In the frenzy to build your company,
you've done what we've read all entrepreneurs do:
You've run up you credit cards, taken out a second on your
house and pleaded for your vendors to take partial payments. Now
you're looking for money, and your little company has managed
to accrue a sizable debt burden. In fact, part of your reason for
raising money may be to pay off this debt so your company can
breathe again.
Sounds logical, doesn't it? Well,
not to most investors. As a general rule, investors hate debt and
will often pass on deals where the debt issue can't be
resolved. If you don't know the difference between what
constitutes "good debt" and "bad debt" in the
eyes of an investor, you could be making a fatal
mistake.
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Basically, investors prefer to invest in
the forward progress of a company and not to cover the debts of the
past. In general, an investor will see debt in the following
ways:
Possibly Acceptable Debt. Any
debt incurred to advance the development of the principal product
of the company may be viewed as acceptable. However, not all debt
in this category is good. First, automatically subtract any
salaries paid--or accrued--to any member of the team. Then, what an
investor may be willing to accept is:
- The cost of parts needed to build the
product
- Legitimate vendor costs to do work that
would not be possible by the team
- Patent attorney fees, but only for a
provisional patent
There's a context in which these
expenses will be viewed that will have a significant impact on
whether or not they would be accepted. If the entrepreneur has made
what the investors deem to be a reasonable, hard cash investment in
the company, then expenses in excess of that amount may be
acceptable. But there's a flip side to this two-edged sword. If
you haven't been prudent in how you've spent the money and,
as a result, have created a mountain of "frivolous" debt,
the investor will be very concerned. This not only creates a debt
issue for the investor, but it also goes to how you manage
money.
Not Acceptable Debt. Generally,
any accrued salary debt is automatically disallowed. Why? Because
that's what sweat equity is all about. In an early stage
investment, the entrepreneur's team most likely hasn't yet
quit their jobs. Thus, paying them a salary during this period is
incremental to their day-job salary. Investors tend to frown on
that.
Sometimes in an effort to be fair, a
team will set compensation guidelines according to what each team
member states is their "minimum survival level." The idea
here is to pay each member only enough to cover their basic living
expenses and then accrue the difference toward a "fair"
salary for all members. This is an admirable goal, but it's one
that's rarely accepted by investors. Again, an investor
doesn't want to pay for the past, so these well-intentioned
strategies rarely work.
Finally, another major source of debt
rejected by investors is that created by loans from "friends,
family and fools." Often, that friend or relative you finally
persuade to invest in your company does so as a loan for which they
expect to be repaid. This sends a poor message to your potential
investor on two fronts: You couldn't even persuade a close
friend or relative to invest in your company without a guaranteed
return of their capital, and once again, this is another example of
paying for the past.
The easiest solution to this problem is
don't incur debt. Unfortunately, that just may not be possible.
So choose your debt wisely. Here are some simple rules of
thumb:
1. Founder salaries. Never accrue
salaries as debt. If you believe in what you're doing,
demonstrate your belief by distributing a reward that reflects your
belief-stock. Once you've decided on an initial stock
allocation based on what each person brings to the party including
their initial cash contribution, set aside at least 20 percent of
the company's stock as an employee option pool. Then decide how
you'll compensate each other for any discrepancies in salary
and/or any "above and beyond" contributions.
2. Loan debt. If someone's
willing to loan you the money but is unwilling to invest it
outright, ask them if they'd be willing to convert their loan
to equity when a significant investor is found. By having this
agreement written into the loan, you'll mitigate any investors
concerns. It's often considered entirely acceptable to provide
special incentives or discounts at their conversion. After all,
they did provide you with money when no one else would.
3. Debt in excess of the
founder's investment. Suppose you and your team of three
partners made a collective investment of $10,000 each for a total
of $40,000. You've been working on this project for eight
months and have incurred a debt in excess of capital of $20,000.
You now want to raise $500,000 to accelerate the growth of your
company and take advantage of some market opportunities. Here's
how an investor might evaluate your potential:
- View from the past. Your
"burn" for the first eight months was $7,500 per month
($60,000 divided by 8 months). None of these expenses included any
salaries, just hard expenses to get product prototypes made and
trips to line up potential buyers. Upon examination, all expenses
look reasonable and well managed.
- Debt to investment ratio.
Roughly one-third of your company's burn is debt. Ordinarily,
this would be deemed high, but the economic status of the founders
suggests they could not put up much more than they already have and
they've been very frugal regarding how they've spent the
money.
- Amount and use of capital. Half
a million dollars is about the minimum most investors feel is
needed to help a company advance to the next significant level. The
use of capital has been carefully laid out over a six-to-nine-month
period with clear milestones attached to specific expenditures.
Although salaries are included in the use of funds--after all, this
investment will require the founders to quit their day jobs and
devote themselves full time to this project-they're modest and
will reflect a true sacrifice by the founders.
- Valuation. Suppose everyone
agrees to a $2 million valuation, which is typical for a seed stage
investment. The $500,000 will buy 20 percent of the company. And
since there's a $20,000 debt to be paid off, only 4 percent of
the investment is going to pay off the past. Typically, any
investment where the amount of legitimate debts that can't be
resolved into equity exceeds 10 percent is one from which investors
may walk away. There's just too much money going to resolve
past events vs. promoting future opportunities.
Jim Casparie is "Raising
Money" coach at Entrepreneur.com and the founder and CEO of
The Venture
Alliance, a national firm based in Newport Beach, California,
that's dedicated to getting companies funded.