Debt funding can be an attractive alternative to equity, particularly for founders and boards who want to retain control while still accessing growth capital. It can also be appealing to investors because it typically provides a fixed return, priority over equity in a liquidation, and, in many cases, security over company assets. Unlike equity, which depends on long-term upside, debt offers more predictable cash flows and enforceable contractual rights.
That said, debt is not without pitfalls. Loan arrangements bring their own risks and complexities. Entering into them without a clear understanding of the legal and commercial consequences can leave a company financially exposed and, in some cases, leave directors personally liable.
With that in mind, here are ten key issues every board should weigh carefully before taking on debt.
- Purpose of the Debt
Lenders will want clarity on how funds will be used, and directors should demand the same. Vague terms such as “general corporate purposes” or “working capital” offer little discipline. A defined purpose, aligned with a business plan and budget, provides a benchmark for measuring performance and reduces the risk of disputes.
- Structure and Type of Facility
Consider whether the debt is a term loan, revolving credit facility, convertible note, or mezzanine finance. Each can carry different repayment obligations, security requirements, and implications for cash flow. Boards should seek advice on which structure best suits the company’s growth stage and funding needs.
- Security and Guarantees
Lenders often require security over company assets or, in some cases, personal guarantees from directors. These commitments can have far-reaching consequences if the business underperforms and struggles to service the debt.
Directors should carefully review the scope of any security package, understand the lender’s enforcement rights, and avoid pledging personal assets unless absolutely necessary. They should also assess how security interests interact with existing facilities, leases, or contractual obligations.
Equally important are the corporate approvals required before a company can grant security. Depending on the company’s constitution, shareholder agreements, or applicable legislation, specific board or shareholder resolutions may be needed. Overlooking these steps can create enforceability risks or even expose directors to claims of breach of duty.
- Covenants and Undertakings
Debt agreements almost always include covenants. These can be financial covenants, such as leverage ratios or interest cover tests, as well as operational undertakings that restrict acquisitions, asset sales, or additional borrowing. Even an inadvertent breach can put the company into default and give the lender significant enforcement rights.
Boards should negotiate covenants that are realistic in light of the company’s business model and strategy. Forecasts should be stress-tested against them, and systems put in place to monitor compliance on an ongoing basis. If the covenants are not commercially achievable based on the company’s future plans, the debt may ultimately become more of a hindrance than a help.
- Interest Rates and Fees
Headline interest rates are only part of the cost of debt. Arrangement fees, commitment fees, monitoring fees, late payment fees, and early repayment penalties can materially increase the effective cost. Boards should compare total cost of borrowing across options, not just the advertised rate.
- Repayment Profile and Cash Flow Impact
The repayment schedule should be tested against the company’s forecast cash flows. Balloon repayments or aggressive amortisation may strain working capital. Boards should model different scenarios, including downside cases, to ensure the business can service the debt without jeopardising day-to-day operations.
- Events of Default
Default clauses often extend beyond missed payments. Breaches of covenants, material adverse change provisions, or cross-defaults under other facilities can all give lenders enforcement rights. Directors must understand exactly what constitutes default, and negotiate cure periods or grace periods where possible.
- Intercreditor and Priority Issues
If the company already has existing lenders or is raising debt from multiple sources, priority and intercreditor arrangements will be critical. Subordination agreements, ranking of security interests, and standstill provisions can all affect repayment outcomes in distress. Boards should ensure they have a clear picture of how different creditors rank and what that means for risk.
- Regulatory and Director Duties
Directors must not allow the company to trade while insolvent. Taking on debt without a reasonable basis for believing it can be repaid exposes directors to personal liability. In addition, financial services and consumer credit laws may apply to certain forms of funding. Legal advice is essential to confirm compliance and mitigate personal risk.
- Exit and Refinancing Strategy
Every debt facility has an end date. Boards should plan for refinancing or repayment well before maturity. Early engagement with lenders or alternative financiers reduces the risk of a last-minute scramble, especially if market conditions shift. Directors should also consider how the facility interacts with broader strategic plans, such as an eventual sale, IPO, or equity raise.
Conclusion
Debt funding can be a powerful tool for growth, but it is not without risk. Boards that approach debt as a purely financial decision may overlook the legal and governance obligations that come with it. By carefully considering structure, security, covenants, repayment capacity, and exit strategy, directors can strike a balance between opportunity and risk.
Above all, boards must remember that debt is not just a line item on a balance sheet. It is a binding legal commitment that can shape the company’s strategy, constrain flexibility, and expose directors personally if not managed responsibly.
For more information, speak with our experienced corporate team today on (03) 9481 2000 or info@tauruslawyers.com.au.