SR&ED financing typically costs more than a traditional bank loan and often times less than equity. The average interest rate for SR&ED financing is between 15% to 25% per year. However, most people don’t look at the annualized cost of the loan because SR&ED financing is usually a bridge loan which is less than a year.
The first thing to do is to consider alternatives for the company. Like most economic decisions, it is a tradeoff between cost, risk and a forecast of the future. Each loan will have different terms and conditions. These can have material effects on the overall cost of the loan.
Let’s use an example where a company is looking for a $300k debt facility and decides to take their bank up on an offer for a $100k facility at 6% interest. Would this be the most sensible decision? On the one hand, the cost of the loan is relatively low. On the other, the bank is now the senior secured creditor and this may prevent other lenders from offering funding to the company. If the company had secured a $300k SR&ED loan for 20% per year instead, it would certainly have cost more money, but the additional capital would have also increased the likelihood of the company achieving its business goals.
Line up all the financing options, ensure you understand the benefits and risks of each, and use the option, or combination of options that makes the most sense for your business.
Key Areas to Assess When Looking for Financing:
- Placement fee
- Interest rate
- Legal fee
- Prepaid interest
- Other fees (ask if there are any)
- Standby fee
- Repayment schedule
- Loan covenants
- Term of loan
- Personal guarantees
- Security / General Security Agreement
Each of these areas requires careful consideration. There may be a covenant which can be tripped easily and exploited by aggressive lenders to take over your company. Good lenders have very few covenants and understand how to help technology companies grow. If all this is confusing, Venbridge has a number of different spreadsheet models they can share to show you the true cost of capital. Contact them with your questions.
Be Cautious with Prepaid Interest
Prepaid interest increases the cost of capital. There are some companies that require the borrower to prepay interest. Typically a lender would hold back interest payments for a period of time. Let’s use a simple example of a $100k loan where the interest rate is 18.0% per year and one lender has no holdback and a second lender has a 6-month holdback. The second lender would hold back $100k x 18.0% x 6 months ÷ 12 months = $9k. Therefore, the second lender would disburse $91k compared to $100k for the first lender. The effective interest rate of the second lender is 18.0% x 100,000 ÷ 91,000 = 19.8%. Therefore, not only are you paying 1.8% more interest per year, but you have $9k less of working capital. Try to avoid lenders that have a holdback, or at least ensure you understand the ramifications from an interest rate and cash flow perspective.
The fundamental question every entrepreneur will ask is: does debt financing make sense compared to the alternatives. There is no doubt that equity is a critical component of the capital structure. However, if equity is relatively expensive, it makes more sense to use bridge financing to achieve your business goals. To compare the costs of debt vs. equity financing, use our calculator.