The Ultimate Guide to Debt Financing
Debt financing is flourishing. In 2019, the private debt market was worth an estimated $575 billion and grew to $848 billion by the end of 2020.
Furthermore, the market is expected to grow by a CAGR of 11.4% by 2025, reaching nearly $1.5 trillion. Although this is partly a reflection of historically low interest rates, it also indicates that most companies now see debt as an integral part of their growth strategy.
DealRoom regularly works with companies looking to raise debt. Invariably, the debt in question is used to part fund an acquisition or a large capital project.
This is a process that has to be properly prepared for: even with low interest rates, lenders aren’t inclined to just give away money.
In this article, we draw from our experience of working with companies seeking debt financing to provide an overview of the process.
What is Debt Financing?
Debt financing is the process through which companies raise funds, by borrowing money from creditors such as financial institutions and investment firms. The terms of the debt financing - what the funds will be used for, the duration of the loan, the interest rate charged on the loan, and more - will be agreed by both parties in advance of the money being issued.
The company (which becomes a debtor after the debt has been issued) is then obliged to repay the principal and the agreed interest over to the creditor over the agreed period.
Types of Debt Financing
Debt financing has arguably seen greater innovation than any other area of finance over the past century.
Even many of the successful fintech applications that have arisen are in some way or another related to debt (by way of example, see the proliferation of peer to peer lending apps, mortgage and loan comparison apps, and even crowdfunding apps).
The innovation, however, is mainly seen in the number of types of debt financing. The most common forms are:
- Bonds: sometimes referred to as ‘fixed income’ debt securities, bonds are more typically associated with publicly listed firms, but can also be issued by private companies through certain intermediaries.
- Debentures: similar to bonds but instead of putting up collateral, the company issuing the debenture (i.e. the borrowing party) depends on their reputation alone. As a result, the interest rate tends to be higher than on bond issues.
- Bank loans: everyone will be familiar with the concept. An issue for small companies for the past few years has been that banks have been able to issue less debt (a hangover of the financial crisis), forcing small companies to look elsewhere.
- Loans from non-financial institutions: the ‘shadow’ lending market - is essentially all parts of the market that provide debt financing that aren’t banks. For example, funds, venture capital and private equity companies, and private debt companies.
- Mortgages: a mortgage is a loan on a physical asset - usually a building. The loan is made based on the value of the asset and interest payments are spread over several years. Refinancing assets using mortgages is one way for a company to raise finance.
- Recurring revenue lending (MRR loans): this is a type of debt financing which is particularly popular among SaaS firms or any other companies whose revenue is largely recurring (usually based on subscriptions or long-term contracts of some kind). Debt is issued as a percentage of the monthly recurring revenue (Hence, ‘MRR’).
Who Provides Debt?
In the aftermath of the global financial crisis that began in 2008, the lending activity of banks was sharply curtailed.
The unintended consequence of forcing banks to clean up their balance sheets has been extraordinary growth of debt availability elsewhere. To put this in perspective, the size of the private credit market has tripled in the past decade.
Commercial bank debt has grown by less than 50% in the same period. Here are just some of the parties now lending to companies:
- Traditional lenders: in here, we’ll put banks, mortgage providers, and credit unions. As mentioned above however, it’s not as easy as it once was. Furthermore, despite their adverts, most of these institutions typically take a few months to provide debt finance.
- Private equity firms: private equity firms have seen that it’s possible to get decent returns (5-15%) on debt issued by some companies. When they’ve got good insight into the industry in question, the risk for them is often minimal.
- Private debt (credit) companies: a slew of companies have grown up in the past decade to fill the void left by a slowdown in bank debt. These are usually organized as funds, with investors providing them with money for a return generated by interest on company loans.
- Crowdfunding: several crowdfunding sites have arisen, allowing smaller investors to provide funds to companies. The drawback for companies going down this route is that the funds usually take a while to access, and interest rates tend to be higher.
- Mortgage Companies: as the name suggests, these companies are focused on mortgages. If your company has good quality real estate, there will nearly always be demand among mortgage companies to provide financing for it, using the real estate as collateral for the debt financing.
Debt Financing vs. Equity Financing
When measuring whether your company should opt for debt or equity financing, there are a number of factors to consider.
As always, bear in mind that the comparisons made here are generalities and the specifics will depend on the prevailing market, your company, and the third parties involved in providing the finance.
This said, here are the main issues that you should consider when deciding which to choose for your company: repayment or control.
Debt financing means that your company has to repay cash according to the terms agreed at the time of its issuing. If your company is unable to generate the cash required for repayment, this can become burdensome very quickly.
By contrast, equity financing just means that the provider of funds receives a share of the company and its profits.
And while this may seem more attractive in the short-term, in the long-term, depending on how much equity (i.e. what share of your company) is issued, it can work out to be far more expensive than debt financing.
the bigger the funds required, the more terms and conditions will be attached. This is as true for debt financing as it is for equity financing.
On balance however, at least debt financing means that terms are only imposed for the duration of the loan being paid. With equity financing, the party that provided equity finance now holds a share of your company and by extension, some of the voting rights.
Depending on the terms agreed, they may even be able to influence your company’s strategy. All issues to ponder when considering the trade off between financing with debt or equity.
Note: While most articles of this kind take the narrative, ‘debt or equity’, we are keen to emphasize that your choice for financing doesn’t have to be one or the other. There are hybrid options (i.e. combinations of the two) that may work out even better, particularly if you believe that your equity will be worth far more in the future.
Our recommendation is that you look at every option for financing available, including hybrid combinations of debt and equity.
Debt Financing: Advantages and Disadvantages
First, the advantages of debt financing:
- There are now a huge number of debt providers out there, so it’s more of a borrower’s market than it’s ever been.
- Right now, interest rates are low (although this may change), making it an attractive time to seek debt.
- If you negotiate the right terms, debt can be a catalyst for your company’s growth, fuelling investments for short-term and long-term capital.
- Repaying debt financing in a timely fashion leads to your company gaining a good credit rating - something which may be a valuable asset at some point in the future.
- There is less control of your company involved with debt financing. You generally gain access to the funds without needing new co-owners to rubber stamp your decisions.
And the disadvantages of debt financing:
- If your company fails to generate the cash to pay off the interest, you’ll still be on the hook for the credit.
- The trade off with debt financing is that the more you need it, the stiffer the terms offered by debt providers tend to be.
- The time taken to arrange debt, particularly when the amount is large, can be a burden for companies looking for quick access to cash.
- Without a solid business plan (i.e. for the use of cash) for the debt, it can be quickly squandered. It will still have to be repaid, regardless of what you do with it.
- Debt has a habit of creeping up on companies, particularly when it’s easy to access. You could quickly find yourself laden down with debt and finding it difficult to pay off.
Debt Financing Checklist
1. Capital-Formation Strategy
- How much capital does the company really need, when does really need it, and whether there are alternative ways to obtain these resources?
- Do both parties have growth in company’s value once enter into an agreement?
- Is the deal structure going to 20% equity with 80% control or any other way? (or any other way)
- Is the chosen Capital Formation Strategy can mitigate risk or has downside protection?
- Obtain feedback on strengths and weaknesses from board members or other third parties.
- Comprehend the company's position against its public or private competitors by recognizing their public or private competitors.
- Asses the company's potential and how it fits into the investor's portfolio.
- Produce a tracking document/envieronment (to contact a lot of investors and process).
2. Preparing Confidential Info
- Make sure the business is on track with realistic and measurable goals, anticipating what is to come, reviewing the plan on a regular basis and revising if necessary.
- Brief history
- Mission and Vision Statement (why you are in this business)
- Discussion of your revenue and business model
- Overview of products and services
- Background of management team
- Key features of your market
- Summary of the company’s financial performance up to date
- How much money you need to raise and why?
- Organizational and management structure
- Operational and management policies
- Description of products and services (both current and anticipated)
- Overview of trends in the industry and marketplace in which the business compete (or plan to)
- Key strengths and weaknesses of the company
- Key products and services currently offered
- Proprietary features, strengths and weaknesses of each
- Anticipated products and services (how future product development and research will be affected by the financing you seek)
- The Role Your Business Plan Plays
- Prepapre a TOWS Analysis
- Strategies for reaching current and anticipated customers or clients
- Pricing policies and strategies
- Advertising and public-relations plans and strategic alliances
- Summary of financial performance for past three to five years
- Current financial condition (include recent Income Statements, Balance Sheets and Cashflows as attachments)
- Projected financial condition (present forecasts for three to five years)
- Discussion of working budgets and how capital will be allocated and used in accordance with these budgets will be extended.
3. Develop a Winning Pitch Deck
- Prepare a good summary than a lengthy discourse and piques the interest of potential investors.
- Problem - explains the market gap that needs to be filled in a way that people can relate to and investors can understand.
- Solution - needs to be concise, clear and scalable.
- Market - outline the past market, as well as future potential growth.
- Product or Services – in action
- Traction and Milestones - month over month growth of the business (e.g. revenue, metrics, etc).
- Team - describe the leadership’s team members.
- Competition – same-industry competitors
- Financials – 3- or 5-years performance and projections of the company
- Amount being raised - Instead of using specific amounts, consider using ranges of numbers.
4. Meetings and Immersion
- Present a brief and descriptive pitch deck
- Make a compelling narrative to share.
- Demonstrate your product or service's one-of-a-kind value.
- Present a solid and realistic data (with back ups)
- Describe your revenue strategy.
- Be prepared for any questions that may arise and be prepared to answer them in advance.
- Wrap it up
5. Creation of a Pro-Forma Cap Table
- Demonstrate the ownership and market value of the company both now and after a potential investment.
- Analyse the impact of investments, aftermath
- Identify the risks and rewards after a potential investment
To find a complete debt financing template visit our templates gallery and utilyze pre-built ready to use playbook. You can always customize it right inside the DealRoom to fit your needs.
Using Debt Financing in M&A
M&A transactions are a common reason for companies turning to debt financing.
Many deals are financed through debt, allowing the increased revenues of the newly merged company to pay down the debt that sits on the balance sheet after the transaction has closed.
While this can be an excellent motive for taking on debt, buyers should remain cautious: a 2021 study conducted into over 1,000 deals cites debt as one of the main reasons that transactions fail. Thus, where M&A is concerned, buyers should use debt financing sparingly.
This is one of the reasons why companies choose DealRoom tools for debt financing during M&A transactions. By utilizing bult-in debt financing playbook and virtual data room to manage this debt financing process.
Debt is given a bad name by investors and companies that misuse it. Used carefully and strategically, debt can help your company access opportunities and generate value faster, both for your company and the debt provider.
Talk to DealRoom today about how our platform can help you through your debt raising and send a signal to debt providers that you’re taking the process seriously.