is also vital that borrowers understand that financing terms can change over time. Variable interest rates can dramatically change repayment terms later on. In the case of maturing balloon debt, as commercial mortgages, there is no guarantee of future availability of capital or terms when you may need to refinance. In the case of revolving credit lines, banks have a history of cutting them off, right when you need them most.

Too much debt can negatively impact profitability and valuation. Meaning, it can lead to inferior equity raising terms in the future or prevent it altogether.

Structures used by early-stage startups such are convertible notes, SAFEs, and KISS. These forms of debt eventually convert into equity on a subsequent financing round so it is a good way to bring on board people that are likely to partner with you in the long run with the business.

For later-stage companies, the route to follow is typically venturing debt.

Convertible Notes

Convertible notes are a debt instrument that also gives the investor stock options. This flexibility gives them security from the downside, and more potential upside if the start-up performs as expected. Theoretically, it can also be easier for some to justify making the loan, which has specific returns and maturity dates, versus the unknown.

Convertible notes are much faster than equity rounds. There are only two documents in place, which are the convertible note purchase agreement outlining the terms of the investment, and the promissory note explaining the conversion and the amount that the investor is investing.

With convertible notes, there are only three main ingredients the entrepreneur needs to look after.

The first ingredient is the interest that the entrepreneur is giving to the investor. This is interest to be accrued on a yearly basis on the investment amount that the investor puts into the company. The interest will continue to be applied until the company does another equity round when the debt will convert into equity with the amount plus the interest received.

The second ingredient is the discount on the valuation. This means that if your next qualifying round is at X amount of pre-money valuation, the investor will be converting his or her debt at a discount from the valuation that has been established in the next round by the lead investor.

The third ingredient to watch is the valuation cap. This means that regardless of the amount that is established on the valuation in the next round, the investor will never convert north of whatever valuation cap is agreed. This is a safety measure in the event that the valuation goes through the roof. It is a good way to protect your early investors and to reward them for taking the risk of investing in you at a very early stage.

Convertible notes are, in my mind, the fastest and cheapest way to fundraise. While equity rounds can be north of $20,000, convertible notes should not cost you more than $7,000.

One thing to keep a very close eye on is the maturity date. This is the date by which you agree to repay unless you have not done a qualifying round of financing in which the convertible notes are converted into equity. For this reason, make sure that the maturity date is a date that you feel confident about. You need to be convinced that you will be able to raise a qualified round of financing on or before that date in order to convert the notes into equity and avoid being in default. The last thing you want to happen is to be in default and to have to shut down your business because investors are demanding their money back.

Below is a good example of how convertible notes play out in real life.

SAFE

A newer instrument created by Y Combinator which has been adopted by many early-stage companies. The Simple Agreement for Future Equity (SAFE) aims to increase simplicity while preserving flexibility.

Y Combinator argues that these notes do not accrue interest, or have maturity dates, which makes them friendlier to entrepreneurs. That relieves a degree of extra burden which can be counterproductive to both parties.

A SAFE automatically converts to preferred stock at the next equity round of funding, or when there is an IPO.

Venture Debt

Venture debt is effectively borrowing to raise working capital and growth capital. This is a valuable source of funding that doesn’t mean giving up more ownership or diluting equity.

Venture debt financing differs from other sources of money in that it is normally provided by specialist entities and banks, such as Silicon Valley Bank, that offer their services to funded start-ups and growing businesses. They understand the dynamics of a start-up, and will often lend even though asset collateral may be weak.

These lenders offset risk by tying loans to accounts receivable, equipment, or rights to purchase equity in a default. A healthy start-up can find venture debt attractive in order to create more time between equity funding rounds so that more notable milestones can be achieved. These funds can also help speed through milestones to reach the IPO

Equity Financing

This type of funding exchanges incoming capital for ownership rights in your business. This may be in the form of close partnerships, or equity fundraising from angel investors, crowdfunding platforms, venture capital firms, and eventually the public in the form of an IPO.

There are no fixed repayments to be made. Instead, your equity investors receive a percentage of the profits, according to their stock. Though there can be hybrid agreements which incorporate royalties, and other benefits to early investors.

Typically the term sheet will be summarizing what are the terms of the equity round.

The Pros of Equity Financing

Equity fundraising has the potential to bring in far more cash than debt alone. It not only means the ability to fund launch and survive but to scale to full potential. Without equity fundraising growth can be far slower, if not seriously capped. These are some of the biggest concerns around the recent talk of Elon Musk trying to take Tesla private again.

Flexibility in distributions is the biggest draw to using equity. If you aren’t making a profit, then you don’t have any debt service. You don’t have that constant drain and stress. This can empower entrepreneurs to make far wiser decisions, than being forced to make rash ones which can cripple their startups, just to make a loan payment.

Far more important than the money is that bringing in equity partners means bringing in others with a vested interest in seeing you succeed. If they have influence, connections, and experience, that can make all the difference in becoming the next unicorn success story, versus languishing as a small business for decades.

Good equity partners can also make it much easier to secure more attractive debt later on.

The Cons of Equity Financing

The primary fear of giving up equity is loss of control. Partners can mean giving up decision making control. That can affect every micro-factor in your business. It can even lead to you being replaced by your partners if you don’t retain enough board seats and voting power.

A reduced ownership percentage can also not only mean that you have to split the profits but in some cases, some investors may be entitled to any positive returns before you can get a penny.

One of the lessors appreciated cons of equity fundraising is the time and effort it takes to soak up. Loan applications and underwriting may not be fun or fast. Though without the right connections and a powerful pitch deck, equity fundraising can be even more arduous and time-consuming. Don’t let it become a detour and distraction from getting right to the important business.

Conclusion

There are advantages and disadvantages of both debt and equity fundraising. Know the pros and cons before you start searching for the money. Understand which may be the most beneficial for your current stage of business and how it could help or hurt for future fundraising needs.

Furthermore, make sure that you have the right legal counsel representing you. Make sure they are corporate lawyers that have closed several transactions before you even consider engaging them.

Alejandro Cremades is a cofounder at Panthera Advisors which is a premier investment banking and financial consulting firm specializing in M&A, Capital Fundraising, Company Valuations, and Strategic Planning.

He previously cofounded Onevest/CoFoundersLab which is with 500,000+ registered.

Charles Rapulu Udoh

Charles Rapulu Udoh is a Lagos-based Lawyer with special focus on Business Law, Intellectual Property Rights, Entertainment and Technology Law. He is also an award-winning writer. Working for notable organizations so far has exposed him to some of industry best practices in business, finance strategies, law, dispute resolution, and data analytics both in Nigeria and across the world.

Facebook: https://web.facebook.com/Afrikanheroes/

This Kenyan Startup Has Just Secured $330k In Debt Finance

July 25, 2019

Optimetriks, the Kenyan sales force automation startup has just defied odds and gone after debt finance. A whole $330,000 debt facility (loan) to grow its customer base and add new features? For a startup that was founded in 2016, this appears a life-saving option. But then, why not fund-raising?

Here Is The Deal

Debt financing came from French commercial banks.
The startup intends to use finance to grow its customer base and add new features.
Optimetriks currently serves more than 25 companies across 16 countries in Africa, with its clients operating in sectors such as beauty, telecommunications, food, and professional services. Last month, it took on EUR300,000 (US$335,000) in debt financing from commercial banks in France to fund its growth, with Langlois-Meurinne saying this will go towards product development.

Why Debt Financing?

Although debt financing is an option for fundraisers, so much remains to be said about the strong terms under which loans are given. Optimetriks does not appear to be desperately resorting to borrowing as the nearest funding alternative to remaining in business, however.

The Kenyan startup has previously received grant funding from the GSMA in 2017 and took part in the Francophone Africa-focused L’Afrique Excelle accelerator program earlier this year and has bootstrapped until now. It could also take on Series A investment soon.

“As our company has matured, and based on our existing traction, we are now considering fundraising in the coming months, to benefit from strategic investors, knowledge of East Africa, and consumer goods distribution,” said Langlois-Meurinne.

About Optimetriks

Founded in 2016, Optimetriks has developed a sales force automation platform that helps consumer goods companies and distributors digitize their workflows and operations.

“Typical use cases are route management, defining where the sales representatives need to pass, checking on visits and productivity, providing guidance and background information on the retailers they engage with, outlet management, checking on stock levels, and things like that,” said Paul Langlois-Meurinne, the startup’s co-founder and chief executive officer (CEO).

Optimetriks, which makes money from license and service fees, was launched in a bid to solve key problems in African distribution.

“First, the lack of reliable market information and the costs and limitations that exist when trying to collect and analyse data at a large scale,” Langlois-Meurinne said.

“Second, the fact that there are information asymmetries and sometimes misaligned interests between the actors of the ecosystem. Finally, the fact that middlemen take unnecessary margins at the expense of retailers, and distort the value chain.”

The Optimetriks platform aims to bring more transparency and visibility to the distribution space, and help companies better understand how their resources are being employed.

“We help our clients implement scientific distribution that is data-driven, where every action is logged in the system, and can be tracked. Our clients access our platform either through the mobile app for the field users, or the web app, for office users who need to navigate in the reporting dashboards and configure the deployment.,” said Langlois-Meurinne.

“Our ambition is to be the reference platform that connects directly and on a daily basis consumer goods brands with the millions of African retailers that distribute their products on several key dimensions.”

Charles Rapulu Udoh

Charles Rapulu Udoh is a Lagos-based Lawyer with special focus on Business Law, Intellectual Property Rights, Entertainment and Technology Law. He is also an award-winning writer. Working for notable organizations so far has exposed him to some of industry best practices in business, finance strategies, law, dispute resolution, and data analytics both in Nigeria and across the world.

Facebook: https://web.facebook.com/Afrikanheroes/

New study uncovers China ’s massive hidden lending to poor countries

July 20, 2019

New report shows the extent of China’s hidden power as the developing world’s creditor.

Over 50 developing countries’ Chinese debt accounts for on average 15 percent of their individual GDP.
New report shows that the majority of the world’s developing country’s debt to China is considered “hidden.”
China’s loans for poor countries are primarily for crucial infrastructure.

China’s overseas lending, which was virtually zero before the turn of the century — well, about $500 billion in 2000 — stands today, ostensibly, at around $5 trillion. Indeed, they are now the world’s largest creditor, being twice as large as both the World Bank and the International Monetary Fund, combined.

As much of what China does is under a veiled curtain of secrecy, it’s been difficult to track how all the money is flowing. A new comprehensive study though, by Sebastian Horn and Christoph Trebesch of the Kiel Institute for the World Economy, and Carmen Reinhart of Harvard University, has provided some new insights about China’s official credit lending empire. What did the researchers discover?

More than half of China’s lending to developing countries is what they term “hidden” money — loans that haven’t been reported to any of the international funds, such as the World Bank.

Indeed, economist and author of the report, Tresbesch, recently told Germany’s Spiegel in an interview following the release of the study’s findings, that compiling all of the information was like “a kind of economic archeology.” Their information came from numerous financial world databases, along with some documents provided courtesy of the CIA.

It’s no secret that China would like to keep this type of information occluded from the international scene. Opponents of China’s secretive lending practices fear that Beijing is engaging in predatory debt diplomacy and using their worldwide Belt and Road Initiative to create a new kind of economic colonialism over Africa and other parts of the developing world.

China’s creditor strategy for economic growth

China is in a state of further economic evolution. Long gone are the days of being the world’s impoverished manufacturer. With a thriving consumer market boosted at home, China is now flexing their influence over vast swathes of the world. One of their strategies is by becoming the world’s most involved lender to poor countries.

This can be problematic for a number of reasons. Countries that take this deal, end up grossly indebting themselves to China’s policies in a number of ways, both monetarily and culturally. An example on the extreme end of the spectrum is Djibouti, whose Chinese debt is equivalent to 70 percent of the country’s GDP. On average, the top 50 of China’s borrowers owe somewhere near 15 percent of their GDPs, which, still, on a global scale is quite a lot.

The authors also found that China has never officially disclosed any loans to Iran, Venezuela, or Zimbabwe, which on other records it’s been shown that China is a major creditor. The report speculates that one of the ways to avoid these international cross-border crediting claims is by the Chinese government disbursing loans straight to Chinese contractors rather than the developing governments themselves.

A great deal of these loans isn’t subject to credit rating agencies, because most of China’s foreign loans flow straight from their government. China’s lending practices take on another interesting dynamic, as the country is lending much more than just money: it is also helping build crucial infrastructure in these developing nations. In doing so, China exports a healthy dose of its culture and influence.

Growing influence in Africa

China’s investment in Africa takes the form of loans in exchange for infrastructure development. Oftentimes, Chinese companies and citizens reap the benefits and profits of these large projects. While many Africans welcome the much-needed investment into their countries, it’s not clear how much the continent is benefiting from this Chinese influence.

One major issue a lot of countries are facing is that almost the entirety of their country’s debt load comes from China. For example, of Kenya’s $50 billion in debt, more than 72 percent of it is from China. In Senegal, highways, industrial parks and other crucial developmental projects for a functioning country are all funded by large, risky Chinese loans. Again, much of this value goes back to China. They’re not doing this for humanitarian reasons. The Chinese expect capital and cultural return.

Tim Wegenast, who wrote a report about Chinese mining in Africa states:

“It’s more or less safe to say that Chinese companies employ less local labor than other companies because they bring over many Chinese workers, and when they develop local infrastructure, they provide countries with loans which are being used to pay for it, which is then constructed by Chinese companies and Chinese labor.”

A future of Chinese credit

According to The Economist, China’s lending prowess is more of a mixed bag. While many new loans from China were offloaded with debt relief by Western creditors after defaulting, China has in the past put forth some debt restructuring plans on 140 of their foreign loans. Although at other times, they’ve taken their collateral with ruthless abandon, for example when they seized the Hambantota Port in Sri Lanka.

Many Chinese loans have higher extended interest rates and short maturities, with heavy collateral that includes commodities, or even important strategic foreign infrastructure.

The authors of the report noted that China has started talking about being more transparent and sustainable on their loans in the future. But no clear evidence of this taking place has yet to materialize.

Mike Colagrossi is a Columnist at Big Think Magazine

Charles Rapulu Udoh

Charles Rapulu Udoh is a Lagos-based Lawyer with special focus on Business Law, Intellectual Property Rights, Entertainment and Technology Law. He is also an award-winning writer. Working for notable organizations so far has exposed him to some of industry best practices in business, finance strategies, law, dispute resolution, and data analytics both in Nigeria and across the world.

Facebook: https://web.facebook.com/Afrikanheroes/

Congo Republic’s Debt Is 114% of Its GDP But IMF Has Just Approved A Major Bailout

July 13, 2019

Currently, Congo Republic’s debt stands at 114% of its GDP but the International Monetary Fund is helping to cut it down. Alone, about 1.6 trillion CFA francs ($2.7 billion) is owed to China according to a February 2018 report by the French Embassy in Congo, which cited the Finance Ministry.

Private creditors like Glencore and Trafigura are owed 1.2 trillion CFA francs, it said. Chinese entities account for about 34 percent of Congo’s external debt. But all that is about to change with this IMF intervention.

Here Is The Deal

The bailout did not just happen. Congo Republic had been mounting intense pressure on the IMF for a bailout.
But IMF had insisted that China would agree to restructure debt owed by the Republic of Congo before it grants the debt-laden central African nation a bailout.
Congo’s negotiations for a bailout has been on for two years before this.
In April 2019, Congo reached an agreement with China to restructure a portion of its Chinese debt
Under the terms of this restructuring deal, repayment of 944 billion CFA francs will be extended to an additional 15 years.
Congo, however, must pay off a third of that amount by the end of 2021 and China will not reduce the amount of principal owed, a process known as taking a haircut.
According to the IMF, this is a substantial reduction in the amount of debt service that would have been required during the program period.
What is hoped to achieve here is that the extension of the debt’s maturity will ease Congo’s debt service burden in following years?
The International Monetary Fund’s (IMF) executive board, in exchange, has now approved a bailout worth nearly $449 million for the Congo Republic.
But all that would not happen just like that. For Congo to continue to benefit from the bailout, IMF has demanded that Congo put in place processes to ensure the long-term sustainability of its debt as a precondition before going for a three-year extended credit facility programs, going forward.

Congo’s economy suffered from a sharp drop in crude prices in 2014, and debt levels had ballooned to 118% of GDP by 2017.

Now, This Move Is So Significant For Other African Countries Under Heavy Debt Burdens With China And Here Is Why

Government debt as a percent of GDP for African countries, 2017. *Source: IMF, 2018. Regional Economic Outlook*

This bailout potentially set a precedent for other nations struggling under the weight of large debts to China.

It appears that what IMF has succeeded in doing is to alert other countries borrowing from China that China would never cut off any percent from any borrowed sum, but may instead, prolong the period of repayment.

Many observers see Congo as a test case for the IMF.
A number of African countries facing unsustainable debt resulting from commercial borrowing, a boom in Eurobond issues and years of Chinese lending on the continent are expected to turn to the IMF for help in the coming years.

In 2017, public debt as a percent of GDP in sub-Saharan Africa was 45.9 percent relative to the 117 percent external debt-to-GNI ratio of 1995.

This is even bound to grow more because sovereign debt financing is inevitable given that African countries budgetary resources are insufficient to finance their vast development agenda.

“The IMF is tacitly accepting that China will not take a haircut on debts to African governments,” said one banker, who has followed the negotiations.

The IMF is also advising Congo’s government to restructure high-interest debt it contracted with oil traders including Glencore (GLEN.L) and Trafigura despite a previous pledge to the Fund that it would not engage in oil-backed borrowing.

“I think they’ve learned their lesson as to the costs of these kinds of practices,” Alex Segura, IMF mission chief for Congo, told Reuters.

IMF Is Also Pitching Its Stakes And Leaving African Countries At Their Own Mercy

Description of events leading to the present debt situation

All that bailout would not just happen without a reciprocal deal. For instance, the IMF said in November that Congo’s government must take a series of steps before the lender agrees to a bailout, including reforms to improve governance and transparency, adjustments to the state budget. It’s also requested “explicit financing assurances,” including debt relief, from creditors before it considers a bailout.

With all these, African countries with heavy debt burdens may all be sitting on a time bomb.

Charles Rapulu Udoh

Charles Rapulu Udoh is a Lagos-based Lawyer with special focus on Business Law, Intellectual Property Rights, Entertainment and Technology Law. He is also an award-winning writer. Working for notable organizations so far has exposed him to some of industry best practices in business, finance strategies, law, dispute resolution, and data analytics both in Nigeria and across the world.

Facebook: https://web.facebook.com/Afrikanheroes/

Ethiopia Is Now $52 billion In Debt, Twice The GDP of Uganda

July 6, 2019

Ethiopia ’s debt profile is headed for another level. With over $52 billion debt, the country’s public debt is now more than 65% of the country’s Gross Domestic Product (GDP), and twice the GDP of the East African country of Uganda.

“We borrowed a lot of money but we have been unable to repay on the given time… We have borrowed significantly for infrastructure projects which really failed to achieve the desire result,” said Eyob Tekalign, State Minister of Finance of Ethiopia who presented the 11 months performance report to the Parliament.

What This Means

Although Ethiopia’s fast economic growth registered for over a decade was attributed to being driven by the public investment mainly relying on loan, the economic growth has not been able to make the country pay back its debt.
The Ethiopian government total debt from foreign and local lenders now surpasses $52.3 billion.
As a result, Ethiopia is now forced to restructure the debt repayment schedule negotiating with the major leading country — China as well as by avoiding new debts and new public investment projects

“We have already avoided commercial loans because these loans when they have matured have really created a challenge of accumulated debt,” he said explaining some of the actions undertaken by the ministry as a result of the ongoing reform launched by Prime Minister Abiy a year ago.

“…We have prioritized supply side of economic growth which means working on productive sectors including mining, tourism, manufacturing even agriculture. We are still importing wheat and edible oil which in an economy like Ethiopia is really unacceptable” the Minister said.

The Gross Domestic Product (GDP) in Ethiopia was worth $80.56 billion in 2017. This year the government expects 9.2 percent growth through the economy of the highly indebted east African country has been not doing so well as a result of the internal political crisis and instability.

Charles Rapulu Udoh

Charles Rapulu Udoh is a Lagos-based Lawyer with special focus on Business Law, Intellectual Property Rights, Entertainment and Technology Law. He is also an award-winning writer. Working for notable organizations so far has exposed him to some of industry best practices in business, finance strategies, law, dispute resolution, and data analytics both in Nigeria and across the world.