Inside Entrepreneurship: How to fund a company with debt

Q: I know of someone who invests in his various businesses only through debt. He pays himself back over time, plus interest. What are the advantages of this? I'm planning to start a consulting firm when I take early retirement from my current job. I'll probably have to invest $20,000 upfront for office space, equipment and some support staff to compete on projects. All I read about online is investing personal savings as equity.

-- K.E., Hartford, Conn.

A: Raising money for a new business is always front and center in the minds of startup entrepreneurs. The matter is not just about where to find funding but also how funds are invested in the company.

Entrepreneurs can invest personal savings in a company in exchange for shares of stock as an equity investment or lend the company money. Of course, entrepreneurs also can do both at the same time.

From a conceptual standpoint, investing in a company through debt is a form of leverage. To the extent that the business is able to steadily pay back the loan, the owner's investment risk goes down. Further, at the same time the owner is building the value of the business, the returned funds can be put to work in other investments.

I suspect your colleague doesn't like locking up his money for long periods of time. This approach works especially well for business owners who don't expect to seek additional funding from independent investors or commercial lenders.

Angel and venture capital fund investors typically will force founding entrepreneurs to roll any debt position into equity. They believe that entrepreneurs should not be paid back before investors.

Entrepreneurs also should expect that commercial lenders will want their loans to have a "first position" or "first lien" over the entrepreneur's loans. This means if the business should hit hard times, the bank will get paid back in full before the entrepreneur. Some commercial lenders also may decline funding because the company's important debt-to-equity ratio is perceived as too thin to support additional debt funding.

Does this mean a startup entrepreneur should not fund a company with debt because of potential for additional funding requirements? Not at all. Debt-oriented investments give entrepreneurs flexibility and options. Lending agreements can allow entrepreneurs to convert their shares into equity on some preferred terms whenever they choose. Entrepreneurs also can lend money in the form of a line of credit and can raise and lower the debt outstanding to match business needs.

I called up Greg Rosica, tax partner with Ernst & Young, to talk about some of the fine points of funding a startup through debt. Rosica emphasizes, "If the investment is debt, it should look like debt and act like debt. All loans should be well-documented and detail interest and repayment terms."

Here's some additional guidance from Rosica: