Session 3 — Raising Debt and Capital

Part of: Accounting Capital Structure, Equity & Debt Financing, Valuation, Funding Lifecycle Key concepts: Capital Structure, Leverage, Common Stock, Preferred Stock, SAFE, Pre-Money Valuation, Post-Money Valuation, Tax Shield

1. Financial Identity — Recap from Session 2

The Balance Sheet is the company's financial identity. It captures the company's position on a single day, and is built from three sections that always satisfy the fundamental equation:

The Balance Sheet shows ending balances of cumulative accounts since the company was incorporated — it is a "snapshot," not a "movie." Every dollar spent (Asset) had to come from somewhere (Liability or Equity). This session is about the right-hand side: how the company gets those resources.

Mental model

Think of the balance sheet like a kitchen: the ingredients in the fridge (Assets) had to be paid for either by money you borrowed (Liabilities) or money out of your own pocket (Equity). The ingredients can never be more or less than the money you used to buy them.

2. Capital Structure

The mix of Liabilities vs. Equity that funds the company is its Capital Structure. The choice has huge implications for risk, cost, and control.

2.1 Leverage

When a company funds itself with more liabilities and less equity, it is said to be highly levered.

Why leverage = risk

Equity has no repayment date. Debt has a fixed schedule. A levered company has contractual future cash outflows (principal + interest). If the business hits a rough patch, it might be unable to make those payments — leading to default or bankruptcy.

2.2 Why is Debt Riskier to the Borrower?

2.3 Capital Structure Pyramid — Risk to the Lender / Provider of Capital

This is the single most important diagram of the session. It ranks every form of capital from safest (top) to riskiest (bottom) for the person putting money in:

                    ▲ Low Risk · High Default Priority · Low Cost (to company)
              ┌────────────────────┐
              │ Senior Secured     │  ← Bank loans, first-lien bonds
              │      Bonds         │
              ├────────────────────┤
              │ Senior Unsecured   │  ← Corporate bonds, credit lines
              │      Bonds         │
              ├────────────────────┤
              │ Convertible &      │  ← "Mezzanine" — sits between debt & equity
              │ Subordinated Debt  │
              ├────────────────────┤
              │ Preferred Stock    │  ← Equity, but with preference rights
              ├────────────────────┤
              │   Common Stock     │  ← Last in line; biggest upside
              └────────────────────┘
                    ▼ High Risk · Low Default Priority · High Cost (to company)

Reading the pyramid two ways

• Risk: As you go down the pyramid, the holder is paid LATER in a bankruptcy → higher risk → demands higher return.
• Cost to the company: Higher risk capital is more expensive to raise. Senior secured debt might cost 5%, common stock might "cost" 15–20% (i.e. the return investors expect).

2.4 The Order of Payment in Bankruptcy ("Waterfall")

2.5 Detailed Risk Hierarchy (from the Slides)

3. The Road of Funding — Start-up Lifecycle

Different sources of capital are appropriate at different stages. The "valley of death" is the early period when a start-up has costs but minimal revenue — surviving it is the central financial challenge.

What does "FFF" stand for?

Family, Friends, and Fools — the people willing to back you on belief alone, before the metrics exist to convince a professional investor.

4. Raising Equity

Equity = giving up a slice of ownership in exchange for cash. The investor becomes a part-owner; the founder is diluted.

4.1 Shares Equity — Key Vocabulary

Every company has a registered capital pool defined in its Articles of Association. Within this pool, shares move between three states:

Every share has a Par Value — a nominal "face value" set at incorporation (often $0.01 or even $0). It plays no real economic role today, but historically served as a legal cushion protecting creditors. Par Value × number of issued shares = Share Capital on the balance sheet. Anything paid above par goes into Additional Paid-in Capital (APIC).

Identity worth memorising

Cash received from a share issuance = Share Capital (par × shares) + Additional Paid-in Capital (premium × shares)

4.2 Worked Example — Issuing Shares to a New Investor

Company ABC, Inc.

• Registered capital: 1,000 shares, par value $0.01
• Founders contributed $100,000 in exchange for 600 shares
• An investor invests $1,000,000 for 20% of the company

Q1: How many shares does the investor receive?

The investor will hold 20% post-issuance, so the founders' 600 shares = 80% of the total post-issuance.

$\text{Total shares post-issuance} = \frac{600}{80\%} = 750$

$\boxed{\text{Investor receives } 750 - 600 = 150 \text{ shares}}$

Q2: What is the issue price per share?

$\text{Price per share} = \frac{\$1{,}000{,}000}{150} = \$6{,}666.67$

Q3: How does the Statement of Shareholders' Equity look after issuance?

Line item	Founders	Investor	Total
Shares issued	600	150	750
Share Capital (par × shares)	$6.00	$1.50	$7.50
Additional Paid-in Capital (APIC)	$99,994	$999,998.50	$1,099,992.50
Total Equity Contributed	$100,000	$1,000,000	$1,100,000

Journal entry for the new investment:

• DEBIT Cash $1,000,000
• CREDIT Share Capital $1.50 (150 × $0.01)
• CREDIT Additional Paid-in Capital $999,998.50

4.3 Pre-Money vs Post-Money Valuation

This is the most-confused vocabulary in start-up finance. Memorise the relationship:

Pre/Post Worked Example (slide 9)

Investor invests $250,000 at a $1,000,000 pre-money valuation.

$\text{Post-money} = \$1{,}000{,}000 + \$250{,}000 = \$1{,}250{,}000$

$\text{Investor \%} = \frac{\$250{,}000}{\$1{,}250{,}000} = 20\%$

Founders go from 100% → 80% (diluted by 20%).

Common trap

If a term sheet says "valuation $1M, investment $250K", always ask: pre or post? A $1M post-money valuation gives the investor 25% ($250K/$1M), not 20%. The difference can be life-changing.

4.4 Common Stock — Ordinary Shares

Common stock is the basic equity security. Holders get:

The very first ordinary shares issued are often called "Founders Stock." Modern IPOs (especially "unicorns") sometimes issue multiple classes of common stock with different voting rights — e.g. Founders' Class B with 10 votes/share vs. public Class A with 1 vote/share. This lets founders keep control even when they own a minority of shares.

4.5 Preferred Stock — Preferred Shares

Preferred stock sits above common stock in the capital structure. The "preference" is a bundle of contractual rights negotiated with each round:

The Mezzanine Twist

When preferred stock includes features that look more like debt (mandatory redemption, fixed dividend, etc.), accountants reclassify it on the balance sheet outside Equity, in a section called Mezzanine (between Liabilities and Equity). This is purely a presentation rule — the security itself is unchanged.

4.6 SAFE — Simple Agreement for Future Equity

A SAFE is a contract used in early-stage rounds. The investor gives cash NOW in exchange for the right to receive equity LATER (usually at the next priced round). It is not debt — there's no maturity date and no interest.

How SAFEs convert (intuition)

When the next priced round happens, the SAFE converts at the better of:

• the new round price discounted by, say, 20%
• the price implied by the valuation cap

The cap protects the SAFE investor if the company's valuation explodes between SAFE and next round.

SAFE Conversion — Numerical Walk-through

Investor signs a SAFE for $100,000 with:

• 20% discount
• $5M valuation cap

Next round (Series A) prices the company at $10M post-money at $10/share.

Method	Calculation	Implied Price
Discount	$10 × (1 - 20%)	$8.00 / share
Cap	$5M cap implies $5/share (vs. $10 actual)	$5.00 / share

Cap wins (lower → more shares for investor).

Shares received = $100,000 / $5 = 20,000 shares Without SAFE protections, investor would have got only 10,000 shares — the SAFE doubled their stake for the same money.

5. Raising Debt

Debt = borrowing money you must repay, with interest, by a contractual date. Unlike equity, lenders get no ownership and no say in the business — they just want their money back on schedule.

5.1 Types of Debt — From Short-Term to Mezzanine

Secured vs. Unsecured

Secured debt is backed by specific collateral (e.g. a building, inventory, receivables). If the company defaults, the lender seizes the collateral. Unsecured debt has no specific collateral — only a general claim on the company's assets behind secured creditors.

5.2 Why Raise Debt? — The Tax Shield

This is the single most important reason a profitable company prefers debt to equity:

Tax Shield Identity

Interest expense is tax-deductible. Dividends are not. $\boxed{\text{Net cost of debt} = \text{Interest} \times (1 - \text{Tax Rate})}$

If you pay $100 of interest and the corporate tax rate is 25%, your real after-tax cost is only $75 — the government effectively pays $25 of your interest bill by reducing your tax.

5.3 Public Debt Offering — The Process

Issuing bonds to the public is far more involved than taking a bank loan. The high-level steps:

┌──────────────────┐    ┌──────────────────┐    ┌──────────────────┐
│ Advisor Selection │ → │  Credit Rating   │ → │   Debt Offering  │
└──────────────────┘    └──────────────────┘    └──────────────────┘
     ↓                       ↓                        ↓
 • Strategy &           • Rating agency          • Decide debt
   Preparation            presentation              terms (size,
 • Information          • Due diligence            maturity, etc.)
   gathering            • Rating decision        • Appoint
 • Rating agency        • Information              underwriter
   selection              gathering              • Prepare
                                                   prospectus
                                                 • Bid book
                                                 • Issue & list

Key terms to define before going to market:

• Term — how many years until maturity?
• Fixed or floating interest — locked-in rate vs. tied to LIBOR/SOFR
• Indexing — is the principal indexed to inflation? (common in Israel)
• Convertible — can it convert into equity?
• Warrants attached — does the bond come with extra equity options?
• Trustee — independent representative of bondholders

Note from slides

The same process applies to both public and private debt placements. The biggest difference is whether the bonds are listed on a stock exchange and accessible to retail investors.

6. Worked Exercise — Bank Loan Accounting

The Slide-17 Exercise

On 1 Jan 2022 a company takes a $9,000K loan from a bank. The loan is repaid in 3 equal annual installments of $3,000K, starting 31 Dec 2022. Interest is 7% p.a., paid on 1 Jan of the following year for the preceding year. Tax rate 25%.

Operating Income: 2022 = $12,000K · 2023 = $9,500K · 2024 = $11,700K

Step 1 — Compute Interest Each Year

Interest is charged on the outstanding balance during the year. Since principal repays at year-end, the entire year is at the opening balance:

Step 2 — Build the Income Statement (in $K)

Step 3 — Tax Shield Quantified

The interest expense saves tax of Interest × 25%:

Step 4 — Balance Sheet (Loan-Related Lines, $K)

The trickiest part is the Accrued Interest Payable (cut-off account from Session 2) — interest is incurred in the year but paid on Jan 1 of the next year.

Why split current vs long-term?

Anything due within 12 months is shown as a Current Liability. Anything due later is Long-Term. Splitting matters for ratios (e.g. Current Ratio = Current Assets ÷ Current Liabilities) used by lenders to assess liquidity.

Step 5 — Spreadsheet Layout (for Excel practice)

This is exactly how you'd structure it in a workbook:

Step 6 — Journal Entries (for completeness)

Key entries for 2022

Jan 1, 2022 — Loan received:

• DEBIT Cash $9,000K
• CREDIT Loan Payable $9,000K

Dec 31, 2022 — Accrue interest (no cash yet):

• DEBIT Interest Expense $630K
• CREDIT Accrued Interest Payable $630K

Dec 31, 2022 — Repay principal:

• DEBIT Loan Payable $3,000K
• CREDIT Cash $3,000K

Jan 1, 2023 — Pay accrued interest:

• DEBIT Accrued Interest Payable $630K
• CREDIT Cash $630K

7. Financing at a Glance — The Master Comparison Table

This is the cheat-sheet. If you understand this table, you understand the session.

8. Israeli Tech Exit Landscape — Context

The slides closed with a snapshot of Israeli high-tech exits (M&As, Buyouts, IPOs) from 2015–2025. Two stand-out points:

Why this matters for an entrepreneur

The exit environment determines the valuations late-stage investors are willing to pay, which feeds back to early-stage SAFE caps and Series A pricing. A "bad year" for exits (like 2023) means tighter terms for founders raising today.

9. Summary — Key Takeaways

1. Capital Structure is the mix of debt and equity. More debt = more leverage = more risk to the company but cheaper after-tax cost.
2. The Pyramid ranks every form of capital from safe (top, low cost) to risky (bottom, high cost). Common stock holders are last in line in a bankruptcy.
3. Pre-Money + Investment = Post-Money. Always clarify which valuation a term sheet is quoting.
4. Common stock = voting + dividend + dissolution rights. Preferred stock = those plus negotiable extras (liquidation preference, anti-dilution, etc.).
5. SAFE is a fast, valuation-deferred way to take early money — but stacked SAFEs can dilute founders unexpectedly when they convert.
6. The Tax Shield is the headline benefit of debt: after-tax cost = interest × (1 − tax rate).
7. Accrual accounting (from Session 2) is what produces the Accrued Interest Payable liability when interest is incurred in one year and paid in the next.
8. Funding follows the lifecycle: FFF / Crowdfunding → Seed → VCs → Mezzanine → IPO → Secondary. Match the instrument to the stage.

10. Quick Reference — Vocabulary

Related notes

• Accounting — subject hub
• Session 2 - Accounting Fundamentals — financial statements, double-entry, accrual & cut-off accounts (foundation for everything in this session)
• _Wiki-Link Registry — concept-link tracker