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Debt funding for startups: The pros, cons and key considerations
Posted by Grace Townsley
September 11, 2023
Every new business venture needs adequate financing to get off the ground and grow. Many entrepreneurs are familiar with bootstrapping — financing your business with your own savings — and equity financing, where a piece of your company is exchanged for capital. But there is a third financing method worth considering: Debt financing for startups.
This financing method, which includes multiple forms of funding, like venture debt financing, allows startups to push through the early growth stages and build a stable financial foundation for their venture.
What is debt financing for startups?
In the early stages of a startup’s growth, capital is the lifeline that keeps your business afloat — especially if you have yet to reach profitability. One effective way to raise capital without losing control of your venture is through debt funding for startups.
At its core, debt financing involves borrowing money from external sources, with the promise to return it within an agreed upon timeframe — and often with interest. Unlike equity financing, where you must trade a share of ownership in your business for the infusion of cash, debt financing gives you the freedom to raise funds without losing significant control or ownership.
One important kind of debt financing is venture debt financing
Venture debt funding is one of the most sought-after forms of funding for startups because it offers the benefits of a traditional bank loan, often with fewer restrictions and less paperwork. In 2022, venture debt lenders poured nearly $30 billion of funding through November 30 into the startup ecosystem, giving hundreds of startups access to the capital they need to grow.
Venture debt financing is provided by specialized lenders to startups that are usually backed by venture capital investors. Though, a startup doesn’t have to be venture backed to qualify for this beneficial form of funding. This form of financing is another way to secure the capital you need to grow, without further diluting your equity. Venture debt financing is often used to extend your startup’s cash runway, fund R&D or expansion initiatives, or help your startup make it to the next round of funding.
Why should startups consider debt financing?
The financing options you choose have a direct and long-term impact on the growth and stability of your startup. Debt financing can be one viable way to get the cash infusion you need without hurting your potential growth for a few strategic reasons:
1. Debt financing allows you to stay in control
One of the best benefits of debt financing for startups is your ability to retain full ownership and control over your venture. Unlike equity financing, where you must relinquish a portion of your ownership, debt financing allows entrepreneurs to maintain their full stake in the company and autonomy over its trajectory, as long as they meet the financing terms.
In some cities and states, the interest paid on this form of business financing is tax-deductible, which can lower your startup’s tax liability. This financial benefit can make debt financing a more cost-effective fundraising option for some startups, when compared to bootstrapping or equity financing.
3. Debt financing has a set starting and ending date
Unless otherwise negotiated, equity financing is a permanent funding arrangement, with shareholders owning a portion of the company throughout its growth cycle. But debt financing has a set starting and ending date, giving startup leaders greater control over their company. Plus, debt financing can be pursued at any point in your company’s launch and maturation, not just during certain financing rounds or growth stages.
What are the drawbacks of debt financing for startups?
Debt financing can be one of the most beneficial funding options for startups across every industry. But this form of funding is not without its drawbacks:
1. Repayment obligations
Debt financing must be repaid in periodic installments, with interest added. For startups struggling to bring in stable revenue, these repayments can cause a financial strain. The obligation to meet repayment obligations — or risk paying high penalties or losing some control over your startup — can increase the financial and cash flow risks of this funding form.
2. High interest rates
Depending on your lender, creditworthiness and market conditions, interest rates on debt financing can be higher than other forms of funding. High interest rates increase the overall cost of your capital, which can make debt financing a more expensive growth option in the long run.
3. Limited flexibility due to warrants
Some debt financing lenders ask for warrants in their funding terms. Warrants are special terms that allow the lender to purchase company equity at a predetermined price. This gives the lender the opportunity to profit from the growth and success of the company they’re funding, but it does require the company to give up a bit of ownership in the form of equity shares. Warrants also add to the paperwork burden, which can make executing debt financing more complicated.
Should your startup leverage debt financing?
Debt financing offers the benefits of retained ownership, tax deductions and clear repayment terms. But it can also be complicated to secure and the repayment obligations can restrict your cash flow.
As a business owner, it’s essential to evaluate every funding option available before you apply, choosing the one that meets your startup’s needs and growth stage. Ultimately, the decision to leverage debt financing, bootstrapping, equity funding or another option should be carefully calculated based on your long-term business goals.
Want more? Since 2006, Escalon has helped thousands of startups grow faster with our back-office solutions for accounting, HR, payroll, taxes, insurance and recruiting — and we can help yours too. Talk to an expert today.
This material has been prepared for informational purposes only. Escalon and its affiliates are not providing tax, legal or accounting advice in this article. If you would like to engage with Escalon, please contact ushere.
As a professional copywriter in the finance and B2B space, Grace Townsley offers small business leaders big insights—one precisely chosen word at a time. Let's connect!