SmartAB™ Wisdom #1: Avoid Taking Debt!

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And now, let’s proceed to the proverbial question on every startup’s mind: to debt, or not to debt? My advice… below:

In most cases, startups’ fundraising boils down to raising equity or debt. Occasionally, it’s the combination of the two that finds its way into a Term Sheet.

So, more often than not, you will come across the thesis claiming that the most obvious advantage of using debt versus equity is linked to maintaining control and ownership in your company.

After all, giving up equity is a loss of certain controls. And we all heard so many stories about founders being replaced by shareholders if they didn’t retain enough board seats and voting power.

And yes, once the debt is repaid, the liability is over. Hence, there is no shortage of various structures to be used by early-stage startups — that eventually convert into equity on a subsequent financing round. Meanwhile, you keep 100% of your equity. What’s not to like?

Well, my answer to the above is as follows: 100% of ZERO is still one big ZERO. And in some cases, the debt you take may bring the value of your equity to ZERO — much faster than you think…

What They Don’t Teach You At Harvard Business School…

Far too many entrepreneurs assume that no investors will force their company into bankruptcy by calling the loans… Such a premise boils down to a simplistic assumption that if an investor ever recalled a loan to a startup, it would have killed the company — and the investors would lose all their investments.

Well, it might be true in some cases, but the fact that calling the loan forces the company to file for bankruptcy — could also be used by some investors to buy the struggling company “for a song”.

You see, the debt holder, or the so-called “Debtor In Possession (DIP)” — could file a “restructuring” proposal with the bankruptcy court. If approved, the existing shareholders lose all their equity as their existing shares become worthless. The new equity holders can then issue new shares from the treasury — and walk away with the full ownership…

The above scenario couldn’t have happened using equity financing. I have experienced such malicious DIP behavior resulting in a “change of control” first-hand. And I do not wish any entrepreneur to go through the same…

You’ll be surprised how many times companies are forced into bankruptcy by greedy and unscrupulous investors. My advice: beware of the debt and choose equity financing instead…

If It Happened To Me…

By 2001, my AI startup, International Neural Machines (INM), was acquired by a public company trading on Toronto Stock Exchange (TSX). And the post-merger company provided commercially accepted applications in Court, Legislative, and Healthcare markets — whose functions included capture, compression, storage, retrieval, routing, and annotation of voice.

INM expanded the public company’s products and developed advanced synchronization solutions for multi-modal searches of video, audio, and text information — using speech recognition, natural language processing, and Artificial Intelligence…

It all worked well and soon we were successful in winning a very large RFP supplying our systems to all the Provincial Courts in Ontario. The deployment schedule was very tight, and we were forced by our Prime and Sub-Prime consortium partners to deploy the solutions much faster than our cash reserves allowed. It meant… taking on serious debt.

No, there was no shortage of Private Equity (PE) groups offering us the debt as they all were salivating at the prospects of getting rich, fast. Low and behold, with tens of millions of dollars spent on equipment sitting in our warehouses — the Government of Ontario had a sudden change of heart… and canceled the project altogether.

Finding alternative clients fast enough was not an option and we couldn’t service the debt without such sales. A few days later, one of our debt holders, called the loan…

According to Investopedia: “A debtor in possession (DIP) is a person or corporation that has filed for Chapter 11 bankruptcy protection but still holds property to which creditors have a legal claim under a lien or other security interest. A DIP may continue to do business using those assets. However, it is required to seek court approval for any actions that fall outside the scope of regular business activities. The DIP must also keep precise financial records, insure any property, and file appropriate tax returns”.

Debtor in possession (DIP) is typically a transitional stage in which the debtor attempts to salvage value from assets after bankruptcy. The most obvious reason for obtaining DIP status is that the assets are used as part of a functioning business with higher resale value than the assets themselves. DIP status lets bankrupt firms and individuals avoid liquidation at fire-sale prices, which helps both those who are bankrupt and their creditors”.

What followed next was a quick approval by the bankruptcy court of the “restructuring plan” and our PE group walked away from the whole exercise as a “White Knight”. They even boasted out loud about saving some of the jobs…

The “new” company took over all the client lists and started to sell the warehoused platforms, immediately. Its Balance Sheet looked really good — as there was no debt to worry about any longer… And this was it. The founders ended up holding the bag — which was completely empty at that time…

As a curiosity, it’s worth mentioning that I was still a director and BOD member at that time. But when the crucial “restructuring” vote took place — the cunning and conniving PE group ensured that I wasn’t at the table. How did they do it?

Well, I was residing about one and a half hours away from the head office — where the voting took place. After leaving my residence and within 30 minutes of my drive, the company’s secretary called and told me that the BOD meeting was canceled. She was simply kind enough to save me the drive — hence the courtesy call.

Later that afternoon, I saw a press release and learned about the BOD’s decision. The consequential meeting did take place as originally planned — but I wasn’t there. And my earlier cancellation call? Well, it came from the… payphone, not the corporate PBX…

But if you think that similar “Debtor In Possession” plays happen only to startups — think again. By the time ToysRUs filed for bankruptcy in 2017, it was the $7.9 billion worth of debt that caused it. And more than 30,000 retail workers lost their jobs…

My advice: take the equity instead of debt. Even owning 50% of the $100MM company is much better than owning 100% of… ZERO. And there is no shortage of able financial engineers to turn your dreams of wealth into nightmares of poverty, really fast …

For More Information

Please see my additional posts on Linkedin, Twitter, Medium, and CGE’s website.

AI Boogeyman

You can also find additional info in my book on amazon: “AI Boogeyman — Dispelling Fake News About Job Losses”, and on our YouTube Studio channel… Thank you.

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Disclaimer: The opinions are my own. If you require professional guidance about taxation, accounting, or legal issues — please contact qualified lawyers and certified accountants. Thank you.