What Does Raising Debt Financing Mean For Startups?

When it comes to raising capital, it can seem like a tricky choice for founders. Either they have to give away equity for cash, or they have to balance the books until more revenue comes in.

And for founders looking to scale fast, giving away too much of their business can be a tough pill to swallow.

But what if we told you another option existed? Well, it does, and it’s called debt financing.

In short, debt financing gives founders cash as a kind of loan. Rather than giving away equity, they take out a loan with interest and pay it back over time. That way, companies get a cash injection, without having to give away any control.

Done well, it can be a great tool to supercharge growth. Done badly and it can bury a business in debt.

So, what exactly is debt financing?

What Counts As Debt Financing?

Debt financing is used to describe a situation where a startup or company borrows money with an obligation to pay it back, normally with interest, over time.

This could include a set term, where repayment happens over many years, a repeat-borrowing arrangement for ‘as and when’, and revenue based-financing, where future revenue is used as collateral.

One of the main reasons debt financing is so popular with startups is because they can borrow money without releasing equity. That way, the company retains control, but the cash has to be paid back regardless of whether the business sinks or swims.

What Is Venture Debt?

If you’ve heard the term ‘venture debt’, you might be wondering if that is the same thing as debt financing. The truth is that venture debt is a form of lending specifically designed for startups, offering a boost of funding for VC-backed startups. 

It’s normally raised alongside a Seed or Series A round, giving founders the option to access an extra 20-30% of capital without having to give away more equity.

But the money doesn’t come for free. Instead, lenders underwrite the loan based on the company’s growth potential, their access to venture capital as a way to repay the loan, and their ability to raise in the next round.

Whilst venture debt deals are structured individually, common terms include interest-only terms, high interest rates, the right to buy equity later and a requirement for certain metrics to be reported on and maintained.

Why Do Startups Choose Debt Financing?

For companies that want to scale quickly but don’t want to give away too much equity, debt financing can be a good option.

It also gives companies quick access to capital and a bit of breathing room between funding rounds, which can take months to lock down.

And whilst it might seem risky to take out such a big loan, startups lock in under the assumption that the money borrowed will allow them to generate a much higher percentage of revenue, ultimately improving the value and cashflow of the business. In that case, there is a clear ROI on the loan.

How Is Debt Financing Different From Other Business Loans?

Debt financing is a type of business loan, but the main difference is who it’s designed for and how lenders approach it.

Normally, business loans are designed to support companies that have stable revenue, assets to use as collateral and decent cash flow. But that doesn’t really work for many early-stage startups.

Debt financing for startups is slightly different, as it looks at growth potential, backing from VCs and the ability to raise more in the future. This is why debt financing regularly happens at the same time as equity fundraising, has higher interest (as it’s higher risk) and may include terms related to growth milestones.

When Is Debt Financing Not A Good Idea?

Debt financing, like any other kind of loan, does have its drawbacks.

Firstly, debt financing usually comes with high interest rates, so it’s only a good option if a company thinks they can earn back the money faster than the interest accumulates.

Debt financing can also impact cashflow, which can add extra pressure to a business. They also come with strict repayment terms, which mean lenders have to be paid regardless of performance. Again, this could add an extra layer of pressure to founders, especially if there are delays or bumps in the road.

Should Founders Raise Debt Financing?

Debt financing can be a great way for startups to raise funds without giving up any more control.

However, as they are high interest loans, they can also put a lot more pressure on the company.

Ultimately, every business is different, but for founders looking to raise capital fast, debt financing can be a great option.