What founders need to know about debt financing
In the startup space, fundraising is dominated by the idea of equity financing or venture capital. Debt financing is discussed as often and can commonly be misunderstood by founders, because there are so many options available. Here, we will discuss what exactly is debt financing, the most common options, and the advantages and disadvantages to guide entrepreneurs in their fundraising efforts.
What is Debt Financing?
Debt financing is the borrowing of money to fund working capital. The borrowed amount comes from an outside source where the borrowing company agrees to pay the principal plus interest over a specified period of time. Debt financing isn’t limited to traditional bank loans. In fact, individuals not affiliated with financial institutions can lend capital to businesses in the form of debt.
How is debt different from equity financing? Debt, in any form, must be repaid. With equity financing, you are exchanging company ownership for capital. There is a lot of risk associated with equity financing relative to debt financing, making it a very expensive option. While tech startups generally look into the equity financing route, debt financing can be beneficial for these types of companies because they can leverage debt to supplement or extend runway for future financing rounds.
Forms of Debt Financing
Apart from your standard bank loan, here are some of the most common options of debt financing.
Business Line of Credit
A business line of credit is a revolving credit that allows you to borrow capital when you need it up to a certain limit. Lines of credit are best for companies that are looking for short term funding for regular expenses. They are also beneficial for seasonal businesses looking to bridge their busy season, and businesses who need extra capital for new contracts or projects.
Business Credit Card
Similar to a line of credit, business credit cards are also a form of revolving credit. Approval for a business credit card is based on personal credit history rather than company history, so it’s perfect for companies that have a relatively new or nonexistent credit history. Business credit cards are often used for operating expenses, but they generally come with high interest rates if you don’t pay off your balance each month. One of the perks of business credit cards are the rewards that come with it. So when choosing one, keep in mind what type of rewards your business would benefit from the most.
Also known as factoring, invoice financing is a way to borrow money against your account receivables. Lenders (in this case, factors) fund a certain percentage of specific customer accounts. Doing this will allow you to control your cashflow and continue to move business forward without having to wait on customer payments. Invoice financing is most beneficial for businesses with larger accounts or payments to pull forward.
Merchant Cash Advance
Merchant cash advances (MCAs) are often given to businesses that heavily rely on payments from credit and debit card sales. Businesses receive a lump sum from a provider and repay it with a percentage of their sales. MCAs are often seen as a last resort, because they are known for having very high annual percentage rates. However, they can be an option if you don’t qualify for other types of financing because credit scores and business history isn’t a huge factor in receiving an MCA.
Venture debt is a type of debt financing to venture-backed companies by specialized banks or individual lenders to fund working capital. This can be difficult to acquire as venture debt lenders use a similar due diligence process used for venture capital, and it poses higher risks than other forms of debt financing. We talk more about venture debt and how it differs from venture capital here.
Advantages and Disadvantages of Debt Financing
You maintain ownership of your business
While there’s a lot of energy around venture capital and angel investors that appeal to a lot of founders, ultimately you will lose a good chunk of your business that can affect your decision making power in your company. Debt financing is non-dilutive, meaning that equity isn’t compromised by bringing in a lender to dilute your ownership, making it also a cheap alternative.
Interest is tax deductible
One of the perks of using debt financing is that the principal and interest is classified as a business expense. Because of that, they can be deducted from your business income taxes.
Lower interest rates
Along with the tax deduction perks, choosing debt financing means that you will ultimately be paying a lower overall tax rate. For example, let’s say you have a loan with an interest rate of 15% and your business tax rate is 25%. The after tax interest rate is ultimately 15% x (1 - 25%), which equals 11.25%. Because of the tax deductions, you end up paying 11.25% instead of your interest rate of 15%, helping out bottom line results.
Paying back the debt
This is generally no problem if things are going good with your business, but of course this is not always guaranteed. If your business fails, you are still responsible for paying back the debt. There is still risk involved with debt financing, so if you’re business just starting out or in a rough patch, this is important to keep in mind.
High interest rates
Interest rates can vary depending on the form of debt you choose to get funding from. However, several options pose high interest rates, especially for merchant cash advances. Even with tax deductions, know that the interest rates can still be high and can affect your profits.
Can affect your credit score
Anything that you borrow will affect your credit score. Be wary if your credit is weak, because a low credit score can lead to higher interest rates that can be difficult to pay off if you’re in a tight situation.
Repayments and cash flow difficulties
This is especially a disadvantage for seasonal businesses. Debt is generally paid back in equal monthly installments, so if your sales take a dip and make a late payment, this can hurt your credit score long term.
When choosing debt financing, keep in mind what you need the capital for, if your customers pay on time, and if you can make regular payments. Debt is a great solution to prevent equity dilution, and it’s important to have a high-level understanding of debt financing as a founder if retaining equity is a priority for you.