So you’ve got a friend or a relative, or maybe even an early stage third party seed investor who is ready to fork over a few grand to help you get your startup off the ground. The deal is simple: they give you cash, you promise to pay it back. What does it all mean?
This is what we call debt financing – but it can get a whole lot more complicated than a simple loan. In addition to a loan (which specifies an interest payment and repayment terms), debt financing usually takes the form of either a promissory note or a debenture. For the sake of keeping things simple, let’s exclude ordinary course debt like an operating line of credit or a company credit card. These are not good ways to finance your business! (Apologies for stating the obvious on this one.)
A promissory note is essentially a very simple loan agreement – and it does exactly what it says: Party A promises to pay Party B $X on or before date Y.
A debenture is similar to a promissory note, but it will normally come from an investor with more sophisticated requirments. A debenture will contain certain restrictions on what you can and cannot do with the money (what we call the “use of funds”), and what important business transactions will require the consent of the investor. This is a way for the investor to keep an eye on management. If management goes ahead and does something that’s not permitted under the debenture, the terms of the debenture will usually permit the investor to call their investment back (plus penalties in some cases).
Many of you have probably also heard of “convertible” debt, which usually takes the form of a convertible debenture. This “convertible” feature allows the investor and/or the company to convert the debt into equity if a certain event occurs (for example, a financing round, a sale of the shares or business, a new issuance of shares, etc.).
Food for thought
One thing to remember when financing your business through debt is that the investors become “creditors” of the company. In the event things go bad and the company goes bankrupt, they will rank ahead of the shareholders… You pay your creditors (debt holders) before you pay yourself (shareholders/founders).