Accessing Capital: Debt Financing for Startups

How Debt Financing for Startups Works

When a business pursues debt financing, it will approach a bank or other financial institution and apply for a loan. The lender will evaluate the business’ creditworthiness, which involves assessing its financial history and current position to determine its ability to repay. The loan agreement will outline the interest rate and repayment terms, and the process often requires the business owner to provide collateral like inventory or real estate. Additionally, the loan agreement might include a lender loss payable clause to protect the lender in case of loss or damage to the collateral.

Unlike equity financing, where investors may receive a share of profits through dividends or capital gains (and regular payments are not needed), startups must pay debt financing back. That’s why it is often used for specific projects or investments, such as funding the purchase of equipment, while equity financing is often simply used for “ongoing operations.”

Debt financing for startups can include the following:

1. Installment loans are when startups receive a lump-sum payment and will have set repayment terms and monthly responsibilities.
2. Revolving loans, like a credit card, provide access to a line of credit. They ease the burden on small accounting departments as only a single monthly bill is paid out, and borrowers can use, repay, and repeat.
3. Cash flow loans are financial arrangements where businesses can obtain immediate cash by selling their unpaid invoices to a third-party company, sometimes known as invoice financing.

When businesses face challenges obtaining bank loans, bonds also provide a solution by enabling alternative investors to step in as lenders. Investors who purchase bonds essentially lend money to the issuer for a fixed period, with a predetermined interest rate and maturity date. The company then pays out interest regularly — typically every 6 to 12 months — and returns the principal when the bond reaches maturity.

Benefits of Debt Financing for Startups

If a business does fail, the lenders are protected by the collateral they have with debt financing. This can give lenders peace of mind knowing their investment is safe. In turn, that also means debt capital is much less expensive than equity financing, where investors demand a return on their investment.

Debt capital typically carries lower interest rates than other types of financing too. This is because lenders take on less risk when they issue debt capital, as they are more likely to receive repayment. Therefore, this financing can help startups conserve cash, preserve profits for growth and reinvestment, and provide a more secure source of financing.

Another benefit of debt financing is that the business retains ownership over its assets and operations. In contrast, equity financing and venture capital investments involve selling ownership shares in the company to investors, which dilutes equity. However, the obvious downside is that the business must make regular payments on the loan, which can be a significant financial burden, especially if the business experiences a downturn.

Interest payments associated with debt capital are also often tax deductible, meaning that companies can reduce their tax bill by taking out loans instead of issuing equity or venture capital.

How Startups Can Leverage Debt Financing

Startups can fund major milestones with less risk with debt financing. By utilizing debt capital, businesses free up their cash flow to invest in new equipment, hire additional staff, and upgrade facilities. Companies can also cover short-term expenses or take advantage of new opportunities without dipping into their operating budget.

For example, debt was pivotal in Tesla’s expansion and innovation efforts. In 2013, the company financed its expansion and growth using convertible debt. The company took advantage of low-interest rates while allowing investors to convert debt into equity (bonds into stocks) in the future — if Tesla’s stock price appreciated enough. Tesla issued $2 billion of convertible bonds in 2014 and $850 million in 2017.

They chose this strategy to support aggressive growth, capitalize on market opportunities, and position themselves for long-term success.

Startups should also follow the following steps when leveraging debt financing:

• Customize debt repayment plans according to your business strategy.
• Always avoid defaulting on loans.
• Be mindful of restrictions lenders might place on your business.
• Use debt financing to refinance existing debt at a lower interest rate, reducing the overall cost of capital and improving your financial position.

To be one step ahead of the game regarding these pointers, startups must establish a budget, forecast cash flow needs, and create a repayment plan that allows for timely payments and flexibility in case of unexpected changes.

How Risk Management Supports Successful Debt Financing

Debt financing can be risky if your business is not solid. Failure to make regular payments or defaulting on debt can result in penalties or bankruptcy. Equity financing does not carry the same financial risk, as investors share in the risk and reward. That’s why a solid risk management plan is essential for organizations to identify and mitigate potential debt financing risks proactively.

The plan must employ a combination of best practices, savvy financial strategies, and insurance policies:

• Mitigate market risks impacting your ability to service debt: This includes assessing interest rate risks, currency risks, commodity price fluctuations, and other external factors. By implementing risk mitigation strategies such as hedging instruments, borrowers can safeguard against adverse market conditions and ensure the stability of debt repayments.
• Ensure compliance with relevant regulations and legal requirements: This involves adhering to disclosure norms, maintaining accurate financial records, and meeting debt servicing obligations on time. Non-compliance can lead to penalties, legal disputes, and reputational damage.
• Have access to a full suite of insurance products: Loan protection insurance covers debt payments if the insured cannot pay due to an unprecedented event. If a business owner dies or suffers a severe or critical illness, lenders have the right to demand any loans are paid back. This could represent a significant risk to business continuity. Startups can consider directors and officers (D&O) insurance as well as cyber and professional liability, but having access to all of them simultaneously is an added benefit.
• Do regular monitoring and reporting: Risk management is an ongoing process that requires continuous assessment.
  • Regularly review risk indicators, key performance indicators, and incidents to identify any changes or new risks.
  • Develop clear reporting mechanisms to inform stakeholders about necessary adjustments to the risk management plan.
  • Provide training and education on risk management principles.

Most startups will need some form of debt financing to cover expenses and fund day-to-day operations like buying equipment, machinery, supplies, inventory, and real estate. But the main concern with debt financing is that the borrower must be sure they have sufficient cash flow to pay the principal and interest obligations tied to the loan. We know it can be difficult to understand what coverage your company needs when you engage in debt financing. That’s why we are the perfect partner to shield you from potential risks, roadblocks, and uncertainty.