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Good Debt vs. Bad Debt

Learn which kind of debt investors HATE, which kind is OK, and how to keep yours from holding your business back.

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.

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 the "Raising Money" coach at Entrepreneur.com and the founder and CEO of The Venture Alliance, a national firm based in Irvine, California, that's dedicated to getting companies funded.

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