Financial statements are vital to investors. But how do investors use financial statements? Before your meeting, learn what they want to see and why.
March 21, 2022
When it comes to startups, funding makes the world go round. Without it, startups can’t scale or achieve their business goals.
There are several ways a startup can acquire financing. Often, founders fund their own startups until they reach the pre-seed or seed stage, after which the company offers investors equity in exchange for funding. In some cases, startups also take the crowdfunding approach to raise capital. If a startup doesn’t want to dilute its equity further but still requires funding, one avenue it can explore is debt financing.
What is debt financing for startups, and when should a business consider this road? Here we’ll cover all that, including the advantages and disadvantages of debt financing and how a startup can acquire this type of funding. Plus, we’ll explain some common terms you’ll need to know if you choose to seek debt financing for your startup.
Debt financing is a type of funding provided to startups by an investor or lender, such as a bank, for a certain amount of time. Debt financing walks the line of a traditional loan in that the startup borrows money and pays it back with interest.
While private equity funding, or venture capital funding for early stage startups, is one of the most popular financing sources, debt financing is in the simplest terms, just the opposite, and plays an important role in getting a startup off the ground.
To compare, the main advantage of equity financing is that there is no obligation to repay the money acquired through it (rather you pay back the cost of the shares at a later date). Under equity financing, the startup essentially sells a portion of the company in return for capital. Often the investor will not only have partial ownership, but a voice in future business decisions.
Alternatively, with debt financing, borrowers do not need to offer equity or partial ownership in return. The debt financing serves as credit and the lender has zero ties to internal business decisions as long as payments on the financing are made as per the financing contract.
The main goal of debt financing is to help startups extend their runway between rounds of equity financing. Below we break down some common advantages and disadvantages of debt financing so that you can make the most informed decision for your business and current situation.
What benefits can debt financing provide startups? There are several reasons to consider it a viable source of funding:
While there are clear advantages to using debt financing for startups, it should be approached with a strategic outlook. Be aware of these disadvantages of debt financing:
Successfully getting debt financing for startups can be challenging. So, it’s important to prepare basic financial statements before trying to secure it. At a minimum, startups will need a forecast, business plan, profit and loss statement, and a balance sheet to make intangible and hard assets clear to the lender.
Banks, for example, will want to see how a startup can pay back the loan. Lenders will look for a revenue stream and an associated cash balance to see whether the startup can make payments on the financing. If a startup’s financials don’t clearly indicate how it can pay back the funding, it likely won’t qualify.
While banks are a common source of debt financing, there are non-bank lenders that startups can also approach. However, it’s important to note that they will likely require a higher interest rate than banks.
Non-bank lenders won’t be looking at the startup’s hard assets, but they may want a highly structured deal instead and negotiate to receive equity in certain situations. Many non-bank lenders are interested in convertible debt where they can see gains in equity.
While your interest rate will depend on your terms, business history, credit profile and type of lender, among other variables, average annual interest rates for small businesses and startups typically run on average between 3-10% of the principal loan amount.
In addition, in debt financing lenders often receive warrants on the company’s common equity — the right to purchase a company's stock at a specific price and at a specific date. The total value of the warrants usually runs anywhere from 5% to 20% of the principal loan amount.
While there are many types of debt financing for startups, here are a few that we see most commonly with the entrepreneurs that we work with:
Zeni combines industry-leading AI-powered accounting and bookkeeping with a team of expert finance professionals. It offers your startup the financial capabilities and records it needs to apply for, secure, and maintain debt financing.
The Zeni Dashboard makes it easy to share the high-level financial data that investors and lenders care about. With the Investor Access option, funders can see real-time metrics and your key financial statements (P&L, balance sheet, and cash flow statement).