3 Type Debt Financing for Startups

What is debt financing for startups?

Startups may get debt financing from an investor or lender, such as a bank, for a set period of time. Debt financing is similar to a regular loan in that it involves a startup borrowing money and then paying interest on it.

How does debt financing compare to equity financing?

Debt financing is, to put it simply, the complete opposite of private equity investment, or venture capital funding for early stage firms, and it is crucial for a startup’s success. Debt financing is one of the most common forms of financing.

In contrast, the fundamental benefit of equity financing is that there is no requirement to pay back the money obtained through it—instead, the cost of the shares is reimbursed at a later time. In an equity financing arrangement, the entrepreneur essentially sells a share of the business to raise money. The investor frequently has a say in future corporate decisions in addition to having a portion of ownership.

Instead, while using debt financing, borrowers are not required to give up any of their ownership or equity.As long as payments on the debt financing are made in accordance with the financing contract, the debt financing functions as credit, and the lender has no involvement in internal business decisions.

Why consider debt financing for startups?

Debt financing’s main objective is to provide entrepreneurs more time between rounds of equity funding. We’ve included some typical debt financing benefits and drawbacks below so you can make the best choice for your company and current circumstances.

Advantages Of Debt Financing for Startups

What advantages does debt funding offer for startups? Consider it a feasible source of finance for a number of reasons:

• No further dilution of ownership: Contrary to equity financing, debt financing does not deprive the startup’s shareholders of any equity. This is a significant benefit for entrepreneurs who no longer want to dilute their equity and prefer to keep some of it.

• Full control over decisions: The lender has no control over business decisions because they do not own any equity in the company. The degree of control that the startup had prior to loan financing remains largely the same. Without contacting the lender, the business can choose how it wants to spend the money. Startups sometimes use this kind of investment to finish a particular campaign or project, buy inventory or equipment, or quicken growth for a certain effort.
• Defined period of time:Debt financing has a predetermined tenure, unlike equity funding, which might be considered everlasting. After a predetermined period of time, the startup is required to repay the loan, at which point the lender’s involvement with the startup is over. Usually, agreements have definite start and end dates. Additionally, unlike equity financing, which only occurs in particular rounds, debt financing is available to entrepreneurs at any time.

Disadvantages Of Debt Financing for Startups

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: The fact that debt financing is difficult to get may be its largest disadvantage. Before approving a startup for financing, the majority of banks will want proof of its financial stability and a list of its assets. Startups frequently lack the tangible assets needed for bank funding.
• Difficult to maintain: If a lender does approve a firm for debt funding, the startup will have to adhere to a set of loan covenants. Usually, to continue receiving funding, the business must provide the lender with specified computations and detailed financial reports. The lender may increase the interest rate or take remedial action against a startup if it fails to adhere to the loan covenants. This can involve demanding that the startup repay the financing. Startups typically rely on knowledgeable finance professionals to comprehend loan covenants and develop reports to satisfy the criteria.
• Required to pay back: Debt funding, in contrast to equity financing, entails a deadline for repayment by the startup. The lender may take corrective action, such as seizing ownership of the business or its assets, if a startup is unable to make payments. Typically, debt funding is regarded as “senior” debt, which means it has priority over other debt and is responsible for repayment before any other commitments.

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 — Repayment terms for short-term debt financing are frequently less than a year. Long-term business loans have substantially longer repayment terms, which can be advantageous for bigger, longer-term projects within your organization such significant equipment upgrades, real estate purchases, and an expanding payroll.

• Monthly Recurring Revenue (MRR) — Most SaaS businesses with some sort of subscription model or recurring income stream will use this type of debt financing. Therefore, loans are determined by the company’s monthly revenue. Lenders will often offer financing that is between three and five times your MRR.‍
• Revenue-based Financing —Payments are based on a proportion of monthly income in this more adaptable type of debt financing, which can also be advantageous for businesses with subscription-based business models or those with high growth expectations. Without requiring ownership, the flexible monthly payments are made to account for the revenue of the company’s ups and downs.