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 whatwe've read all entrepreneurs do: You've run up you creditcards, taken out a second on your house and pleaded for yourvendors to take partial payments. Now you're looking for money,and your little company has managed to accrue a sizable debtburden. In fact, part of your reason for raising money may be topay off this debt so your company can breathe again.
Sounds logical, doesn't it? Well, not to most investors. Asa general rule, investors hate debt and will often pass on dealswhere the debt issue can't be resolved. If you don't knowthe difference between what constitutes "good debt" and"bad debt" in the eyes of an investor, you could bemaking a fatal mistake.
Basically, investors prefer to invest in the forward progress ofa company and not to cover the debts of the past. In general, aninvestor will see debt in the following ways:
Possibly Acceptable Debt. Any debt incurred to advancethe development of the principal product of the company may beviewed as acceptable. However, not all debt in this category isgood. First, automatically subtract any salaries paid--oraccrued--to any member of the team. Then, what an investor may bewilling to accept is:
- The cost of parts needed to build the product
- Legitimate vendor costs to do work that would not be possibleby the team
- Patent attorney fees, but only for a provisional patent
There's a context in which these expenses will be viewedthat will have a significant impact on whether or not they would beaccepted. If the entrepreneur has made what the investors deem tobe a reasonable, hard cash investment in the company, then expensesin excess of that amount may be acceptable. But there's a flipside to this two-edged sword. If you haven't been prudent inhow you've spent the money and, as a result, have created amountain of "frivolous" debt, the investor will be veryconcerned. This not only creates a debt issue for the investor, butit also goes to how you manage money.
Not Acceptable Debt. Generally, any accrued salary debtis automatically disallowed. Why? Because that's what sweatequity is all about. In an early stage investment, theentrepreneur's team most likely hasn't yet quit their jobs.Thus, paying them a salary during this period is incremental totheir day-job salary. Investors tend to frown on that.
Sometimes in an effort to be fair, a team will set compensationguidelines according to what each team member states is their"minimum survival level." The idea here is to pay eachmember only enough to cover their basic living expenses and thenaccrue the difference toward a "fair" salary for allmembers. This is an admirable goal, but it's one that'srarely accepted by investors. Again, an investor doesn't wantto pay for the past, so these well-intentioned strategies rarelywork.
Finally, another major source of debt rejected by investors isthat created by loans from "friends, family and fools."Often, that friend or relative you finally persuade to invest inyour 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 investin your company without a guaranteed return of their capital, andonce 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 debtwisely. Here are some simple rules of thumb:
1. Founder salaries. Never accrue salaries as debt. Ifyou believe in what you're doing, demonstrate your belief bydistributing a reward that reflects your belief-stock. Onceyou've decided on an initial stock allocation based on whateach person brings to the party including their initial cashcontribution, set aside at least 20 percent of the company'sstock as an employee option pool. Then decide how you'llcompensate each other for any discrepancies in salary and/or any"above and beyond" contributions.
2. Loan debt. If someone's willing to loan you themoney but is unwilling to invest it outright, ask them ifthey'd be willing to convert their loan to equity when asignificant investor is found. By having this agreement writteninto the loan, you'll mitigate any investors concerns. It'soften considered entirely acceptable to provide special incentivesor discounts at their conversion. After all, they did provide youwith 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 collectiveinvestment of $10,000 each for a total of $40,000. You've beenworking on this project for eight months and have incurred a debtin excess of capital of $20,000. You now want to raise $500,000 toaccelerate the growth of your company and take advantage of somemarket opportunities. Here's how an investor might evaluateyour potential:
- View from the past. Your "burn" for the firsteight months was $7,500 per month ($60,000 divided by 8 months).None of these expenses included any salaries, just hard expenses toget product prototypes made and trips to line up potential buyers.Upon examination, all expenses look reasonable and wellmanaged.
- Debt to investment ratio. Roughly one-third of yourcompany's burn is debt. Ordinarily, this would be deemed high,but the economic status of the founders suggests they could not putup much more than they already have and they've been veryfrugal regarding how they've spent the money.
- Amount and use of capital. Half a million dollars isabout the minimum most investors feel is needed to help a companyadvance to the next significant level. The use of capital has beencarefully laid out over a six-to-nine-month period with clearmilestones attached to specific expenditures. Although salaries areincluded in the use of funds--after all, this investment willrequire the founders to quit their day jobs and devote themselvesfull time to this project-they're modest and will reflect atrue sacrifice by the founders.
- Valuation. Suppose everyone agrees to a $2 millionvaluation, which is typical for a seed stage investment. The$500,000 will buy 20 percent of the company. And since there'sa $20,000 debt to be paid off, only 4 percent of the investment isgoing to pay off the past. Typically, any investment where theamount of legitimate debts that can't be resolved into equityexceeds 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.
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