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A primer on debt-funding options for startups

Posted by Shivali Anand

August 19, 2022

Managing complicated financial situations is critical for businesses looking to discover market opportunities, delve into expansion and boost exports. With a rising market of alternative financing choices offering a plethora of capital sources in addition to traditional bank loans, it can be challenging to determine whether funding is appropriate for a particular company, not to mention understanding the related financial jargon.

Typically, there are three different types of funding available for businesses: equity, mezzanine and debt funding. This article will give you an overview of debt funding, including pros and cons, and the various forms of debt funding.

What is debt funding?

Debt funding, also called debt financing or debt lending, is a way for a business to get money through borrowing without giving up equity. It entails taking a loan from a third party and repaying it in regular monthly installments with interest over an agreed-upon time frame. The financial institution from which you obtained the debt will determine how quickly you are required to repay the money.

Debt funding for startups can come in many forms, and depending on the type and source of funding, it may also coexist with equity investments in your business. Debt can be used to help all shareholders, including founders and investors, fund the business's growth without dissolving the existing shareholders' ownership stance.

Most startups in their early phases have neither the established cash flow nor the readily available assets to secure loans from traditional lenders like banks and financial institutions. Through the conditions of their investment instrument, early-stage equity investors typically restrict the type and amount of debt a firm may carry, mostly done for various reasons, including the following:

• Investors don't want their debt funding to be used to pay off your startup's past debts.

• They are concerned that your company's current financial strategy does not provide enough assurance to commit to future payments of principal and interest.

• Debt forms that demand pledging intellectual property as collateral for a loan are not preferred by investors.

Venture capitalists consider IP to be an asset that can either be sold or licensed to offer some financial return on their investment in an adverse scenario where the business cannot carry out its vision. IP can be licensed to other companies as well.

However, startups in their later stages usually have more options for adding debt funding from different sources because they have cash flow from operations that they can use to pay back the capital with interest on their debt.

Understanding the benefits and downsides of debt funding

Benefits of debt funding Drawbacks of debt funding
It is a broad and flexible category that lets you choose the right financing option for your needs. Depending on your finances and credit score, it can be hard to get the loan you want.
You would be able to manage the actual cash flow and observe how the capital is spent. Interest payments on debt must be made to lenders regardless of the revenue you make.
You don’t have to give up the operational and strategic management of the firm to convince investors. The lender may confiscate business assets if you default on a loan.
Interest and principal on corporate loans are frequently deductible business costs, which is a significant tax benefit. It can be a risky financing option for businesses with inconsistent cash flow.

Reasons companies may choose debt funding

• When a firm receives a loan, the owner's equity is not reduced since the lender gets no ownership interest in the company.

• Debt might be a cheaper way to fund expansion if the company is expanding rapidly.

• As the debt principal is repaid, leveraging the firm through debt is a continuous method for enhancing shareholder equity.

• The interest paid on debt is often a tax-deductible business expense, making it a desirable option.

• The process of securing debt funding is often simpler than that of obtaining shareholder consent.

• Numerous lenders specialize in industries, company stages, and asset kinds.

• A debt is canceled after it is paid in full.

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The viewpoint of a borrower

Although the interest rate on debt is an ongoing expense, the debt itself poses a considerable potential risk to the organization's continued existence. Lenders can foreclose if interest and principal aren't paid on time, forcing the company to shut down and sell off its assets. However, issuing stock results in future gains being shared with investors but poses less risk to the company's survival if profitability declines.

When a company's assets are sold, the priority of its debt holders is given before the company's equity holders. This means that the profits from any asset sale, whether compelled or voluntary, will be split less evenly. Lenders are not obligated to restructure a non-performing loan, but if they do, they will likely agree to withhold, which would extend the term of the debt and may even result in interest accruing to the lenders, although at a higher rate.

Types of debt funding

Many kinds of debt funding are available for startups, but below are some that are most frequently opted for:

1. Short-term and long-term loans:

The average payback time for short-term debt funding is less than a year. Long-term business loans often provide significantly more generous payback terms, making them ideal for financing long-term investments for things like machinery and expanded office space. In addition, higher payrolls can't be made with short-term funding.

2. Revenue-based financing:

This is a more flexible type of debt financing in which payments are based on a percentage of monthly revenue. Revenue-based financing can be helpful for subscription-based businesses or businesses that want to grow quickly. Monthly payments are variable to account for company revenue fluctuations.

3. Monthly recurring revenue:

This type of debt financing is most common for SaaS companies with subscription or recurring revenue streams. As a result, the company's monthly revenue is used as collateral for loans. On average, lenders may lend you between 3 and 5 times your MRR.

4. Cash flow lending by non-bank institutions:

When evaluating firms for traditional loans, banks consider credit, investment, assets and profit. Banks try to minimize risk by figuring out if you will be able to pay them back. Cash flow loans from non-bank lenders operate similarly, although approval is based on a much-reduced number of criteria. Financial institutions look at a company's cash flow rather than its assets for loan eligibility.

5. Loan from family or friends:

The initial funding of many successful firms comes from close personal connections. These loans often come with far more flexible conditions, providing startups their first exposure to real-world finance and investments. However, before taking a family loan, businesses should consider their financial situation seriously. Startups should get into family loans with a solid plan to repay family and friends investors to avoid risks and challenges.

6. Peer-to-peer lending:

The proliferation of crowdfunding and loan matching platforms like Prosper, Kickstarter, and GoFundMe has given rise to peer-to-peer lending. It connects people needing financial assistance with individual investors who are confident in the company's ability to deliver such services. This approach is best for small startups comfortable with disclosing their financial information publicly.

7. Bonds:

Companies, governments, and other entities can raise money by selling bonds to investors, who lend the issuer the money they need to repay the loan. A bond is issued by a firm that promises to repay the original investment plus interest at maturity. Bonds can be secured or unsecured, which means they are either backed by collateral or not. Unlike stocks, a bond's characteristics are set by an indenture, an agreement between the two parties.

8. Credit card:

Using credit cards has long been a way for business owners to invest in their businesses and establish credibility with potential lenders. Since the buyer's personal credit is used as collateral for the card, a small business doesn't need to have a lengthy credit history of applying for and using a credit card. Many have attractive starting deals, such as zero annual percentage rate for the first year.

The bottom line

Most businesses will require some sort of debt funding. To expand, companies need money to spend on aspects like human capital, infrastructure and product development. Startups and small enterprises need access to cash to purchase essentials like machinery, tools, supplies, inventory and even physical space. The primary issue with debt financing is ensuring that the borrower will have enough income to meet the loan's principal and interest payments.

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Shivali Anand
Shivali Anand

Shivali Anand is a content developer at Escalon Business Services. Her expertise lies in creating consistent and relevant B2B marketing, SEO and social media content. She is armed with a PG Diploma in English Journalism from the IIMC Dhenkanal, Odisha. After starting as a travel writer, she embarked upon a career as a copyeditor, news content specialist, and researcher across organizations including Ministry of MSME, Vaco Binary Semantics LLP, Doordarshan News, and New Delhi Times.

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