In debt financing, an investor lends money to a startup, and the startup promises to repay the debt with interest. There is no cash exchange for shares or equity; the startup gets investors to invest in exchange for a return on the capital at a pre-agreed interest rate.
The startup must repay the loan and interest. If they cannot pay, the investors will claim whatever collateral the startup put down. Debt financing is time-bound, where the borrower must repay the loan and interest within the agreed period. You could make the payments in installments or in total, depending on the approved modality.
Also, the loan is typically dependent on the value of the assets owned by the startup. The founder attaches some of the company’s assets, and the loan is given. If the loan is unsecured, the line of credit is usually less.
Before lending money to startups, investors consider a few factors, such as the capacity of the startup to make repayments, the collateral the startup is willing to pledge, and the industry factors that may affect the viability of the business.
Startups could select from bank loans, bond issues, or family and credit card loans. Banks often offer lending and interest rates according to the business’s financial situation.
When exploring debt financing using bond issues, the bond certificate typically includes a principal value, a term by which repayment must be completed, and an interest rate generally expressed as a percentage of the principal. Individuals or entities who purchase the bond become creditors by loaning money to the startup. Startups also take loans from family and friends or borrow credit cards.
Debt financing is not classified according to the startup’s growth stages but the nature of its needs and the tenure of the loan. Based on this, it could be either short-term or long-term. Short-term debt financing is typically used to fund working capital for day-to-day operations, such as paying wages and rent.
The repayment schedule for short-term debt financing is usually within a year. An example of short-term debt financing is a line of credit secured with collateral; this is common among startups. Long-term debt financing is commonly used to purchase equipment, buildings, and machinery. These assets can be used as collateral to secure the loan. The repayment schedule for long-term debt financing is usually more extended, with fixed interest rates and installment repayments.
Debt financing preserves company ownership; the lenders are only entitled to repayment of capital and the agreed interest. Founders can terminate obligations to the lender once the debt is paid off. Investors do not interfere in the functioning, operations, or business decisions.
Also, the interest on The amount paid is tax-deductible and reduces tax obligations. In addition, you can raise startup debt financing at any stage of the business, and it only depends on the availability of funds and payment timeline.
However, it may become difficult for a startup to repay a loan as it needs to ensure that it generates sufficient income. Where there is a default in repayment, you can seize the assets used as collateral.
A startup using its assets to pay off a loan can suffer a considerable loss; the credit ratings of the startup can also be negatively affected by late or failed payments, making it more difficult to obtain debt financing in the future. Startups risk potential bankruptcy with debt financing; even if this happens, they are still obligated to repay the debt.
The high-interest rate is yet another disadvantage of debt financing. Investors recognize that investing in startups is very risky – the failure rate for startups is high, and there is no guarantee that the startup will turn out a profit.
The investors attach high-interest rates to the loans since repayment of the loans with interest is inevitable. If the startup has low business performance, repaying the loan at a high-interest rate results in more significant losses for the startup. Banks and non-bank financial companies (NBFCs) are hesitant to give startups loans.
Stages of a Debt Financing Round
A debt financing round typically involves some form of research carried out by the startup and the investors it will approach. Generally, the following steps should guide a debt financing round:
- A startup needs to identify its needs and fund requirements. This will help limit how many loans they collect and guide them in selecting an investor that is the right fit for their situation.
- Conducting a thorough market survey of investors or firms that are into startup debt financing and have a good track record. These could be individual investors, venture capitalists, banks, NBFCs, and microfinance institutions. Some factors to consider in selecting an investor include credibility, terms and conditions of the loan, feasible interest rate, etc.
- Presentation of a pitch with clearly outlined plans and strategies, company balance sheets, and a growth plan with supporting documentation. Founders must work hard to persuade investors that furnishing the startup with a loan at the right time is a good idea.
- On the part of the investors, in turn, they carry out their research after a startup is pitched to them. The investors go through the startup’s documents and conduct due diligence checks to verify its claims and credibility.
Startups will always need funding at different stages, but before opting for debt financing, startups should carefully examine the pros and cons, including the startup’s needs. It would help if you also carried out proper research to select the right investors.