How leveraging debt can benefit a tech business
At what stage in a business lifecycle can you take on debt?
Companies at all stages in their life cycles take on debt. But there’s a distinction between how growing and mature businesses use it.
Mature businesses have mostly left behind significant capital expenditure. What’s more, they’re likely to operate in mature and stable markets.
At this stage in their life cycles, mature companies have complex capital structures. So they will use debt to adjust their capital structure, pay off shareholders, refinance expiring facilities and even fund an IPO.
Whereas, for smaller, yet fast-growing companies, the critical consideration is not running out of cash, which can be fatal. So they’ll use debt finance to fund:
- Equipment purchases and staff to help them to scale up
- A bridge to the next funding round
What is debt leverage?
When a company leverages debt, it uses borrowed capital to make a purchase or to invest in a project to enable rapid growth.
Why is it essential to understand debt leveraging?
Smart financial management is the cornerstone of every successful business.
When making financial decisions, CEOs and CFOs should aim for an optimal capital structure to ensure the most flexible funding at the lowest cost.
How is debt leverage measured?
High street lenders and alternative financiers use several different financial ratios, including an aptly named ‘debt leverage ratio’ to measure debt leverage.
The use of financial ratios largely depends on the size of your business and for what the loan is needed.
For this reason, venture debt providers have a very different outlook on leverage to that of a high street bank.
What does it mean if your company is over-leveraged?
When you do not have sufficient cash flow to pay the interest on your debt and reimburse the lender, your company is considered over-leveraged.
What are the causes of over-leveraging debt?
As well as taking on too much debt, a company can become over-leveraged if other factors have transpired against it.
For example, a drop in revenue or profit can result in you having too much debt at a specific time.
How can a tech company avoid being over-leveraged?
The best starting point is common sense.
Ask yourself a series of ‘what if’ questions to arrive at a judgement. You can then use excel models, financial analysis, ratios and a whole plethora of other tools to help you with your decision making.
What are the effects of over-leveraging debt?
First off, you risk breaching existing loan covenants.
Then and most importantly, unsuitable debt facilities with high repayments can impact available cash flow and put you at risk of insolvency.
What are the warning signals that a company might be over-leveraged?
In addition to keeping a close eye on your ratios, warning signals include not achieving sales or cost plans.
If you think you might be over-leveraged, what should you do?
Don’t ignore the warning signals. Keep calm under pressure and take urgent action to reduce the debt, such as increasing sales or reducing costs.
Be aware that solving problems takes a lot longer than you think.
How does debt affect the value of a company?
Taking on debt does not affect the value of a business.
But it goes without saying lenders and investors see over-leveraging as a red flag.
A bank lender uses assets to manage loan risk. How do private debt financiers manage risk?
Alternative financiers, including private debt funds, use IP assets or recurring cash flows as leverage when structuring debt finance facilities.
Sometimes, they’ll have a plan ‘b’ in mind when they lend.
To illustrate, a traditional venture debt lender would get comfort from (but not rely on) a company’s VC investment to support a company through tough times.
Where should tech companies seek advice about raising debt?
A specialist debt advisor objectively analyses situations and needs.
Consequently, it can work out what the role of debt in the capital structure means for both the borrower and the lender.
To sum up
Taking on debt doesn’t mean you have to push boundaries.
Debt is simply another tool in your financial toolbox.
Indeed, when used correctly leveraging debt can help your tech business to grow and provide value to the marketplace.
What could be more important?
If you’d like advice about leveraging debt to fuel your tech business’s
growth, drop me a line, and we’ll set up a time to chat.