Why Are Businesses Paying “higher” Rates to Crowdfund Debt?

Why are savvy business owners crowdfunding debt? It might appear that successful entrepreneurs are paying higher interest rates for money that they could get more cheaply from equity investors or banks.

Are you missing something?

Many people don’t realize that debt can be used strategically to finance a business.

When you look at how your company is growing, pay attention to its debt-to-equity ratio, which indicates how much debt your business utilizes relative to equity. Some people have an aversion to debt and strive to attain a low debt-to-equity ratio, but this could signal that your company is relying too much on outside equity. Outside equity is the most expensive way to finance a business. Compared to debt, equity investors expect higher absolute returns, and a growing business could find itself paying those returns in perpetuity until the equity investors are bought out. On the other hand, a high debt-to-equity ratio may be a red flag that a business is too leveraged and may not be able to repay debts.

Senior secured debt

Banks and other traditional sources of lending are often the go-to source for debt financing. Banks may insist on collateral and/or personal guarantees, will require that a certain loan-to-value ratio be satisfied and will want to be first in line for payments. This is why a bank loan often takes the form of senior secured debt (senior in the payment line, secured by collateral and/or personal guarantees). When a company needs to meet the loan-to-value ratio necessary to secure a bank loan, existing owners can put in more funds or sell more equity to outside investors. Or, the company can utilize debt crowdfunding.

If the notion of using debt securities to secure a bank loan sounds odd, we need to venture into a different area of financing: something that’s not strictly debt or equity.

Mezzanine debt

Now you’re entering the world of mezzanine debt. It occupies the space between senior debt and equity, and is often used in conjunction with senior debt to reduce the amount of equity required to sustain a business.

Mezzanine debt has elements of both debt and equity, thus the separate designation.

For example, mezzanine debt provides repayments based on sales or available cash flow, but is behind senior secured debt in the payment line. Because of its position in the capital structure, returns on mezzanine debt tend to be more like equity returns than typical debt investments (such as a senior secured corporate bond). Mezzanine debt may also be structured to provide a business with greater flexibility in repayment terms than is possible with senior debt.

Finally, from the perspective of senior debt, mezzanine debt is the same as equity: subordinate. A bank doesn’t care whether a company has 40% equity or 20% equity and 20% mezzanine debt; from the perspective of the senior debt lender, they are the same. This is how businesses can crowdfund mezzanine debt as an equity substitute to obtain a traditional bank loan. Filling the gap in the loan-to-value ratio with crowdfunded mezzanine debt is much cheaper than issuing traditional equity, and prevents the existing equity holders from being diluted.

mezzanine debt

Cool idea

Debt crowdfunding can raise mezzanine or senior debt

A company can now reduce its overall cost of capital by crowdfunding mezzanine debt, where traditionally it would have needed to issue additional equity—thereby diluting existing owners and possibly bringing in third party investors. In addition, because those equity holders are as a group contributing less cash to the business, they are able to create more leverage, thereby enhancing their potential return. Check out this article from The Motley Fool for examples on how savvy equity holders use mezzanine debt to achieve higher returns.

Mezzanine debt is also attractive to investors because they’re able to obtain equity-like returns and are paid out before actual equity investors. Unlike equity holders, mezzanine debt investors receive regular payments over the term of the debt and don’t need to figure out if, how or when they can cash out.

There are, however, many reasons that a business may not want a traditional bank loan. For some, the personal guarantees required by a bank blur the lines of limited liability that their corporate structure is intended to create. For others, the myriad of forms and other hoops are simply too much to handle. And then there are businesses that are simply not able to obtain a bank loan due to their lack of operating history, type of business or lack of adequate collateral.

In each of these scenarios, debt crowdfunding can entirely replace the bank or other traditional senior lender. In this case, where a business satisfies the necessary loan-to-value ratio, crowdfunded debt takes the role of the senior lender in the overall capital structure.

crowdfunding mezzanine debt

Is debt crowdfunding right for my business?

As outlined above, debt crowdfunding provides businesses with an alternative source of funding to traditional bank loans and equity financing. Two key criteria that apply to any type of debt crowdfunding are that (1) crowdfunding should not be the single source of financing and (2) the business must be capable of generating sufficient revenue in the near term to service the debt. A business that can satisfy both of these criteria can utilize debt crowdfunding as part of its overall financing strategy.

Keep in mind that crowdfunded debt securities (both mezzanine and senior) generally have higher rates than bank loans. This is mainly because they have less restrictive covenants – for instance, personal guarantees may not be required.

Crowdfunding also provides repeated engagement with the community: it’s a source of capital that businesses can tap year after year. Under Regulation Crowdfunding, a business can raise up to $1 million every 12 months and utilize debt crowdfunding as part of a long-term strategy for growth.

It’s more than just financing for companies

Aside from the pure financial aspects of debt crowdfunding, consider the social marketing advantages associated with crowdfunding—a component that is altogether absent from traditional financing methods. Simply put, crowdfunding is a great way not only to obtain financing, but also to attract local investors that will become customers and—perhaps more importantly—advocates for your business. In the end, the excitement behind crowdfunding is about much more than a financial transaction and leveraging debt. It’s a way to create a collaborative and supportive community.

 

Further Reading Material

“A Refresher On Debt-To-Equity Ratio.” Gallo, Amy. Harvard Business Review. July 13, 2015. https://hbr.org/2015/07/a-refresher-on-debt-to-equity-ratio

“Mezzanine Debt: What It Is and How It Works – With Examples.” Wathen, Jordan. The Motley Fool. May 22, 2015. https://www.fool.com/investing/general/2015/05/22/mezzanine-debt-what-it-is-and-how-it-works.aspx

 

The information provided on this blog is based on publicly available information, and NextSeed makes no representations with regards to the accuracy or completeness of such information. Any opinions expressed herein are our own, prepared solely for informative purposes. NextSeed does not provide any investment advice or recommendation, and does not provide any legal or tax advice with respect to any securities.