Today’s article is a shorter one discussing a question I see asked all the time: Why doesn’t AITX use debt financing instead of equity-based financing (issuing new shares, warrants, etc.)? To answer that question, I’ll first need to go through at a basic level how lenders evaluate prospective companies to lend to. Then we can answer why AITX doesn’t seek out this type of financing.
Just so we’re all on the same page, corporate debt is when a company is lent money (principal) from some financial institution or debt investor. The company then must pay some interest rate every month, year, etc. over the term of the loan until they repay the principal. The principal is either repaid as a portion each payment period (amortizing) or all at once at the end of the loan.
Debt is typically collateralized against the company assets. So if it doesn’t t pay back the principal it owes plus any accrued interest, the lender can seize the company’s assets to recoup anything they’re owed through a liquidation, etc.
Easy enough right?
How do Lenders Evaluate Prospective Borrowers?
As is probably evident from the above, a lender is primarily concerned about two things. First, will the company be able to repay the principal plus any interest? If the worst should happen and the company can’t pay, the second question is then what assets can I claim from the company to recoup the money I’m owed? Let’s unpack both of those questions:
Debt coverage is the first thing a lender will look at. Essentially, is the company able to service the debt through the regular cash flows generated by the business. A company with strong, steady cash flows will always be much more enticing than a company not cash flow positive. If a company isn’t cash flow positive, the odds of them paying back my debt are not great. They’d likely need to issue more debt or receive some sort of equity financing to be able to repay me.
For us homeowners, remember how militant your lender was about seeing pay stubs, W2’s, etc. Same concept.
The second question then is that of the balance sheet and what assets I have claim to. Say my prospective borrower wants 1m, has no debt, and has a factory worth approximately 10m. Even if they borrower is scraping by with little positive cash flow at the end of each month, if all goes south I can at least (hopefully) get my money back through a liquidation of assets.
However, using the same example above, now say they currently have $20m in debt outstanding already with only $10m in assets. If things go south, I’m going to be fighting it out in bankruptcy court with the other debtholders to try and get even a fraction of my money back when the factory is liquidated.
All the above lead us to the risk profile of a borrower. The riskier a borrower is, the less lenders are inclined to lend to them, the more lenders are going to charge them in interest, and the shorter the term of the loan lenders will give them (in general). For example, your mortgage may have been a 30 year fixed rate loan at 3.5% interest. In contrast, a very risky OTC company would be getting terms like 20% interest with a term of two years and a conversion option into common shares at a hefty discount.
Just remember, lenders have a very different viewpoint of a company. They just need it to survive enough to get their money back plus interest. They don’t care if it becomes the next Amazon, that’s what equity owners want.
Now let’s bring this into the realm of AITX. Now believe it or not, AITX has raised some capital using debt. Through Q2 FY 2022, AITX had net proceeds of almost 8m from debt. However, this was before AITX started the S-3 shelf registration and began a large 30m funding round through common share issuances and warrants.
So then why doesn’t AITX just keep issuing more debt so we can stop with all the dilution?!
If you’ve ever read an AITX SEC filing, you’d know their balance sheet is not in great shape, which is not uncommon for an early-stage company. As of Q2 FY 2022, they had about 5.5m in assets and 23m in liabilities. Thinking back to my example above, this is not exactly a prime target for a lender. AITX does not have the heavy asset base that makes a lender comfortable as there isn’t much to collateralize against. Furthermore, AITX is not profitable/cash flow positive, nor will they be in the next few years.
Therefore, a lender in this case would ask for a ridiculous interest rate and very short-term loan, probably one to three years. This is not ideal for AITX when compared to equity financing. Why?
From a cash flow perspective, AITX needs cash now from investors with the expectation that investors will make a hefty return in the long run (5-10 years, etc.) It is counter productive for AITX to raise expensive debt that charges high interest rates that they then must pay back within a year or two. The company would just get eaten alive by interest expense and the cost of constantly rolling over debt with more debt to pay off the first guy!
What equity financing provides is flexibility. Investors inject capital into the company for a share in any non-guaranteed profits from the company’s success down the road. AITX has no obligation to ever pay these investors back and investors (should) understand that. That’s the whole point of these equity investors making this investment. A debt investor will only ever earn whatever interest rate they charge. An equity investor through the S-3 could earn 10,000% returns, or it could earn nothing.
So for an earlier stage company like AITX, raising capital through equity investments is better for everybody. The company isn’t bogged down by junk debt and being bled dry by interest expense, and it has the flexibility of its cash injections to grow for the long term.
So in short, if you see this question asked of why AITX is raising capital through dilution and not debt, it comes down to a couple of things. AITX is not an attractive investment for a lender, it is not profitable and does not have a sufficient asset base with which to collateralize debt against. Equity financing does not need to be repaid, nor do investors charge interest. Equity investors have a vested interest in the long-term success in a company, whereas lenders just want their principal plus interest back by any means.
If AITX does start moving towards being cash flow positive in 3, 5, etc. years, expect it to pivot from equity financing to debt financing. With positive cash flow typically comes a cleaner balance sheet. This brings more attractive debt terms which are feasible for the company. But that is several years away.
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DISCLAIMER – I CURRENTLY HOLD A LONG POSITION IN $AITX. THIS ARTICLE IS NOT FINANCIAL ADVICE AND IS INTENDED ONLY FOR EDUCATIONAL PURPOSES. AT THE TIME OF WRITING THIS ARTICLE, PERSONS AFFILIATED WITH THE COMPANY ANALYZED ABOVE MAY BE PROVIDING MONETARY COMPENSATION AS MONTHLY PATRONS THROUGH MY PATREON. THIS COMPENSATION IS NOT PROVIDED IN RETURN FOR ANY SERVICE, WRITING ABOUT A PARTICULAR TOPIC, AND/OR FAVORABLE OR UNFAVORABLE OPINIONS. MY PATREON SUPPORTERS HAVE NO INFLUENCE ON THE CONTENT OF MY ARTICLES.