Debt Financing 101: A Guide For Founders
Without cash in the bank, your startup has zero chances of surviving long term.
In fact, one of the leading reasons startups fail is a lack of cash reserves — they simply run out of money.
The good news is that there are a number of different ways you can generate some working capital to help stay afloat, pay your employees, and keep on growing toward unicorn status.
One such method is debt financing, which, roughly speaking, is like a business loan.
In this article, we’re going to discuss the ins and outs of debt financing to help you decide if it’s the right funding option for your business:
Table of contents:
- What is debt financing?
- How does debt financing work?
- Where to get debt financing
- Pros and cons of debt financing
- How to decide if debt financing is right for you
- Debt financing vs equity financing
What Is Debt Financing?
Debt financing is an arrangement where a company sells debt instruments to an investor (whether an institution or a wealthy individual).
Let’s break that down a little.
A debt instrument (not the $4,000 guitar you borrowed money for just after college) is a tool that businesses can use to raise cash. Loans, credit cards, bonds, and lines of credit are all forms of debt financing.
It sounds a little complicated, but the simple way to look at it is like this:
You borrow money in some form, which you’ll need to pay back. Usually, this includes some form of interest, and some kind of collateral (an asset the financier can claim if you fail to repay your debt).
Pretty straightforward, right?
You’ve probably even engaged in debt financing in your personal life, whether by obtaining a mortgage, financing a new vehicle, or simply taking advantage of a credit card offer from your bank.
In the startup world, the stakes are obviously a bit higher, and the debt amounts are a whole lot bigger.
Though the majority of companies in today’s startup ecosystem opt to take the equity financing route (the main alternative to debt financing), this is still an advantageous and sometimes preferable option, particularly if you’re reluctant to give up partial ownership in your enterprise.
How Does Debt Financing Work?
To illustrate, let’s take the simplest example of debt financing: the loan.
Imagine you’ve decided to pursue the debt financing route, and you need to raise $500k to get your idea up and running and to a point where you’d see a viable route to accessing seed funding.
You apply for a business loan at your bank and get approved for the required amount.
Now you’ve got $500k in cash with which to grow your business. But, of course, you’ve got some financial obligations to meet.
Your loan will include repayment terms, meaning you’ll need to pay it back in monthly or quarterly installments, including interest.
There are a lot of variations here, such as:
- The interest rate you receive
- The term of the loan (how long you have to pay it back over)
- The amount of time before repayments begin
In addition, your debt financing arrangement will include certain stipulations as to your obligations around the debt should your company go under and your ability to repay the debt dissolves (for example, the financier may receive a preferential stake in remaining assets in the event that your business liquidates).
Common Sources of Debt Financing
When we think of debt financing, most of us think of obtaining a loan from our bank.
Though this is certainly a common route, there are plenty of other ways to obtain debt financing.
Some investors, for example, prefer to engage in debt financing arrangements rather than trading capital for equity in your company.
The major sources of debt financing to consider include:
- Banks and other financial institutions
- Credit unions
- Angel investors
- Venture capitalists
- Building societies
- Finance companies
- Peer-to-peer lending
- Credit card companies
In some cases, you might even be able to access debt financing through friends and family.
Pros and Cons of Debt Financing
Compared to other forms of obtaining capital, debt financing offers some pretty significant benefits. Like most things in life, though, it comes with a couple of important drawbacks.
Pro: You Retain Complete Ownership of Your Company
This is a big one.
Unlike equity financing (where you’re receiving capital in exchange for some of the equity in your business), debt financing allows you to retain complete ownership.
This means all of the decisions regarding company direction remain yours.
Con: You Have to Pay Back the Money You Borrow (Plus Interest)
The major problem with debt financing is the fact that you do need to pay back the amount you borrow.
With equity financing, you’re giving up a stake in your company, and so the investor assumes that risk (and the potential gain should your business succeed), meaning there is no obligation to repay that money.
Debt financing, however, is more like a loan. You retain complete ownership, but you need to pay back what you borrow, including interest.
Depending on the terms of your agreement, this may include recourse for the financier to seize assets in the event that your company is no longer able to meet those obligations.
Pro: You’ll Continue Earning 100% of Your Startup’s Profits
When you give up equity, you also give up a percentage of your company’s profits.
Because debt financing doesn’t involve equity, and you retain complete ownership, any profits you make (and hopefully there will be plenty!) will continue to be yours to either draw on or reinvest in the business.
Con: You’re Committing to Another Outgoing Expense
Cash flow is perhaps the most important factor to consider in startup operation, particularly in the early years.
When you obtain financing, you’re committing to yet another regular expense, meaning you’ll need to ensure your revenue streams grow to meet this obligation.
Pro: There May Be Some Tax Benefits
In many states and countries, the interest portion of your debt repayments is tax-deductible, meaning you’ll be able to offset this expense against your revenue and reduce your tax bill.
Of course, you’ll need to balance this advantage with the obvious downside of having to pay that interest in the first place.
Con: There Is Less Opportunity to Leverage the Network of Your Financier
With financing arrangements like investor funding, you’re often able to tap into the experience, expertise, and network of the person or organization you’re getting capital from.
While this may be true in debt financing arrangements, such agreements are typically less involved.
Also, since the primary source of debt financing is from a bank or other lending institution, the likelihood that you’ll be able to take advantage of this benefit is inherently lower.
Pro: Your Payment Obligations Are Predictable
When you engage in debt financing, you’ll sign a contract that stipulates the terms of the agreement, including repayment dates and amounts.
That means you have a calendar for your financial obligations from the get-go, making things like forecasting and financial planning much easier (and more reliable).
Con: It May Be Challenging to Obtain
Like any kind of funding, debt financing can be difficult to obtain.
However, when you’re obtaining capital from say, an angel investor, your primary requirement is to convince them that the idea is sound. If you can get them on board, then they’re willing to assume the risk because they believe your company will succeed.
With debt financing arrangements, it’s more about your ability to repay the loan amount. So, if your company is still very new and not making much (or any) revenue right now, debt financing might prove a tricky route to pursue.
How to Decide If Debt Financing Is Right for Your Business
Still not sure if debt financing is the right move for your business?
Here are a few questions to consider:
What’s Your Cash Flow Situation?
If you obtain debt financing, you’ll need to meet strict repayment obligations.
As such, it’s important that your company is cash-flow positive, meaning you’re making more each month than you’re spending (or at least you’re confident that this will be the case in the very near future).
Is Control of the Company Important to You?
If retaining 100% ownership of your business is vital, then debt financing might be the only option outside of bootstrapping.
How Important Is Access to Investor Networks?
As we discussed earlier, equity financing arrangements often provide access to the connections and expertise your investor has.
While this may be true in some debt financing agreements, it’s less common.
If this kind of access is important to you (perhaps this is your first startup and you could use some advice and valuable connections), then consider whether the type of debt financing arrangement you pursue is going to be able to assist here.
What Are Your Immediate Options?
Is debt financing an option for you right now, based on financial requirements? Would you be able to receive funding from a venture capitalist if you decided to take that route?
In some cases, the most immediate option is the best option, particularly if you need to be agile to capitalize on a current market trend.
Debt Financing vs. Equity Financing
Psst. If you’re looking for a more in-depth rundown on equity financing, check out our full article here.
Otherwise, let’s just cover the basics.
Debt financing is an arrangement where you receive capital from a financier (typically a financial institution, though investors do engage in debt financing), and in exchange, you’ll pay back the principal amount, plus interest, in regular installments.
Equity financing is an arrangement where you receive capital in exchange for equity (partial ownership) in your company. For example, the investor may receive a 20% stake in your business for a $2m capital investment.
|Debt Financing||Equity Financing|
|Ownership||You retain ownership of the company||You give up partial ownership of the company|
|Repayment||Requirement to pay back the debt||No requirement|
|Tax||Interest is tax-deductible||No tax benefits|
|Networks||Usually provided by financial institutions, with no opportunity to expand your network||Often includes the ability to expand your network|
|Decision-making||No consultation required||Will need to consult with your investors|
Planning to Pursue Debt Financing?
If you’ve decided, after digesting all of this information and weighing up the pros and cons, that debt financing is the best path forward for your business, then your next step is to get your financial records in order.
Lenders will want to know about your revenue model, your traction in the market, your plan for growth, and, above all, your ability to meet repayment obligations.