Debt financing is a strategy by which the entrepreneur borrows funds from either a lender or investor, which would be repaid in future with possible interest charges. The major kinds of debt financing available to entrepreneurs are regular loans, private placement of bonds, convertible debentures, leasing arrangements, debt factoring, soft loans, public sector loans and various forms of trade credit.
Debt factoring frees up cash on a timely basis by purchasing the entrepreneurial firm’s accounts receivable. Rather than waiting for customers to pay invoices, the business receives immediate payment for sales. This is provided either as recourse financing, in which the business is ultimately responsible if its customers do not pay, or non-recourse financing, in which the factor company carries the risk. This is only viable for businesses with accounts receivable and therefore may no t have been useful for entrepreneurial bankers.
A company can improve its cashflow by leasing various types of equipment from a leasing company, instead of making large capital investments in purchases. Equipment leases usually involve only a small monthly payment, while enabling the business to upgrade its equipment quickly and easily. Entrepreneurial bankers could have leased high technology equipment like ATMs and IT systems. Unfortunately vendors in Zimbabwe could not support this and foreign based ones were cautious because of the country’s perceived high risk due to foreign currency shortages and political instability.
Royal Bank was initially capitalised through debt financing supported by one of the founders’ shareholding equity in the fast growing telecommunication company, Econet. Because of the new regulations, and probably due to the founding entrepreneurs’ desire to retain control, they could not access sufficient equity financing.
The decision to use debt financing is affected by prevailing conditions concerning taxation levels, risk levels, nature of assets and financial slack. Tax relief advantages can accrue on interest payments in a profit making venture. Capital allowances often lead to tax advantages as well. In hyperinflationary environments like Zimbabwe with negative real interest rates, debt financing may be useful as long as prudence is exercised in case the interest rate policy changes. Many entrepreneurial ventures were caught flat footed when a new central bank leadership introduced a tight interest rate regime.
Entrepreneurial firms with intangible assets have a high risk of financial misfortune and therefore should avoid or at least minimise the use of debt financing.
Royal Bank used debt financing effectively because it included buildings as physical assets in its acquisition of new branches from established banks and hence had built-in residual equity value. It created an opportunity to leverage the tangible assets. If an entrepreneurial company has a high growth strategy it would need to have financial slack that enables it to access competitive financing to exploit emerging opportunities.
However if it is highly geared (high debt to equity ratio) then it may disadvantage itself. From the sample of banking entrepreneurs reviewed, only Royal Bank used debt financing as its major source of funds. Mzwimbi prudently pursued a debt financing strategy because he had sufficient value in his Econet shares. He could have sold a portion of his equity in Econet and financed the launch of the bank. It was his belief that his equity would grow in value if he just leveraged it as collateral rather than dispose of it. In effect he was exploiting the negative real interest regime that obtained in Zimbabwe at the time. His decision was vindicated as the value of his equity in Econet soared a few years later, while Royal Bank comfortably repaid its loan.
The fact that only a small minority of entrepreneurial banks used debt financing testifies to the limited use of debt in hyperinflationary environments as a source of start up capital. This is contrary to the finding in developed countries where entrepreneurs prefer debt financing, which enables them to retain full control, and the practice of risk avoidance strategies.
Advantages of Debt Financing
Debt financing allows entrepreneurs to retain ownership and control. This explains the phenomenon of equity aversion exhibited by most entrepreneurs. Some entrepreneurs have been known to avoid loss of control through delegating some equity even if this was a prerequisite for optimising profitability, business development and business growth.
A degree of financial freedom is maintained as debt obligation is limited to the loan repayment period only, whereas the claims of equity investors would subsist as long as they hold on to their equity. Consequently it enables the entrepreneur to make key strategic decisions without being encumbered by investors. The profits of the organisation would predominantly accrue to the entrepreneur and can therefore be reinvested rather than be distributed to investors.
Although debt financing is expensive in the short term, in the long term it proves to be cheaper due to the impact of inflation. This is even more enticing in hyperinflationary environments.
Disadvantages of Debt Financing
Debt financing requires regular loan repayments which may cause discomfort as the initial stages are characterised by inconsistent cash flows in most start ups. As a result, the entrepreneurial firm may be faced with either stiff penalties for delayed or missed payments or, even worse, the whole loan may be recalled.
As previously discussed, the availability of debt financing to start ups is limited due to the MacMillan Gap. The issue of interest rate risk in volatile economies is a cause for concern. The high collateral requirement is also a disadvantage.