There are many forms of debt. In fact, other than common stock, all other forms of capital are basically debt. By definition, debt carries an interest component. Some debt interest is paid on a regular basis. Other forms involve deferred payments or accruals until the term of the loan expires.

Most venture capital deals include Preferred Stock, convertible to common, with an interest earning component. That is real debt, as is a loan to a business with collateral in the form of some of the business assets. If the lender is a financial institution, the loan is known as senior debt. Next in line to the bank is junior debt, usually at a much higher coupon rate. This debt is usually referred to as mezzanine funds.

These forms of debt are reflected on the company balance sheet, in terms of short and long term. Short term debt is placed opposite the current assets. It is that portion of the debt that is repayable within a year. Long term monies owed are reflected next to shareholders' equity (common stock). The combination of long-term debt and common equity value are summed to determine enterprise book value.

So, when is debt not debt? As part of a business valuation:

  1. When the owner(s) has loaned monies to the company, this amount is not considered as "real" debt. Essentially, this "loan" is a prop to keep the company afloat. Even if there is a written contract with the funds provider, and a reasonable interest rate, this loan will never be repaid if the company sells. The cash has been consumed via working capital.
  2. If one owner provides capital or collateral and another one(s) does not, this disparity should be reflected in future distributions or sale proceeds. In essence, an enhanced common stock position. As such, this is pseudo debt.
  3. If debt is attributed or owed to a third party as part of a court settlement, the amount is real. However, as part of a reorganization or bankruptcy, that debt is often reduced (crammed down).
  4. In a family wealth transfer, if the transferor sells the assets to another family member and accepts a loan, is that real debt? So long as the note or loan carries at least the IRS approved rate (AFR), this debt is real. But its "validity" is still subsect, since it can easily be forgiven. On the other hand, the IRS can take the position that any debt forgiveness is taxable at Federal income tax rates.