While there is no formalized list of “Thou Shall Not” items for start-ups seeking funding similar to the Ten Commandments, if there were, Thou Shall Not encumber your balance sheet with debt, would certainly make the list.
Doing so can be a death nail to your company.
Unfortunately, debt which impacts the start-up’s fundability can arise from numerous sources, each potentially lethal. Many forms of debt are obvious, others are not, and it’s potentially those that are not, which place the entrepreneur in the most risk of impacting their funding potential. Let’s take a look at three new business debt pitfalls that the entrepreneur needs to be conscious:
- Current liabilities, such as legal fees for a start-up can quickly turn into excessive current liabilities. Strong founders recognize the need to appropriately document the establishment of the company and file the appropriate documents to protect their intellectual capital. However, this recognition may result in the potential for the founders to rationalize as they incur these expenses, which can escalate quickly. If they do not track such costs on a disciplined basis, incurring only cost in which they have the financial resources address, the potential for large excessive balances on account with professionals and other service providers is high.
- Accrued Compensation, owed to management and employees as a function of agreements between the parties and the company, or otherwise, can be rationalized as being reasonable and appropriate. Additionally, they can amass quickly. Implied in such balances on the accounts of the start-up is the assumption that they will be paid by investors in the next round of financing. This assumption is unlikely to be validated.
- The utilization of convertible debt by the founders to fund the company, especially when it results in the accrual of significant levels on founder accounts, can be problematic. Investors expect the founders to have “skin in the game”. In addition, even if the founder’s equity accounts are robust, investors are unlikely to permit the founders establishing a priority on the company’s assets for themselves in the event of a default. The founders can expect any closing to be conditioned upon conversion to equity. If they balk at the suggestion, the discussions are likely to be terminated.
Being conscious of these less than obvious financing impediments should go a long way toward assisting the entrepreneur in their efforts to manage toward a clean balance sheet and a fundable company. To understand why these new business debt types are considered Mortal Sins by investors. Why Investors in Start-ups Hate Debt