Debt Funding Options for Startups
Did you know startups have several other funding options besides equity? Really, they do!! In this session Molly Otter of Lighter Capital and David Ehrenberg, Founder and CEO of Early Growth Financial Services, discussed a range of debt funding options available to entrepreneurs and the cost benefits of each. Access the presentation deck for Debt Funding Options.
Debt funding is advantageous for growing companies. Not only is it cheaper than raising equity, it also helps you preserve your ownership stake. And when you’re just starting your business, it makes sense to preserve your equity for as long as possible.
It’s impossible to talk about debt or any type of funding without mentioning capital structure. One term you’ll hear is capital stack: which refers to both the cost of capital and the associated requirements. Let’s walk through the types of instruments that are likely to be present in your capital structure.
- Common Equity — Common shares (founders’ ownership); most expensive form of financing
- Preferred Equity — Venture capital, angel investment (accrues interest; paid before common shareholders get paid)
- Junior/Unsecured Debt — (secured by liens) Tech and venture debt; revenue-based financing
- Secured Debt — Traditional bank financing (personal guarantees secured by liens)
The amount and type of capital a business needs varies by type of business of course, but also with the stage of the business.
Startup Funding Options By Stage
Ideation — You need positive revenue and often income generation to get debt funding
<$5M revenue — Banks will be your cheapest form of financing. Local and regional banks that specialize in startups should be your first call.
>$5M revenue — For breakout and established companies growth capital should be the focus.
Established — Traditional commercial loans and venture debt are worth thinking about if you’re raising equity.
Debt Funding Timeframe And Terms
Consider your use of funds (working capital or growth capital) as well as your cash runway when looking at debt financing options to make sure you can line up funding in time and make the best choice for your business.
Although cost-effective versus equity, many debt funding options (for example, merchant cash advances), require personal guarantees. Merchant cash advance and revenue-based lending are good options though if your funding timeframe is short. Here’s an overview of debt lending types and standard terms:
Merchant cash advances
Terms: personal guarantees
Maturity: <6 month maturity Timeframe: 72 hours Bank debt, revolving credit lines (R/Cs), term loans:
Terms: financial covenants and guarantees
Maturity: 7 years on average
Timeframe: 4-8 months to funding
Structure: term loan
Terms: monthly repayments as a set percentage of revenue
Maturity: 5 years on average
Timeframe: 4-6 weeks to funding
Term: covenants; fixed monthly payments, warrants (options for ownership in your company); must already have VC investors from a top 20 firm; VC board seat
Maturity: 7 years on average
Timeframe: 3-6 months to funding
Consider your true cost of capital
Take your true cost of capital into account in your funding decisions. Within debt options, the cost of capital varies significantly. That said, the highest-priced debt is still cheaper than equity funding. For one thing, you always know the price of your debt; it doesn’t change based on your valuation at different funding rounds. Debt also typically doesn’t dilute your ownership and control over your business.
But keep in mind that certain types of debt do impact your equity ownership — so think past the initial round when you consider dilution and know how much control you want to maintain not just once the current round closes, but going forward. Also consider the impact of using convertible debt; because of its maturity and interest features, potential lenders will view it as debt in analyzing your borrowing capacity.
Before you run right out and start approaching lenders, make sure your financials are in order. Messy accounting and record-keeping can ruin your chances of getting financed by raising questions in lenders’ minds as to how well you know your business, your competence in financial management, and your diligence with documentation.
ProTip: Know your numbers and key metrics and be able to answer basic questions about them.
ProTip: Make sure your business is in good standing (bank lenders will run checks to make sure you’ve paid your business taxes and franchise fees).
ProTip: Get professional help if you lack the skills and/or time to devote to this.
ProTip: Make your first key hire is a salesperson who can generate rain — then arm them with the CRM tools (even if they’re very basic at this point) they need to be effective.
Deborah Adeyanju is Content Strategist & Social Media Manager at Early Growth Financial Services (EGFS), an outsourced financial services firm that provides small to mid-sized companies with day-to-day accounting, strategic finance, CFO, tax, and valuation services and support. Prior to joining EGFS, Deborah spent more than a decade as an investment analyst and portfolio manager with leading financial institutions in New York, London, and Paris. Deborah is also a Chartered Financial Analyst (CFA) charterholder.
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