Evaluating Your Startup Debt Before Pitching Investors

Funding is a crucial concern for startup founders, and failing to secure startup funding is one of the biggest startup mistakes you can make. Unfortunately, many “traditional” sources of financing, such as bank term loans with a fixed interest rate and schedule, are usually off-limits to early-stage startups without substantial cash flow or liquid assets.

Instead, most early-stage startups turn to equity funding sources such as angel investing and venture capital firms. These equity investors offer capital in exchange for a share of your business, helping you get off the ground.

As your company expands, however, there are other options for debt funding. That’s especially true for fast-growing tech startups with a seasoned track record. In this article, we’ll discuss the debt financing possibilities for startup founders. We’ll also explain the differences between debt funding and equity funding, and how to handle the question of debt during investor pitches.

What is startup debt financing?

Debt financing for startups provides founders with different options for financning their business. The various types of debt for startups include:

• Credit cards: Credit cards can be an easy and convenient way to increase founder liquidity. Look for small business credit cards that offer deals such as an introductory 0% APR interest rate. However, be warned that if your company goes under, you’ll be financially and legally responsible for paying these credit card debts.
• Business loans: Getting a startup loan is more difficult than with an established company, but by no means impossible. Many lenders require you to be in business for a given amount of time. They might also require a certain amount of assets for collateral. The types of startup business loans include:
  • Term loan: A (typically long-term) loan that provides a lump sum of cash to be repaid according to a fixed schedule.
  • Line of credit: A flexible loan that can be accessed as needed up to a given limit and then repaid.
  • SBA loan: A loan from the U.S. Small Business Administration for businesses that have been rejected for a standard bank loan.
• Alternative loans: Companies such as BlueVine, Kabbage, and Fundbox offer funding solutions for startups that need access to credit. Also consider peer-to-peer (P2P) lending services, which cut out the middleman and allow individuals to loan money directly to businesses. 

Can startups get debt financing?

For many startups, debt financing is a viable alternative to the traditional equity financing model. However, startups need to weigh the pros and cons of both options as a means of building their capital stack. Below are some important considerations:

• Ownership: Whereas equity financing requires you to give up a stake in your company, debt financing allows you to retain ownership. By assuming debt, startup founders can maintain total control of the business.
• Collateral: Taking on debt often requires a large amount of collateral and a low risk profile. This means that debt financing may not be available to newer startups or founders without significant assets.
• Risk: Since debt financing is a secured loan, startup founders must offer assets as collateral. If the company fails, however, the lender has the right to repossess these assets in order to recoup its money.
• Qualification: Due to the risks involved, lenders often require startups to meet a series of stringent requirements. Some founders fall short of the criteria, while others find the qualification process too time-consuming or invasive.

Founders who do qualify for debt financing have several options. For example, so-called “debt-as-a-service” businesses like Sivo have sprung up to meet startup financing needs. These lenders function similarly to a line of credit. In exchange for collateral, startups receive a business banking account and access to various lending programs.

Are startups debt- or equity-financed?

Most startups receive a large majority of their funding by raising equity. As your business grows, however, debt constitutes a greater and greater portion of the company’s liquidity. Debt forms just 2 percent of early-stage startups’ capital base, but roughly 30 percent of the capital base of S&P 500 firms.

For startups in this intermediate stage, venture debt is a viable option. Venture debt refers to a loan from a traditional lender offered to startups that have also secured equity financing. This route is most often available to high-growth businesses, such as early-stage tech companies, that need to quickly raise and spend large amounts of capital.

Venture debt is an appealing choice for founders who need to raise more funding to hit business milestones, but who don’t want to give up more equity in the company. Most commonly, venture debt is used for short-term funding (3 months to 1 year). It is often essential for growth strategies like hiring a marketing team or developing a new product.

Another intermediate option between debt and equity is revenue-based financing. With this option, investors provide capital in exchange for a percentage of your future revenues and repayment of the seed money. This can be an intriguing alternative for founders who don’t want to give up equity in exchange for funding. However, be aware that the repayments are often substantially higher than the initial investment. This compensates investors for the risk they assume.

Regardless of which debt financing options you choose, it’s important to be upfront about your level of startup debt when pitching investors in later funding rounds. If potential investors are interested in moving forward, the amount of debt your company has assumed will be clearly defined in the financial documents that you provide as part of the due diligence process.