Debt funding can be an essential tool for companies seeking to finance projects, expand their operations, or manage cash flow. However, it comes with risks and requires careful consideration to ensure long-term sustainability and alignment with business goals. In this article, we will explore key factors to consider when deciding to take on debt.
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Structuring the Debt
Debt transactions are often structured in creative ways, offering various options to businesses, based on their needs. Some common debt structures include:
- Traditional Term Loan – The lender advances funds, known as a the ‘principal’, to the borrower for a fixed period, being the loan ‘term.’ Interest typically accrues on the principal, either at a fixed or variable rate. Repayments are made according to an agreed schedule, which could include periodic payments or a lump-sum repayment (known as a “balloon” repayment) at the end of the term.
- Revenue Loan – The borrower receives funds in exchange for a percentage of their revenue until a specified repayment amount is reached. This is often attractive for businesses uncertain about their ability to meet traditional loan repayments, as repayments align with business revenue. However, such loans often have higher interest rates and longer terms and may not suit pre-revenue businesses or businesses with unstable Annual Recurring Revenue (ARR) and Monthly Recurring Revenue (MRR) metrics.
- Revolving Credit Facility – This agreement gives the borrower access to a maximum amount of money, which they can draw on repeatedly without having to enter into, and negotiate, a new financing instrument on each occasion. While this may offer flexibility, a revolving credit facility often has minimum drawdown and repayment requirements.
- Convertible Loan – under a Convertible Loan, the principal and any accrued interest may convert into equity, being shares in the borrower’s company, upon the occurrence of a ‘trigger event.’ Common ‘trigger events’ include an equity capital raise, an IPO, or the sale of substantially all of the company shares or assets. Conversion can happen automatically or at the election of a party.
Each of these debt options, along with others, has its own advantages and disadvantages. It is essential to understand the available financing options so you can choose the structure that best aligns with your specific needs.
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Costs and Fees
When considering debt, it’s essential to understand the true “cost” of borrowing. This includes interest on the principal, which can vary based on factors such as the lender’s risk appetite, the borrower’s creditworthiness, and the broader economic climate.
Non-traditional lenders, such as venture debt providers, may charge higher interest rates due to the higher risk of lending to businesses ineligible for traditional financing.
In addition to interest, debt financing can involve hidden costs, such as:
- Administrative fees
- Default interest fees (in the event of non-payment)
- Break costs (if the debt is repaid early or refinanced)
These costs can significantly impact liquidity if not carefully considered upfront.
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Serviceability
Before taking on any debt, borrowers should assess their ability to meet repayment obligations based on both current and projected cash flows. Repayment terms must be realistic and achievable to minimise the risk of default and avoid financial strain. This careful evaluation helps ensure that repayment is manageable and reduces the likelihood of serious financial consequences. Our experienced transactions team can advise you on contractual protections, such as ‘grace’ periods, that can help mitigate the risk of default.
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Collateral, Security, and Guarantees
To mitigate risk, lenders may require borrowers to provide collateral or security. This typically means the lender holds a “security interest” in some or all of the assets of the company or personal assets of the borrower. If the borrower defaults, the lender can seize and sell these assets to recoup the loan amount.
Secured loans often come with restrictions that limit the borrower’s flexibility in using or disposing of those assets during the loan period. Additionally, if the borrower is a company, directors may be asked to provide personal guarantees, making them personally liable for the debt if the company defaults. This could lead to significant financial liability for the directors.
If your company already has existing debt obligations, we recommend seeking advice to understand how new debt will interact with those obligations to avoid violating the terms of existing financing instruments.
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Use of Funds
It’s crucial that the financing agreement clearly defines how the funds can be used to avoid any potential disputes. For instance, lenders may expect the funds to be used for business growth and working capital, not for repaying existing debts.
From the borrower’s perspective, it’s important to keep the permitted use as broad as possible to maximise financial benefit. From the lender’s perspective, the permitted use should be subject to reasonable limitations to mitigate risk and ensure the loan is repaid.
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Existing Shareholders and Corporate Governance Documents
Taking on debt could implicate the value of the shareholders’ equity or result in reduced control if the debt terms require the issuance of additional shares or give creditors input in relation to critical business decisions. In the event of a liquidation or winding-up, shareholders may not recover their investments if creditors are repaid first, as is generally accepted under the law.
The company’s Shareholders Agreement and/or Constitution may also require certain board and shareholder approvals before entering into transactions that result in the company incurring financial indebtedness. To avoid inadvertently breaching any existing corporate governance documents, it is prudent to engage an experienced lawyer to review these documents and determine the necessary approvals.
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Navigating debt funding requires careful planning and a clear understanding of the various financing options available. It is crucial to evaluate the costs, risks, and repayment terms thoroughly to avoid potential financial strain. If you are considering debt funding, take the time to consult with experienced financial and legal advisors.
For legal assistance with debt funding, contact our experienced corporate transactional lawyers at 03 9481 2000 or info@tauruslawyers.com.au.