For most start-ups, access to funding is critical to help them get to the next stage. Whether it is ramping up production, money to burn or even building the first prototype. For some reason, a lot of entrepreneurs I have talked to seem to shun debt as an option for finance. Always preferring the equity route. (See also: KENNETH LEGESI takes a Look at the Alternative Sources of Funding for Ugandan Startups)
There is good praise for equity, yet, if acquired the right way, debt can be healthy for a company’s growth. Here’s why;
1. You get to keep control of your company
With debt, founders do not have to worry about losing their share structure holding. It’s all intact. Yet, with equity, you usually have to give out a large chunk of your shareholding.
This could be VCs or Angel Investors. These argue that they need "more skin in the game" for the money they are giving, otherwise, why are they investing?
With debt, all the investor wants is his principal and if at all his interest. If you pay back his principal in good time, he will almost reinvest, even before the interest has gets paid back. This, in turn, improves your business credit score.
2. Debt can almost always be restructured whenever it comes due
About loan repayment deadlines, these terrify a lot of people. Yet I have come to learn over time that you can restructure debt can.
Let’s say you’ve borrowed from an Investor USD 2000. You needed it to increase marketing, or produce more, or improve the design. Because nothing is ever constant with business, you hit a snag or fall behind on schedule.
This affects your repayment power, since, let’s face it, you won’t have the money to pay back what you borrowed. If you realize that you can’t pay back in time, it is important to notify your investor. Do this early enough.
You can either request an extension or restructure the loan to meet both your needs. Defaulting on debt is not new. It’s how you deal with it that counts.
3. You can opt for convertible notes
This is one of the ingenious ways startups can benefit from investor funding. Especially for small amounts of money.
A convertible note is money given to you that converts into equity. It can be in form of two instruments; convertible debt or convertible equity.
Angel investors and startups opt for this when they are uncertain of the true valuation of a startup. Yet want to defer that discussion, especially if it is an idea. (See also: KENNETH LEGESI explains how to Rightly Establish the Valuation of Your Ugandan Startup)
With both convertible debt and convertible equity, the investment translates to equity later. Say when the company is fundraising for series A round.
But, there's a difference between the two. In the latter, the investor may get entitled to preferred shares on conversion of the investment. What you need to know about convertible notes is that in the short term they are one of the best options for startups. Because they are less costly than equity round financing.
But, take note of these terminologies when signing and committing to your term sheet; discount rate, valuation cap, interest rate and maturity rate (for convertible debt) and performance milestones.
4. Interest payments on debt are tax-deductible
When you’re filing income tax returns, you will be able to claim for a tax deduction. This is based on the amount of debt your business took out and used in operations.
The tax deductions are computed on the interest rate attached to that debt and determined by the tax rate. So say, for example, you took a debt worth $50,000. Corporate income tax in Uganda stands at 30% at the moment. Let’s say the debt was borrowed at an interest of 12%.
Tax Deductible Interest = Debt x Interest rate
= 50,000 x 12%
=$6,000
Interest tax shield = deduction x tax rate
=6000 x 30%
= $1,800 (what you save when filing your returns.
Thus you pay income taxes less interest tax shield. This also lowers the actual cost of the loan to the company.
5. You get to keep your profits
If structured and forecast well within a business’s operation, you will find that taking a loan is actually not a bad.
Once you have paid back the loan plus interest, you can get to keep all future profits. This can’t happen when you give away equity, as you will have to share all subsequent profits with your partners.
Of course, this needs careful planning. To ensure you do meet your loan obligations to the investor, and maintain an amicable business relationship.
Maria Auma is a business owner and runs an investment management firm. Together with her US-based partner, they are working on putting a fund together for the sub-Saharan market with interested investors in the diaspora and Western market.