In 2021, Boast.ai, a company that integrates into business systems and automatically locates R&D tax benefits, revealed that Brevet Capital provided a $100 million credit line. Again, prop-tech startup States Title reported that HSCM Bermuda, which had already invested in the company, closed on a $150 million loan transaction. Lloyed Lobo, co-founder and president at Boast.ai informed TechCrunch in an email that equity is expensive plus the stress of bringing on partners that you have to be answerable to in your company. 

For States Title, CEO Max Simkoff remarked that debt is finite and for States, it was a good thing. Explaining further, he added that States Title intends to use the funds to help it restructure its cap table, expand into new markets, drive new product traction, and acquire and serve clients. What does this mean for these startups? Firstly, by taking on debt rather than giving away equity, they maintained full control of their company and its strategic direction. This allowed the founding team to execute their vision without external interference. 

Furthermore, with the injected funds, these companies could accelerate their research and development efforts, enhance their platform's features, and amplify their marketing initiatives, resulting in an exponential increase in customer acquisition and revenue growth. In this article, I will explain the meaning of debt funding, the various types available, and essential considerations for startup founders. By the end of this article, you'll not only understand the benefits and risks associated with debt funding but also gain valuable insights on how to choose the right debt funding strategy for your startup's growth and prosperity.

What is Dept Funding?

Debt funding refers to a financial arrangement in which a company or individual borrows money from a lender with the agreement to repay the borrowed amount, along with interest, over a specified period. This money often comes from external sources, such as banks, financial institutions, or alternative lenders. To meet various business needs, including working capital, expansion, equipment purchase, or debt consolidation.The easiest way to understand debt funding is to see it like you are borrowing money for your business. Instead of giving away a piece of your startup as a share to investors, you take on a loan that you'll pay back with time.  This method of fundraising can be a game-changer for startups. Why? Because it gives you the freedom to use the funds as you see fit.

You can invest in product development, hire top talent, ramp up marketing efforts, or anything else that will propel your startup forward. Unlike equity financing, where ownership shares are sold in exchange for capital, debt funding involves taking on a loan or issuing debt instruments such as bonds or promissory notes. The borrower is obligated to make regular interest payments and repay the principal amount within a predetermined timeframe. Debt funding usually involves a contractual agreement outlining the loan terms, including the interest rate, repayment schedule, and any collateral or personal guarantees required. It allows businesses to access capital without diluting ownership or giving up equity shares. While the lender earns interest on the loan as a return on their investment.

Pros and Cons of Dept Funding

Debt funding offers several advantages for startups. 

First and foremost, it allows you to retain full ownership and control of your business. Unlike equity funding, where you give away a piece of your company, debt funding lets you keep the reins in your hands. You get to call the shots and execute your vision without external interference. Another perk is flexibility. With debt funding, you have the freedom to use the funds as you see fit. Whether you want to invest in expanding your product line, scaling your operations, or boosting your marketing efforts, it's your call. You're not beholden to investors' expectations or demands.

Additionally, debt funding can be more accessible and faster to secure compared to equity funding. Because lenders focus on the financial health and prospects of your business. So if you have a solid revenue stream or valuable assets, you stand a good chance of getting approved. Plus, the process tends to be quicker, allowing you to access the funds when you need them most.

Debt funding has its downsides too. 

The primary concern is the obligation to repay the loan, often with interest. As falling behind on repayments can put your business at risk and strain your cash flow. Another potential drawback is the cost of borrowing. Interest rates vary based on factors such as your creditworthiness, collateral, and the lender you choose. Higher interest rates can eat into your profits and impact your bottom line. Lastly, taking on debt introduces a level of financial risk. If your business faces unexpected challenges or doesn't generate enough revenue to cover the repayments, it can put a strain on your operations.

Types of Debt Funding

• Revenue-Based Financing

Revenue-based financing is a type of debt funding where loan repayments are tied to a percentage of your company's revenue. Instead of fixed monthly payments, the repayment amount adjusts based on how well your business is doing. When your sales are thriving, you'll pay back a higher percentage, but during slower periods, the repayment amount decreases. This flexible approach aligns with your business's cash flow and allows you to manage repayments more comfortably.

• MRR (Monthly Recurring Revenue)

MRR loans are tailored for startups that have a subscription-based business model. Lenders assess your monthly recurring revenue—the predictable and consistent income generated from your subscribers. They then offer you a loan based on a percentage of your MRR. As your subscriber base grows and your MRR increases, you become eligible for higher loan amounts. It's like having a loan that grows alongside your business's recurring revenue stream.

• Venture Debt

Venture debt is a form of debt funding specifically designed for high-growth startups. Unlike traditional loans, venture debt offers larger loan amounts to fuel ambitious expansion plans. Specialized lenders who understand the startup ecosystem provide this type of financing.  Venture debt often comes with more flexible repayment terms and might include options like warrants or equity kickers, which provide additional benefits to lenders. It's an attractive option for startups looking to scale rapidly and take advantage of market opportunities.

• Convertible Debt

Convertible debt combines debt financing with the potential for converting the loan into equity in the future. It allows startups to borrow money as they would with a traditional loan. But with the added possibility of converting that debt into ownership shares at a later stage. Usually during a future funding round or exit event.  This can be advantageous for both the startup and the lender, as it provides the startup with immediate funds while giving the lender the potential for an equity stake in the company if it achieves significant growth. A venture capital firm, an angel investor, or a loan lender is always the one to offer this kind of debt funding.

What to know about debt funding

1. How Startup Founders Can Get Debt Funding

Startup founders have several avenues to explore when seeking debt funding. One option is approaching traditional lenders such as banks or credit unions. These established financial institutions offer loans to startups based on various factors. They only consider the startup's creditworthiness, business plan, collateral, and the founder's personal credit history. Traditional lenders may have more stringent requirements. But they often offer lower interest rates and longer repayment terms.

Alternatively, startup founders can turn to online lending platforms, crowdfunding websites, and specialized fintech companies. Alternative lenders offer more flexibility, faster approval processes, and cater specifically to the needs of startups. While interest rates from alternative lenders may be slightly higher, they can be a viable option for startups with limited credit history or unconventional business models.

2. Interest Rates in Debt Funding

Interest rates in debt funding can vary based on many factors. Traditional lenders offer lower interest rates. Especially if the startup has a solid credit profile, substantial collateral, and a proven track record. Startups with strong financials and a compelling business plan may negotiate more favorable rates. On the other hand, alternative lenders might have slightly higher interest rates to compensate for the higher risk they assume by lending to startups.

Therefore, startup founders should always compare interest rates from different lenders and consider the overall cost of borrowing. Factors such as loan duration, repayment terms, and market conditions can also influence interest rates. By thoroughly researching and exploring options, startups can find lenders offering competitive rates that align with their financial capabilities.

3. Secured vs. Unsecured Debts

Debt funding can be categorized into two main types: secured and unsecured debts. Secured debts require collateral, which is an asset that the lender can claim if the borrower defaults on the loan. For example, a lender may ask a startup to pledge their inventory, equipment, or real estate as collateral. Startups offer a form of security to the lender through the collateral they provide. Which often results in lower interest rates and higher borrowing limits.

In contrast, unsecured debts do not require collateral but are based on the startup's creditworthiness and ability to repay. Without collateral, lenders rely heavily on the startup's financial health and credit history to determine the loan terms. Unsecured debts generally have higher interest rates since the lender assumes more risk in the absence of collateral.

4. Resolver vs. Term Loan

When considering debt funding, startup founders may come across two common types of loans: resolver loans and term loans. A resolver loan, also known as a revolving line of credit, provides a predetermined credit limit that the startup can borrow against as needed.  It operates similarly to a credit card, allowing flexibility in borrowing and repaying multiple times. Resolver loans are beneficial for startups that require ongoing access to capital or face unpredictable funding needs. They provide the freedom to withdraw funds when necessary and make repayments accordingly.

On the other hand, a term loan offers a fixed amount of funds upfront. Which the startup repays over a specified term with regular installments. Term loans are suitable for specific one-time investments, such as purchasing equipment, expanding operations, or funding a major project. Startups receive the entire loan amount at the beginning and then make regular payments over the agreed-upon term.

5. Traditional Lenders vs. Alternative Lenders

Startup founders have the option to seek debt funding from traditional lenders or alternative lenders. Traditional lenders include banks, credit unions, and other well-established financial institutions. These lenders offer a wide range of financial products and services, including loans. Working with traditional lenders can provide stability and access to a variety of financial resources. However, the application process can be lengthy, and approval criteria may be stricter.

Alternative lenders include online lenders, crowdfunding platforms, peer-to-peer lending networks, and fintech companies. These lenders leverage technology and innovative approaches to streamline the lending process and make it more accessible for startups. Alternative lenders often have a more flexible approach to underwriting and can cater specifically to the unique needs of startups. They may be more willing to take on higher risks associated with startups that lack established credit history or collateral.

Startups can benefit from considering both traditional and alternative lenders. Traditional lenders provide stability and long-term relationships. While alternative lenders offer convenience, speed, and tailored solutions.  

Is debt funding right for startups?

If you read to this point, you may have been nursing the question “Is debt funding right for startups?”  Without a doubt, debt funding is a viable option for startups.  But it's important to carefully consider its advantages and potential drawbacks ( as earlier discussed) before making a decision. Also, an understanding of some key factors will help us assess whether debt funding is right for startups. First on the list is:

Financial Flexibility: Debt funding allows startups to access capital without diluting ownership or giving up equity. This means that founders maintain control and strategic decision-making power over their business. Upon securing a loan, startups fund their operations, invest in growth initiatives, acquire assets, or manage cash flow gaps. For example, the popular ride-sharing company Uber initially relied on debt financing to expand its services globally. Including the two startups - Boast.ai and States Titles - cited in our introduction.

Interest and Repayment: Debt funding comes with interest rates that can impact the overall cost of borrowing. Startups need to assess their ability to generate sufficient cash flow to meet interest payments and repay the principal amount.

Risk and Creditworthiness: Startups with a limited credit history or uncertain revenue streams may find it challenging to secure debt funding. As traditional lenders often require a track record of financial stability, collateral, and personal guarantees. 

However, alternative lenders and specialized fintech companies have emerged to cater specifically to the needs of startups. Wherefore they offer more flexible lending options based on different criteria. For instance, Kabbage, an online lending platform, provides working capital loans to small businesses, including startups. They utilize alternative data sources and technology to assess creditworthiness. Which makes it easier for startups to access debt funding based on their unique circumstances.

‍Growth Potential and Return on Investment: Startups should evaluate their growth potential and assess whether the benefits of debt funding outweigh the financial costs. Debt funding can accelerate growth by enabling startups to seize market opportunities, invest in marketing campaigns, scale operations, or expand into new markets. For instance, aside from the three startups we've cited so far, Warby Parker, an online eyewear retailer also raised debt funding to fuel their expansion plans. From this, they opened new retail stores, invested in product development, and enhanced their e-commerce platform. 

Cash Flow Management: Startups must carefully manage their cash flow to ensure they can meet debt obligations. Since irregular or unpredictable revenue streams can pose challenges when it comes to making regular interest and principal payments. Startups should conduct thorough financial projections and consider potential market fluctuations and seasonal variations. To assess their ability to manage debt payments effectively.

So is debt funding right for startups? Yes. But once again, the suitability of debt funding for startups depends on factors like financial flexibility, interest rates, risk tolerance, growth potential, and cash flow management. While some startups have successfully utilized debt funding to fuel their growth and achieve remarkable success, conducting a thorough analysis, and assessing individual circumstances before making a decision makes it a favorable funding option for startups. 

Remember, finding the right balance between debt funding and equity financing is almost compulsory (if not so) for sustainable growth and long-term success.

How to choose the right debt funding for your startup

Here are some key considerations to help you navigate this process and make an informed choice:

Assess Your Funding Needs: Begin by understanding your specific funding requirements. Determine the amount of capital you need. The purpose of the funds, and the timeline for repayment. This clarity will help you identify the most suitable debt funding options that align with your business goals.

Evaluate Your Financial Situation: Assess your startup's financial health, including revenue streams, cash flow projections, and existing debt obligations. Lenders will evaluate your creditworthiness. Hence, having a clear understanding of your financial position.

is paramount. Calculate your debt service coverage ratio (DSCR), which compares your cash flow to your debt obligations, to assess your ability to repay the debt.

‍Research and Compare Lenders: This is where you explore different lenders - both traditional and alternative - to understand the terms, interest rates, repayment schedules, and eligibility criteria they offer. To do this, consider factors such as reputation, customer reviews, and the lender's experience in working with startups. Look for lenders who specialize in startup financing and understand the unique challenges and opportunities of your industry.

‍Understand Loan Terms and Conditions: Read and comprehend the terms and conditions associated with each debt funding option. Look for flexibility in repayment schedules, early repayment options, and any restrictions or covenants that may impact your business operations. Consider how the loan terms align with your growth plans and ability to generate cash flow.

Seek Professional Advice: Consult with financial advisors, accountants, or business mentors who can provide guidance based on their expertise and experience. They can help you understand the intricacies of debt funding as well as identify potential risks, and offer insights into the financial strategy for your startup.

Consider Future Financing Needs: Anticipate your future financing needs beyond the current round of funding. Take out time to evaluate whether the chosen debt funding option will leave room for future borrowing or impact your ability to secure additional funding in the future. Maintaining a healthy balance between debt and equity financing is essential for long-term growth.

Never forget that debt funding is just one piece of the financial puzzle for startups. It should be part of a comprehensive financial strategy that combines multiple funding sources, including equity financing, bootstrapping, and grants, to create a robust and sustainable financial foundation.

‍Related article:Crowdfunding 101 - Here Is Everything You Must Know Before Starting A Crowdfunding Campaign For Your Startup