What is debt financing?
As businesses grow, they have to bring in funding from somewhere. Unless the founders are able to bootstrap, then looking for an external financing option is essential, and even if bootstrapping is the first choice, companies usually (hopefully!) grow big enough that founders can’t maintain them forever.
So what choices do you have? Equity financing, where you obtain working capital in return for a share of the business, is a great choice when you’re a startup and still have to prove your business idea and model. You may have to give away a large stake, but the risks to you are minimal if the ideas fail.
Debt financing is the other option and when most people think of debt, they picture a traditional bank loan. But there are many alternative debt financing options available. The number of federal regulations imposed on traditional financial institutions in the last couple of decades have been increasing, and many startups or companies that are not brick and mortar fail to meet those terms. What options are available for them?
Types of debt finance
Debt finance is the opposite of equity funding, where capital is provided in return for a share in the company. With debt, capital is loaned to the company on the condition it is repaid and often with conditions attached, including payment of interest.
The main benefit for debt financing for a company is that the amount owed is certain, and is non-dilutive. As a founder looking to maintain control while growing a startup, this non-dilutive option can make debt financing much more attractive.
Installment loans are ones where debt is paid back using monthly payments over a period of time until the full amount owed is paid off. This is where traditional bank debt sits, and lenders will often look at the totality of the business to assess whether they’re willing to lend.
That means that startups, businesses with either a bad line of credit or no credit score, and those businesses that are asset-light will usually struggle to obtain financing.
These kinds of loans can also include ones where the collateral used to ‘insure’ the loan comes from a founder, such as a home equity loan, a personal loan, or a family-and-friends loan.
It’s also possible to obtain some government-backed loans, for example from the Small Business Administration (SBA). While the terms on these can be quite favorable, they usually come with a lot of red tape and can take a long time to put into place, so they aren’t a great option if you need capital fast or with a specific purpose in mind.
If you need to purchase assets, then equipment loans can be a useful way to pay for those, by using the piece of equipment as collateral.
Peer-to-peer lending (P2P), such as Kickstarter and GoFundMe is another option that has become more common in recent years, and can yield large amounts, but there is a risk that you don’t fully fund your campaign, and you usually need to be comfortable disclosing your financial information in public.
Credit debt finance
Obtaining credit for your business is another form of debt financing that can be useful and doesn’t usually come with as many regulations as a traditional bank loan, but generally interest rates are high and payback terms are often strict and onerous if you break them.
While credit may be part of your debt financing strategy, it’s unlikely to be the only form of financing you rely on.
Credit cards and home equity lines of credit (HILOC) are both based on the personal finances or assets of the founders, and therefore may be available to startups or businesses who can’t meet the requirements of other lenders in relation to loans.
Interest on business credit cards can be as high as 30% if you don’t pay them off in full each month. A business line of credit is another option that does not require a founder to personally guarantee it, but repayment terms, like with credit cards, are often short.
Recurring revenue funding
A merchant cash advance (MCA) is probably the most expensive form of debt financing available at the moment. First thing to note is that it’s an advance, not a loan, based on the future credit card sales of a business. These usually provide a fast injection of capital into a business, but the interest rates frequently sit in the 20% - 40% range. The holdback amount is what the business pays every day, based on a percentage of their receivables.
Growth financing (or as we like to call it at Capchase, programmatic financing) is a newer form of non-dilutive lending that allows SaaS companies and recurring revenue businesses to access capital on terms that feel similar to those offered through banks and more traditional lenders, but using anticipated growth of monthly recurring revenue (MRR) rather than assets or credit history.
This can be a great way to agree a loan amount based on the likely growth of the business, but not have to drawdown all the funds immediately, meaning you only pay interest on funds as and when you use them.
The other bonus is that the available capital is based on a percentage of your ARR and therefore will grow as you do, so you don’t need to continually renegotiate terms. Generally, this type of financing is very efficient to fund once accounting and bank systems are synced between the lender and the company looking to borrow.
While this kind of financing is available for businesses at an earlier stage than traditional debt funding, companies usually still need to have been in business for at least 6 months, have consistent recurring revenue, and a low churn rate.
Benefits of debt financing
The main benefit of debt financing over equity is the most obvious - you don’t give up control of your business. For early startups it may seem easy to offer a share of the company in return for an injection of cash, but as companies prove their business case and start to grow fast, the potential value of the equity becomes more important. Equity lenders take a big risk ‘betting’ on startups, and when the risk pays off, they are rewarded handsomely for it.
Debt financing can also be a great flexible option when working outside the traditional lenders that are bound by federal regulations and interest rates, which can be high and defined (meaning that provided you follow the terms of the loan, you can quantify exactly how much you have to payback over time).
Drawbacks of debt financing
Lenders have a variety of ways of assessing whether a business qualifies for a loan, and that often means that startups and emerging industries can be left out, even when they have a growing and sustainable business model. SaaS companies, for example, can have strong, consistent recurring revenue, but little in the way of physical assets that a traditional bank would look to when offering a loan. That means there’s a vital need for searching out alternative types of financing that cater to their way of doing business in SaaS.
While debt financing provides a specific repayment amount and shorter repayment terms than equity financing, interest rates can be high, and default terms onerous. Lenders will often look to founders for personal guarantees, which means the business is not completely standing on its own.
Taking control and obtaining financing on your own terms
As a growing business, there are so many different types of financing you can obtain, from equity to traditional bank loans, to alternative types of non-dilutive financing that are based on your recurring revenue.
Make sure you’re aware of all your options, compare terms, and consider what your business will (hopefully) look like a few months or years from now and how you want to be using financing not just now, but in the future.
To learn more about what your runway could look like with growth financing, check out our runway calculator.