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The Inventors Guide
Debt Financing
Debt financing is borrowed money, which you repay over a specified period of time, with interest. The lender charges interest for the loan of money, but does not get a share or equity in the business.
It is generally difficult for inventors to get debt financing unless they are willing to provide personal assets (i.e. house or land) as security.
Types of Debt Financing
Secured Debt
Secured lenders look for repayment in one of two ways: normal repayment from cash flow, or liquidation of the assets held as security. When a secured lender looks at your company, they are looking for enough historical cash flow to pay the loan payment AND enough tangible security (land, buildings or equipment) to fully repay the loan advance, plus interest and expenses.
Secured debt is the cheapest to obtain because it is relatively low risk for the lender. It is also the most widely available. Secured loans can include operating lines of credit, term loans and mortgages. Lenders include banks, term lenders, asset-based lenders, franchisers, factoring companies, sales and leaseback sources, export-related sources and equipment leasing companies.
Subordinated Debt
Also known as participating debt, junior debt, mezzanine debt and quasi-equity. Banks will provide subordinated debt in situations where there is insufficient tangible security to cover the loan if your historical cash flow is more than sufficient to service future payments of principal and interest, as well as future capital expenditures to maintain the physical plant in its present condition. Lenders look for a debt service coverage ratio of at least 1.5 to 1.
Lenders enhance their rate of return by charging bonus interest, or a royalty on sales, or by participating in the available cash flow. They may request an option or warrants for common shares in your company.
Because of the higher risk, subordinated debt has higher fees and rates of interest than secured debt.
Unsecured Term Loans
Unsecured loans are granted only to firms with projected and historical financial data to prove ability to repay. They usually require you to put up 30% to 50% of the funds needed, depending on the type of business.
Real Estate Financing
These include commercial or industrial mortgages for up to 75% of the appraised value of your property, for terms of 10 to 20 years.
Equipment Loans
These loans permit a company to purchase equipment or use owned equipment as collateral when unable to qualify for unsecured loans. Loans are generally 60% to 80% of the equipment's value, with terms for repayment of up to five years or the equipment's useful life.
Equipment Lease
Banks and leasing companies will underwrite leases with minimum three-year terms or up to 80% of the useful life of the equipment.
Line of Credit
A line of credit provides an upper limit to which you can borrow, at a set interest rate. You do not get the cash in a lump sum, but draw on the line of credit as required. Interest is paid only on the amount borrowed. A line of credit can be an important tool for coping with cash flow problems and financing working capital. Banks usually recommend a credit card line-of-credit for amounts under $50,000.
Debt Financing Institutions
Financial institutions tend to regard start-up businesses as high-risk ventures. Start-up companies should be prepared to pay high interest rates (prime plus 3% at least), contribute at least 25% (up to 50%) cash into the deal, sign personal guarantees and put up security. You will also need a business plan.
Institutions associated with the provincial or federal government may be more likely to fund start-up companies, because assisting new businesses may be part of their mandate.