Why Startup Investors Hate Debt

debt

Avoid the purgatory of being non-fundable. Find out the investor’s view and structure of their balance sheet in an “investor friendly” manner before submitting an executive summary to startup investors.

Entrepreneurs will share who they are and how they operate as they structure the balance sheets of their companies with startup investors.

Often times, entrepreneurs will kill their chances for funding before investors even see their executive summary. While unintended, many of the messages point the investor to a single conclusion – the startup and its management are not fundable.

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 created with the expectation of a future funding round and conversion to equity are effectively treated as equity for investor purposes. They will utilize it to determine the future impact on the Cap Table once converted, not as a risk factor on the debt table.

Next Step, Screening Meeting with Interested Angel Group: Are You Prepared? 

Debt includes:

  • 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 (significant legal and accounting fees)
  • Contingent liabilities of any kind

All these forms would be viewed negatively by the investor. There are a variety of reasons for this reaction from investors:

(1) Debt carries priority on the company’s assets in the event of a bankruptcy.

If the startup fails 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 significant amounts, actions by the debt-holder to recover their outstanding balance could 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 these cases, entrepreneurs should recognize that investors are unlikely to provide the entrepreneurs the means to build and grow the company. In the case where the entrepreneur is the holder of the debt, the entrepreneur should expect the investor to require it to be paid in full prior to any investment in the startup.

(2) Investors do not want to fund previous growth. 

Investors are providing funding to enhance the business model and grow the valuation of the company. Investors provide resources like capital, networking and supporting expertise to develop, grow and scale the company. They focus on an ultimate transaction event (IPO exist or M&A) when they are rewarded for the risk in investing in the startup.

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(3) Debt funding demonstrates a lack of financial savvy and entrepreneurial sophistication.

Debt may be less expensive. It may also be easier to obtain 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 even 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, investors may still be turned off because these actions have demonstrated a lack of entrepreneurial savvy. Ultimately, this creates questions on their long term ability to execute.

(4) Debt funding demonstrates a lack of commitment from 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. 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.

14 Types of Information Investors May Request as part of their Due Diligence Checklist for Your Startup

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Tony Lettich

Tony Lettich has previous corporate venture capital experience and currently serves as Managing Director of The Angel Roundtable. He is a co-founder of FundingSage, which provides valuable information, tools and resources to entrepreneurs seeking to start, grow and fund a business.