Investment guide:
Debt Financing
Investment guide: Debt Financing 1
Introduction
Debt financing involves borrowing money from lenders like banks, financial institutions, or public
markets, in forms that include loans, promissory notes, bonds, or specialised instruments. Borrowed
funds have a specified repayment period and typically contain an interest repayment element.
Depending on the life cycle stage of the company, debt financing can be useful for developing new
products, meeting working capital needs, acquiring new equipment, or scaling the business.
Key terminologies in debt financing
Term Description Business consideration
Amortization The process of gradually paying off debt Companies should assess their cash flow capacity and align
through regular instalment payments that the amortisation schedule with their financial projections.
include both principal and interest.
Covenants Conditions or restrictions that are included in Companies must carefully review and understand the
the debt agreement that the borrower must covenant requirements to ensure compliance.
comply with. These may include financial Breaching covenants may result in penalties, higher interest
performance targets, limitations on rates, or acceleration of debt repayment, adversely
additional borrowing, or restrictions on impacting the company`s financial position.
certain business activities.
Interest rates The cost of debt is typically represented as a Businesses should consider debt terms such as fixed
percentage of the principal. Fixed interest interest versus variable interest rates within a broad
rates are constant throughout the life of a macroeconomic context to get the best cost of debt.
debt; variable interest rates are linked to
external indices.
Repayment In addition to term loans, which are paid Companies should align repayment terms to their
structure down regularly over a pre-determined cashflows, for instance, businesses using debt to finance an
period, debt may have other repayment upfront capital expenditure may prefer bullet repayment
structures, including bullet payment (full terms where payment on the principal is only due once the
balance paid one time at maturity) or a investment is generating significant cashflows.
revolving facility (repayment varies with a
credit line).
Security Collateral is an asset or property offered by Collateral on secured debt can enforced by lenders if the
(Collateral and borrowers as a guarantee for debt payment. borrower violates the agreement (e.g., through non-
guarantee) Secured loans require collateral, while payment), so companies should carefully decide which
unsecured loans do not. A guarantee is a assets to offer as debt collateral and which guarantees to
legally binding agreement where a third provide to secure the loan. The loan-to-value ratio is the
party assumes financial responsibility for a amount of debt financing the lender can advance against a
debt facility if the borrower defaults. specific value of the collateral. Companies should assess this
carefully when seeking debt
Investment guide: Debt Financing 2
Term Description Business consideration
Tenor The amount of time during which a business Tenor shapes multiple aspects of the debt agreement,
must repay a loan. The maturity date is the including interest rates and repayment structures.
expiration date for any loan agreement, upon Businesses should choose loan tenors that are sufficiently
which any remaining debt or obligations long to create manageable payments.
must be settled.
Seniority The sequence with which debt facilities are Businesses may be subject to covenants from senior debt
repaid upon liquidation of a company. Senior holders that dictate future business activities and may
debt is settled first, followed by subordinate impact the ability to raise further capital until existing
debt. obligations have been met.
Restructuring A negotiation process between the borrower Debt restructuring is a strategic option for companies
and lender to modify the terms of the debt facing financial difficulties. It requires open communication
agreement when the borrower is facing and negotiation with lenders to modify the debt terms. It
financial difficulties. This may involve can provide temporary relief, improve cash flow, and
changes to interest rates, payment schedules, enhance the company`s long-term viability.
or other terms to alleviate financial strain.
Benefits of debt financing for a business
Debt financing provides businesses with:
1. Immediate capital without sacrificing ownership or control,
2. Tax benefits as interest payments can be tax-deductible,
3. Financial flexibility with customisable repayment terms, catering to specific needs and cash
flow capabilities,
4. Predictable repayment schedules enabling businesses to plan and manage finances
effectively,
5. Growth opportunities, allow businesses to expand, invest in projects, or pursue ventures that
have the potential for higher returns on investment.
Investor considerations when providing debt
For investors, debt investment carries risk to capital without ownership or control of the business. To
offset this risk, investors evaluate a borrower’s creditworthiness and use covenants to influence the
borrower’s behaviour.
Some of the indicators that investors consider when determining creditworthiness include:
1. Ability to service debt
Investment guide: Debt Financing 3
To ensure that their borrowers can consistently repay the debt owed, lenders use metrics such as
liquidity ratios (which evaluate a business’s ability to quickly repay the debt), debt-to-equity ratios
(which evaluate whether a company already bears a high debt burden), and debt coverage ratios
(which evaluate whether a company generates enough cash flow to service its debt).
2. Return on investment
The investor will set loan terms (e.g., tenor and interest rate) that ensure the financial returns
compensate for the risk of debt invested. Typically, the investor will apply a discount to the schedule of
future cashflows from repayment to determine the present value of the investment. Discounted cash
flow analysis allows lenders to compare investment opportunities.
3. Credit history
Investors will also look at a business’ borrowing history to see if the business has been able to service
debt in the past. Credit history assessments may be standardised (e.g., via credit scores) where
established credit referencing bureaus exist, but they may also involve bespoke research in regions
without established credit assessment infrastructure.
4. Loan covenants
Lenders often apply covenants, which are legal obligations, on a borrower to protect their investments.
Positive covenants dictate certain actions, such as financial disclosure, that businesses must take to
comply with the loan agreement. Negative covenants restrict actions, such as issuing new debt, that a
company can take. Whilst covenants may help leaders run their businesses more efficiently, they can
also hinder management decision-making.
Types of debt financing
Investment guide: Debt Financing 4
Type of capital Issuer Description
Pre-revenue
Concessional loans Development partners, Favourable terms, lower interest rates, and extended repayment periods
government-owned
banks
Mezzanine financing Private Equity Firms Hybrid form of funding, between traditional debt and equity, offered at
(PE) / Investment banks higher interest rates and often includes warrants or equity conversion
options. Mezzanine financing flexible repayments, so can be used for growth
and financial restructuring. Borrowers must consider the cost and
subordinate position to decide if it is suitable for their needs.
Venture debt Venture debt investors, Loans offered to start-up companies that have a track record of raising
specialised banks capital, based on their ability to raise new capital to fund growth and repay
the debt; lower cost of capital than equity, typically requires warrants to
underwrite the debt
Post revenue
Investment guide: Debt Financing 5
Type of capital Issuer Description
Commercial loans Commercial banks Term loans either secured or unsecured loans for a fixed period to support
needs such as expansion and working capital management.
Trade credit Trade finance Underwriting the purchase of goods by a business. This arrangement is a
institutions, commercial form of risk management for the supplier who transfers the payment risk to
bank the bank in cross-border transactions.
Crowdfunding Crowd funding Debt-based financing from a multitude of individuals, which can be
platforms harnessed to expand operations, advance research and development efforts,
and construct prototypes for businesses that have already begun generating
revenue.
Special debt instruments
Financial institutions have a wide range of special debt instruments that cater to the unique
characteristics and needs of businesses. Instruments such as revenue-participating debt involve
repayments based on a percentage of future revenue, allowing fast growing businesses with irregular
cash flows to access debt financing. Convertible debt originates as a loan but can be converted to
equity depending on pre-defined terms, including conversion price, conversion value (price per
share at which the debt exchanges), conversion ratio (the ratio of debt to shares), and timing of
conversion (e.g., through a liquidity event). Additionally, convertible debt may include a valuation cap
that limits the maximum valuation of the business at conversion, providing potential upside to
investors.
Instrument Issuer Description
Post revenue
Revenue Venture capital Revenue-participating debt can provide the necessary funding without
participating burdening the company’s cash flow. Lenders can participate in the company's
debt future revenues, which allows the startup to allocate its cash flow toward
expansion activities.
Inventory Banks, inventory finance Short-term loans so the business can purchase inventory to meet customer
financing providers and other demand and support business growth without straining their cash flow.
specialized lending
companies
Convertible debt Angel investors, venture Convertible debt is debt with the option to convert it into equity later when
capital the company’s valuation becomes clearer. This enables growing companies to
access capital, advance their business, and attract potential future investors.
Profitable
Revolving credit Commercial banks Loan facility to use a pre-determined amount of credit and pay interest only
lines on the amount borrowed. Once repaid, the credit line is available for future
borrowing.
Investment guide: Debt Financing 6
Managing debt
Non-payment of debt may result in the liquidation of company assets. Therefore, it is crucial to
establish effective debt management strategies to ensure that the business complies with the loan
agreement.
Risks of debt financing
Key Risk Description
Financial penalties Failure to meet debt repayment obligations can result in penalties, late fees, or increased
interest rates, increasing the overall cost of borrowing.
Credit risk Default on debt repayments can negatively impact the credit ratings of a business,
making it harder to obtain future financing at favourable terms.
Bankruptcy risk Excessive debt or an inability to meet repayment obligations may lead to bankruptcy,
potentially resulting in the liquidation of assets or business closure.
Interest rate risk Fluctuations in interest rates can affect the cost of borrowing, potentially leading to
higher interest expenses and an increased financial burden.
Collateral Failure to pay a secured debt may result in confiscation and auction of collateral assets
enforcement such as land, motor vehicles, and other assets to facilitate recovery of unpaid debt.
Debt management strategies for companies in financial distress
Several warning signs indicate potential delinquency and inability to meet debt obligations such as
negative cash flows, declining operating profits, and defaulting on debt payments. In such cases,
companies should consider exploring diverse options to renegotiate their debt obligations.
Key Strategy Consideration
Grace period Companies may be able to negotiate a grace period with their lender to afford time for the
company to adjust operations, survive a temporary hardship, or obtain financial relief from
another investor.
Investment guide: Debt Financing 7
Key Strategy Consideration
Renegotiation Companies may also be able to renegotiate the terms of their loans via a “workout agreement”
that restructures the loan to benefit both the borrower and the lender. The borrower may
receive lenient terms such as a tenor extension, while the lender will be able to avoid the cost
and difficulty of debt collection and repossession.
Refinancing Borrowers may be able to refinance their loans by taking out a new loan to repay the troubled
one. The original lender or a new investor may refinance the debt.
Consolidation This involves lumping up two or more debt facilities together to form one large facility.
Consolidating multiple loans may allow a company to obtain preferable terms as well as
simplify financial planning and budgeting.
Impact of debt on existing equity investors
Key Impact Description
Impact on equity Debt financing affects the capital structure of a company by introducing financial leverage.
structure Higher levels of debt can increase the financial risk and leverage ratio, which is the
proportion of debt to equity. A higher leverage ratio can make the company more
vulnerable to economic downturns and may impact the perceived risk and valuation of the
company's equity.
Interest Debt financing requires regular interest payments to lenders. These payments can reduce
payments and the company's available cash flow for reinvestment in the business. Therefore, equity
cash flow investors should consider the impact of interest payments on the company's ability to
generate long-term returns.
Potential Debt financing introduces a new group of stakeholders, the lenders, who have a priority
conflicts of claim on the company's assets and cash flows. This can create potential conflicts of interest
interest between equity investors and lenders. For example, when a company is experiencing
financial distress, lenders may prioritise debt repayment over the company’s growth and
survival which may not align with the interests of equity investors seeking capital
appreciation.
Dilution of Convertible debt agreements include provisions that give lenders the option to convert
ownership their debt into equity. If this conversion option is exercised, it can lead to a dilution of
ownership for existing equity investors. This means their percentage ownership in the
company decreases, potentially reducing their control and decision-making power.
Decision making Taking on debt financing may impose certain covenants or restrictions on the company,
and control such as debt-to-equity ratio limits or requirements for lender consent on major business
decisions. These covenants can restrict the flexibility and decision-making autonomy of the
company, potentially impacting the strategic choices and growth opportunities available to
equity investors.
Investment guide: Debt Financing 8
Conclusion
Businesses with steady cashflows and good budgeting practices may benefit from debt financing,
which allows them to fund priorities while maintaining control of their companies. However,
businesses that pursue debt financing must be sure they have the financial stability to service debt and
ensure that the terms and conditions of their debt agreements align with company needs and
priorities.
Further reading
A4S Essential Guide to Debt Financing -
[Link] /corporate/home/KnowledgeHub/Gu
ide-pdf/A4S%20Essential%20Guide%20to%20D ebt%[Link]
Debt financing- [Link] asp
Debt Financing: Definition, Types, Advantages & Disadvantages -
[Link]
OECD – New approaches to SME and entrepreneurship financing: Broadening the range of instruments
[Link] /[Link]
The World Bank – Small and Medium Enterprises (SMEs) Finance -
[Link]
How venture debt works [Link]
Investment guide: Debt Financing 9