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.
What is debt financing for startups?
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.
How does debt financing compare to equity financing?
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.
Why consider debt financing?
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.
Advantages Of Debt Financing
What benefits can debt financing provide startups? There are several reasons to consider it a viable source of funding:
- No further dilution of ownership: Debt financing, unlike equity financing, doesn’t take any equity away from the owners of the startup. This is a major advantage for startups that are no longer willing to dilute their equity and want to retain a certain amount of it.
- Full control over decisions: Because the lender doesn’t have an equity stake in the business, they do not have any say over business decisions. The startup keeps the same amount of control it had before debt financing. The startup can decide how it wants to use the funding without consulting the lender. Often, startups use this type of funding to complete a specific campaign or project, purchase equipment or inventory, or accelerate growth for a specific initiative.
- Defined period of time: Unlike equity financing, which is arguably permanent, debt financing has a set term. The startup must repay the funding after a stipulated amount of time, after which the relationship with the lender ends. Agreements typically bake in clear start and end dates. Plus, startups can acquire debt financing at any stage, unlike equity financing, which only happens in certain rounds.
Disadvantages Of Debt Financing
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:
- Difficult to acquire: Perhaps the biggest drawback of debt financing is that it is not easy to get. Most banks will want to see financial viability and a list of assets before qualifying a startup for financing. In many cases, startups don’t have the hard assets that bank loans require.
- Difficult to maintain: If a lender does qualify a startup for debt financing, there will be certain debt covenants the startup will need to meet. Usually, that includes detailed financial reports and specific calculations that the startup will need to show the lender to maintain its financing. If a startup cannot meet the loan covenants, the lender may raise the interest rate or take corrective action against the startup. This may include requiring the startup to payback the loan. Typically, startups rely on skilled finance experts to understand the loan covenants and create reporting to meet the requirements.
- Required to pay back: Unlike equity financing, debt financing means the startup has to pay back the money within a certain period. If a startup cannot make its payments, the lender can take corrective action, including seizing control of the business or its assets. Debt financing is typically considered “senior” debt, meaning it takes precedence over other kinds of debt and must be paid back first over any other obligations.
How To Get Debt Financing For Your Startup
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.
What are the interest rates on debt financing?
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.
What Are Types of Debt Financing?
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:
- Short-term vs. Long-term Financing — Short-term debt financing usually has a repayment period of less than one year. The repayment periods on long-term business loans are much longer, which can be beneficial for larger, longer-term projects within your company such as major equipment updates, real estate purchases and a growing payroll.
- Monthly Recurring Revenue (MRR) — This type of debt financing is most common with SaaS companies that have some type or subscription model or recurring revenue stream. Loans are therefore based on the company’s monthly revenue. On average, you can expect lenders to provide financing between 3-5x your MRR.
- Revenue-based Financing — This is a more flexible form of debt financing where payments are based on a percentage of monthly revenue which can also be beneficial for companies with subscription-based models or those with high growth aspirations. The flexible monthly payments are designed to accommodate the natural ups and downs of the company’s revenue without demanding equity.
Important Debt Financing Terms To Add To Your Vocabulary
- Asset: A resource owned by a business that offers economic value. Examples of assets are inventory, cash, cash equivalents, property, furniture, equipment, trademarks, copyrights, patents, accounts receivables, and prepaid expenses.
- Principal: The original sum of money borrowed that is must be payed down or repaid at the end of the term.
- Interest Rate: Usually expressed as a percentage, interest is the amount of money the lender charges for loaning out funding. The interest rate is in relation to the amount you are paying on the principal.
- Fixed Rate: A pre-agreed upon rate that does not change over time.
- Floating Rate: An interest rate that moves up and down with the ebb and flow of the market, another benchmark rate, or an index.
- Non-bank lenders: These are a type of financial institution that offer lending services similar to banks but with different requirements. In some cases, it may be easier to get financing from a non-bank lender; however, they may have higher interest rates and highly structured deals.
- Term: The length of time for a financing agreement, usually expressed in months or years. Typically, startups receive shorter terms because there is uncertainty about the company's longevity.
See Also: How To Raise Pre-Seed Funding For Your Startup
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