07 April 2021

Debt

Debt
Author/Compiled by
Caroline Truong (CSP)

Executive Summary

Debt financing is a common way of raising capital by borrowing money from creditors such as banks, financial institutions, or other companies. The company is obliged to repay the amount borrowed, also called the principal, at a predefined date in the future and pay some form of interest. In return, the creditor grants the money to the company to pay for capital expenditures or finance its working capital. In case the company goes bankrupt, creditors have a higher claim than shareholders on getting their money back. 

Debt financing can be divided into secured or unsecured debt. The former generally requires collateral in the form of assets to be deposited, while the latter doesn’t. Given that debt investors are more risk averse than equity investors, secured debt is much more common. Thus, debt financing usually requires some form of collateral and a clear future revenue stream. The most common forms of debt financing are bank loans or bonds.

In developing or emerging markets, where the financial sector is less mature, many development actors attempt to enable early-stage enterprises to access debt financing more easily. These actors provide for example subordinated loans or guarantees to local banks or funds to incentivize private actors to do the same and foster development. Thus, enterprises can leverage their impact potential, in addition to their financial track record, to access debt financing in such markets.

When is Debt a suitable financing option?

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Debt financing allows a founder to finance the enterprise without giving up ownership of it and maintaining full decision-making power. Unlike equity, business loans can be used quite flexibly, without or only with limited restrictions. In comparison to equity investors, who engage in deciding on important business issues as shareholders, debt lenders primarily expect the enterprise to pay interest and principal at the end.

Further, debt is a fitting option if the enterprise requires capital in the short term. While equity financing often goes through a lengthy process (e.g., finding the right investor, negotiation), smaller business loans can be accessed quickly, as long as the enterprise demonstrates the ability to service the debt and have all the necessary documents ready. Longer term debt is, however, more difficult to access, due to its illiquid nature and long duration.

Also, debt financing can be more appropriate when raising smaller amounts of capital. Due to the considerable effort needed to receive equity financing, most investors only consider investments that are higher ($300’000 or more). Thus, if the enterprise needs to raise only a small amount of money, debt is more suitable for you.

Debt financing requires the enterprise to be able to pay interest and eventually repay the principal. This means that it needs a future revenue stream and financial track record that proves this ability. This is why debt financing can be difficult to access for early-stage enterprises with a new business model. Also, if the current debt-to-equity ratio, which is the total liabilities divided by equity, is too high, it can make access to debt financing or further equity financing challenging. It is important that the founder only owes what the enterprise can afford to pay back.

The following (non-comprehensive) characteristics and implications provide you with an overview to analyse the pros and cons for this investment instruments:

Enterprise Lifecycle

Early (but often only if collateral is secured) to later stage

Amount

varies

Pay-back period (Maturity)

varies from 1 to 30 years

Use of funds

mostly unrestricted

Source: Based on (Roots of Impact, 2020)

The following table summarises some key characteristics of Debt and implications you should consider:

Characteristics

What does this mean for your enterprise

There is no dilution of ownership.

This means that you as a founder remain in control over the enterprise. Debt lenders have no say in your business and are not given any company shares.

Debt allows for flexibility within overall terms.

Debt options are usually flexible and can be adjusted to your needs. They are also less time-consuming and complex to arrange compared to equity. The latter often requires more negotiation and due diligence work.

Debt financing instruments are senior in case of bankruptcy than equity instruments.

Loans or bonds are repaid first in case of bankruptcy or default. In later financing rounds, equity investors may look at existing debt as a liability that increases the risk of their investment.

Debt usually allows for tax deduction.

A company can deduct its interest payments as a business expense. Interest payments are therefore fully tax deductible which decreases the company’s tax liability and overall costs for debt financing.

Debt can be a financial burden for your enterprise. Keep in mind that you have to not only repay the loan, but also pay regular interest payments, which ultimately lower the amount available for other purposes. This can be a large financial burden if your business is already in distress and has a low revenue flow.
Debt financing can be secured or unsecured. Secured debt generally requires assets such as equipment or machines to be deposited as collateral in order to act as security in case of bankruptcy. Unsecured debt does not include collateral.

Key features

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  • Debt financing usually comes in the form of bank loans or bonds:
    • Bank loan: A bank (lender) grants a sum of money (loan) to a third party (borrower) in exchange for the payment of interest. The bank offers different loan sizes and interest rates according to the individual financial situation of the business. Young companies are usually unable to access unsecured bank loans due to the lack of financial track record and revenue. 
    • Bond: A bond is a debt instrument issued by a company or public administration and sold to investors in the financial market (creditor/ purchaser) in order to secure resources. The issuer has to return the money plus pre-agreed interest payments (coupon) to the purchaser of the bond after a certain predefined period. A bond is typically held on a longer-term basis and the repayment of the principal takes place at the end of the maturity term. Issuers of bonds are usually only large public limited companies or cooperatives. 
  • Green bond: A green bond is a type of fixed income security that finances investments with environmental or climate-related benefits (Ehlers & Packer, 2017). As with a traditional loan, the issuer (can be the government or a company) receives a certain amount of money in exchange for regular interest payments. However, the money has to be used in order to implement a specific climate or environmental project.
  • Crowdlending: Crowdlending (or peer to peer lending) is a form of crowdfunding through loans that involves a large number of lenders but no intermediaries such as banks. As with traditional loans, the lenders expect the company to repay the principal and provide appropriate interest payments as compensation. The borrowing amount and interest rate are usually dependent on the risks associated with the loan but the conditions often prove more advantageous than in the case of traditional loans.

Tips to build your investment case as a young water-related enterprise

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Basic requirements

In order to access debt financing such as bank loans or bonds, you will have to provide proof that you are able to service debt. You not only have to demonstrate an excellent credit history, but also provide future revenue and cash flow projections indicating your ability to cover both principal and interest payment. You typically also need to pledge company assets (such as equipment) as collateral. Thus, in case of bankruptcy, the enterprise needs to sell its company assets in order to pay back the lender. Since most young businesses lack a strong financial track record as well as collateral, accessing debt financing is usually difficult at the very early/seed stage. However, if you already built some market traction and are able to show some revenue (ideally you have a recurring revenue stream) that can cover the cost of capital, this will prove advantageous to your business case.

Leveraging your impact profile to access debt

As an enterprise operating in the broader water sector, the potential to create impact and contribute to a more sustainable water ecosystem can be significant. Thus, more and more initiatives in the development context try to account for impact-oriented enterprises and direct debt financing towards them. Therefore, you should explore whether…

…de-risking structures could provide you with the necessary funding

One of the initiatives that receive increasing attention in the development context are de-risking structures in debt financing. These mechanisms, used by development actors, focus on lowering the (perceived) risk by providing protection to other, commercial, lenders.

There are different de-risking mechanisms within debt financing. One of these mechanisms is “downside protection”. It is broadly defined as a feature that limits the potential financial loss in the event of poor investment performance (Bridges Ventures, 2014). Such features are, for example, first loss capital or guarantees, where an investor with a low appetite for risk is protected by a “layer of capital”. The “layer” presents the capital that is first lost in case of bankruptcy of the borrower. The aim of the mechanism is to provide investment opportunities in impact-driven businesses for private sector investors that would otherwise not participate.

Such de-risking structures are rarely executed on an enterprise level, but rather exist in the form of funds or (special/thematic) bank loans. Water enterprises can leverage their impact potential to improve the chances to access such forms of debt by focusing on the following aspects:

  1. Provide a compelling business case: Work on the justification for your business – how you want to implement your solution and what benefits, risks, and costs your solution entails. You need to provide a clear explanation of your business model, while clearly demonstrating your business’ viability in the long run. From your management to your financial case, make sure you know your business and numbers.
  2. Strengthen your impact profile: Even though your business model and financials are important, your impact performance will play a decisive role. You have to demonstrate your ability to create sustained impact at scale. Substantiate your impact thesis with solid figures and numbers, indicating that you are able to measure your impact.
  3. Build your network and create visibility: You should build strong relations with your local government, development actors and other players in the sector in order to create visibility. Another way to network and promote your business is for example to participate in competitions or similar events.
  4. Be on the lookout for opportunities: Stay up to date on all news in the water sector. Relevant opportunities will likely be communicated via newsletters, social media platforms or through your network.

…your business is able to access microfinance

Another well-known funding option are microloans. There are many microfinance institutions that provide such financial services to small businesses in less developed countries. Microloans are small loans given to enterprises and issued by local financial institutions or individuals. Similar to traditional loans, the lender grants a certain amount of money to a business in exchange for interest and, at maturity, repayment of the principal amount. Yet, due to the riskier nature of such debt financing, the microloan is usually rather small and carries a high interest rate. Lenders usually hold multiple microloans in order to diversify their risk exposure (which can also be considered a de-risking mechanism).

Case study

WaterEquity is one prominent example that focuses on raising and deploying capital in the form of microloans toward a portfolio of water and sanitation enterprises. Its main goal is to contribute to the achievement of SDG6 and accelerate universal access to safe water and sanitation. The fund focuses on providing investments to microfinance institutions, micro-utilities, toilet manufacturers and water purification and sales kiosks at concessionary rates. The provision of “patient capital” is not the only thing that sets WaterEquity’s approach apart from other debt providers. Together with the investee, they set specific impact targets that should be fulfilled along with the debt requirements at the end of the term making sure that interests of both parties are aligned. The impact performance will be tracked and evaluated by a third party.

In order to be considered for microloans such as provided by WaterEquity, your business typically would have to show a strong financial track record and a scalable business model. Alongside the more traditional criteria for debt financing, the business also needs to demonstrate its ability and willingness to use loan proceeds to expand access to water and sanitation and create significant impact for communities at the Bottom of the Pyramid. Some lenders might even be lenient in regards to your financial performance if you are able to demonstrate extraordinary impact potential. Thus, having mechanisms in place that allow you to measure your impact will be highly beneficial for your business case. You can further strengthen your profile, if you can comply with ESG practices and requirements.

Library References

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