4 Reasons Why Startup Investors View Debt As A Mortal Sin! To avoid the purgatory of being non fundable, entrepreneurs should consider the investor’s view and structure their balance sheet in an “investor friendly” manner before submitting an executive summary and financials to startup investors for consideration.
Entrepreneurs share a lot with startup investors about who they are and how they operate as they structure the balance sheets of their companies.
Some will inflict a“mortal blow” to their fundability before startup investors even see their executive summary or financials. While unintended, many of the messages telegraphed point the investor to a single conclusion, the startup and its management are not fundable. While this is clearly not the intention of the entrepreneur, it is in effect what occurs.
If an angel investor, angel group or VC is considering an investment in a startup, one of their initial due diligence requests will be to obtain a copy of the startup’s Cap and Debt Tables. The latter should provide a summary of the startup’s long term debt, including contingent liabilities. It would not include operating debt such as accounts payable, unless such debt was extraordinarily large. Untapped lines of credit would also be excluded. Finally, Convertible Notes, that are created with the specific expectation of a future funding round, and conversion to equity, while included, are effectively treated as equity for investor purposes, as they will utilize it to determine the future impact on the Cap Table once converted, not as a risk factor on the debt table.
However, debt including Notes Payable, Long-term Loans, Mortgages, accrued and unpaid taxes, accrued and unpaid salaries, benefits and or bonuses, debt incurred through the provision of outside services such as significant legal and accounting fees, and contingent liabilities of any kind are all debt and would be viewed negatively by the investor, unless cash has been earmarked and set aside to pay those debts. There are a variety of reasons for this reaction from investors:
(1) Debt Carries with it a Priority on the Company’s Assets in the Event of a Bankruptcy. In the event of a failure of the startup to make a debt payment, the debt-holder typically carries a priority over the shareholder on the assets of the company. Should the outstanding debt be of significant amounts, actions by the debt-holder to recover their outstanding balance may result in a bankruptcy event. Effectively, this provides debt-holders a first call on the assets. In some cases, entrepreneurs will “loan” money to the startup to protect their interests and limit their long term investment. In such cases, entrepreneurs should recognize that investors are unlikely to provide the entrepreneurs such a first call, on the assets in which they are investing, to build and grow the company. In the case where the entrepreneur or a closely related party is the holder of the debt, the entrepreneur should expect the investor to require the debt to be paid in full, prior to any investment in the startup.
(2) Investors Have No Desire to Fund Previous Growth. Investors are, by definition, providing funding to enhance the business model and grow the valuation of the company. Investors provide resources, including capital, networking and supporting expertise to develop, grow and scale the company. Their efforts are focused on an ultimate transaction event in which they are rewarded for the risk they have accepted for investing in the startup.
(3) Debt Funding of the Company Demonstrates a Lack of Financial Savvy and Entrepreneurial Sophistication. Debt may be less expensive. It may also be easier to obtain, at some junctures, as compared to capital. As noted above, the entrepreneur may feel that they want to limit their investment and therefore decide to loan the company capital for growth. Some entrepreneurs may need salaries to survive or believe a salary is appropriate, and accrue them if the company lacks the cash to pay them. Entrepreneurs, should be aware that even if they agree to waive the salaries or convert the debt, some investors may be turned off because these actions have demonstrated a lack of entrepreneurial savvy, ultimately questioning their long term ability to execute.
(4) Debt Funding May Demonstrate a Lack of Commitment on the Part of the Entrepreneur. In the end, it is all about perceptions. If the investor perceives the entrepreneur is not willing to invest his time or personal cash, it may imply to the investor a lack of personal commitment. Such a demonstration typically results in the investor running for the exists.
To avoid the purgatory of being non fundable, entrepreneurs should consider the investor’s view and structure their balance sheet in an “investor friendly” manner before submitting an executive summary and financials to startup investors for consideration.