Debt financing for startups: When and how to get it

What is debt financing for startups, and when should a business consider this road? 

Here we’ll cover all that, including the advantages and disadvantages of debt financing and how a startup can acquire this type of funding. Spoiler alert: it can help you hold on to your equity. Which can be much smarter in the long run. 

Plus, we’ll explain some common terms you’ll need to know if you choose to seek debt financing for your startup.

What is debt financing for startups?

Debt financing is a type of funding provided to startups by an investor or lender, such as a bank, for a certain amount of time. Debt financing walks the line of a traditional loan in that the startup borrows money and pays it back with interest. 

How does debt financing compare to equity financing?

While private equity funding, or venture capital (VC) funding (not to be confused with venture debt financing), is one of the most popular financing sources for an early stage startup, debt financing plays an important role in getting startups off the ground.

To compare, the main advantage of equity financing is that there is no obligation to repay the money acquired through it (rather you pay back the cost of the shares at a later date). 

Under equity financing, the startup essentially sells a portion of the company in return for capital. Often VC investors will not only have partial ownership, but a voice in future business decisions.

‍Alternatively, with debt financing, borrowers do not need to offer equity or partial ownership in return. The debt financing serves as credit and the lender has zero ties to internal business decisions as long as payments on the financing are made as per the financing contract.  

How debt financing compares to venture debt funding

Debt financing is a broad term that refers to many different credit accounts, including installment loans, revolving lines of credit, and atypical arrangements like invoice factoring. As a result, terms can vary significantly, and there are many types of issuers, such as banks, credit unions, and online lenders.

In contrast, a venture debt deal is a specific type of debt financing for startups that have previously raised equity funding from a venture capitalist firm. It’s usually a way to extend your cash runway between rounds or generate additional working capital to drive growth.

Terms may be customized to the borrower’s needs, but you can typically expect your venture debt provider to offer between 20% and 40% of your startup’s most recent equity round.

Venture lending terms tend to range from three to four years, with a temporary interest-only period upfront that lasts up to 12 months. Once it ends, you make fixed principal and interest payments until you pay off your balance, like any other term loan.

In addition to interest charges, venture debt lenders often receive warrants on the company’s common equity — the right to purchase a company's stock at a specific price and at a specific date. 

The total value of the warrants usually runs anywhere from 5% to 25% of the principal loan amount. There may also be an origination fee of 1% to 2%. For example, Madison Development Corporation is a venture debt lender that takes warrants for up to 25% and origination fees between 1.5% and 2%.

‍Why consider debt financing? 

The main goal of debt financing is to help startups extend their runway between rounds of equity financing. Below we break down some common advantages and disadvantages of debt financing so that you can make the most informed decision for your business and current situation. 

Advantages of debt financing

What benefits can debt financing provide? There are several reasons to consider it a viable source of startup funding:

No further dilution of ownership 

Debt financing, unlike equity financing, doesn’t take any equity away from the owners of the startup. This is a major advantage for startups that are no longer willing to dilute their equity and want to retain a certain amount of it.

Full control over decisions 

Because the lender doesn’t have an equity stake in the business, they do not have any say over business decisions. The startup keeps the same amount of control it had before financing. 

In other words, the startup can decide how it wants to use the debt funding without consulting the lender. 

Often, startups use this type of funding to complete a specific campaign or project, purchase equipment or inventory, or accelerate growth for a specific initiative.

Defined period of time 

Unlike equity financing, which is arguably permanent, debt financing has a set term. The startup must repay the funding after a stipulated amount of time, after which the relationship with the lender ends. Agreements typically bake in clear start and end dates. 

Plus, startups can acquire debt financing at any stage, unlike equity financing, which only happens in certain rounds.

Disadvantages of debt financing

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 

Perhaps the biggest drawback of debt financing is that it is not easy to get. Most banks will want to see financial viability and a list of assets before qualifying a startup for financing. In many cases, startups don’t have the hard assets that a bank loan requires.

Difficult to maintain 

If a lender does qualify a startup for debt financing, there will be certain debt covenants the startup will need to meet. 

Usually, that includes detailed financial reports and specific calculations that the startup will need to show the lender to maintain its financing. 

If a startup cannot meet the loan covenants, the lender may raise the interest rate or take corrective action against the startup. 

This may include requiring the startup to payback the loan. Typically, startups rely on skilled finance experts to understand the loan covenants and create reporting to meet the requirements.

Required to pay back 

Unlike equity financing, debt financing means the startup has to pay back the money within a certain period. 

If a startup cannot make its payments, the lender can take corrective action, including seizing control of the business or its assets. 

Debt financing is typically considered “senior” debt, meaning it takes precedence over other kinds of debt and must be paid back first over any other obligations.

How To Get Debt Financing For Your Startup 

Successfully getting debt financing for startups can be challenging. So, it’s important to prepare basic financial statements before trying to secure it. 

At a minimum, you will need a forecast, business plan, profit and loss statement, and a balance sheet to make intangible and hard assets clear to the lender. 

Banks, for example, will want to see how you can pay back the startup loan. Lenders will look for a revenue stream and an associated cash balance to see whether the startup can make payments on the financing. 

If a startup’s financials don’t clearly indicate how it can pay back the funding, it likely won’t qualify.

While banks are a common source of debt funding, there are non-bank lenders that startups can also approach. 

However, it’s important to note that they will likely require a higher interest rate than banks.

Non-bank lenders won’t be looking at the startup’s hard assets, but they may want a highly structured deal instead and negotiate to receive equity in certain situations. 

Many non-bank lenders are interested in convertible debt where they can see gains in equity.

What are the interest rates on debt financing?

While your interest rate will depend on your time in business, business credit history, and type of lender, among other variables, average annual interest rates for small businesses and startups typically run on average between 3-10% of the principal loan amount.

What Are Types of Debt Financing?

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

Short-term debt financing options usually have a repayment period of less than one year. 

The repayment periods on a long-term startup business loan are much longer, which can be beneficial for larger, longer-term projects within your company such as major equipment updates, real estate purchases and a growing payroll. 

Monthly Recurring Revenue (MRR)

This debt financing option is most common with SaaS companies that have some type or subscription model or recurring revenue stream. 

Loans are therefore based on the company’s monthly revenue. On average, you can expect lenders to provide financing between 3-5x your MRR.‍

Revenue-based Financing

This is a more flexible form of debt financing where payments are based on a percentage of monthly revenue which can also be beneficial for companies with subscription-based models or those with high growth aspirations. 

The flexible monthly payments are designed to accommodate the natural ups and downs of the company’s revenue without demanding equity.

Equipment Financing

Equipment financing is a type of installment debt that helps you purchase business equipment, like machinery or technology. The secured loans use whatever equipment you buy as collateral, much like a mortgage uses real estate.

Because the lender can seize the underlying asset and use it to recoup its losses if you default, equipment financing may be easier to qualify for than an unsecured business loan.

Invoice Financing

Invoice financing lets you borrow against your outstanding invoices, which can be highly beneficial for businesses with slow-paying customers. Depending on the arrangement, you or your lender may be responsible for collecting the invoices on the back end.

Typically, you can use invoice financing to borrow between 70% and 95% of your invoice value. For example, Altline typically offers up to 90%.

SBA Loans

SBA loans are bank loans partially guaranteed by the Small Business Administration (SBA). They’re designed to increase small business and startup founder access to debt funding but are subject to government restrictions that can make applying a challenge.

However, an SBA loan may offer more favorable terms, like higher principal amounts, longer repayment terms, and lower interest rates. For example, the 7(a) program offers up to $5M, and interest rates on loans for more than $350K can’t exceed the base rate plus 4.5%.

Important Debt Financing Terms To Add To Your Vocabulary

• Asset: A resource owned by a business that offers economic value. Examples of assets are inventory, cash, cash equivalents, property, furniture, equipment, trademarks, copyrights, patents, accounts receivables, and prepaid expenses.

• Principal: The original sum of money borrowed that is must be payed down or repaid at the end of the term. 

• Interest Rate: Usually expressed as a percentage, interest is the amount of money the lender charges for loaning out debt capital. The interest rate is in relation to the amount you are paying on the principal.

• Fixed Rate: A pre-agreed upon rate that does not change over time. 

• Floating Rate: An interest rate that moves up and down with the ebb and flow of the market, another benchmark rate, or an index. 

• Non-bank lenders: These are a type of financial institution that offer lending services similar to banks but with different requirements. In some cases, it may be easier to get financing from a non-bank lender; however, they may have higher interest rates and highly structured deals.

• Term: The length of time for a financing agreement, usually expressed in months or years. Typically, startups receive shorter terms because there is uncertainty about the company's longevity.

See Also: How To Raise Pre-Seed Funding For Your Startup

Zeni helps startups like yours navigate the world of debt financing.

Zeni combines industry-leading AI-powered accounting and bookkeeping with a team of expert finance professionals. It offers your startup the financial capabilities and records it needs to apply for, secure, and maintain debt financing. 

The Zeni Dashboard makes it easy to share the high-level financial data that investors and lenders care about. With the Investor Access option, funders can see real-time metrics and your key financial statements (P&L, balance sheet, and cash flow statement).