Build With Someone Else's Money - An Introduction to Debt Options for Startups

April 5, 2023
Debt is too often ignored by startup founders who are thinking about raising capital. In the right circumstances debt can be a fast, flexible, and reliable form of financing that also has the benefit of reducing dilution and loss of control.

Most startups should be using debt in their capital structure. Equity is great, but debt comes with a number of advantages including 1) it is often faster to secure. Certain loans can be acquired in less than a week. 2) It reduces the amount of equity investment needed, thereby reducing ownership dilution for founders and other equity investors, 3) it also allows founders and operators to retain more control over the direction of their business. Most lenders simply want their investment repaid - they don’t want to be involved in strategic decision making.

Below is a breakdown of the most common forms of debt financing for startups

  1. Traditional Commercial Bank Lenders - traditional banks can be a great option for startups that are already generating sustainable and level positive cash flow. They tend to be less expensive than most other financing providers, but they are also less willing to be flexible on what are called covenants. Because traditional banks tend to be highly risk averse, they will not be an option for many startups.
  2. Business Development Corporations ("BDCs") and Other Specialty Lenders - BDCs and other specialty lending groups are like the “new school” version of commercial banks. They are more expensive (higher interest rates and other fees), but they are much more flexible and more likely to lend to riskier businesses. Specialty lenders can often give periods of interest-only payments or sometimes no payments at all until a company gets its cash flow into a good spot. In addition, they may take small portions of equity or other compensation such as PIK interest in order to compensate them for their risk.
  3. Venture Lenders - Venture lenders are investors who will back startups that have already taken equity investments from institutional venture capitalists. These lenders are comfortable taking on riskier loans because they know the VC is well capitalized, and they expect that the equity holders will step in to prevent the company from defaulting on its loans. Venture lending can be a really great option for early stage founders who are looking to minimize dilution during an equity round (often venture lenders can fill out part of a round so that less equity investment is required). They are also useful in providing bridge financing for venture-backed companies that are looking for just a little extra cash to carry them through to their next round of equity investment.
  4. Other Royalty-Based Financing Providers - Royalty-based lending is an attractive option for many startups. It’s a type of borrowing where a company borrows money from a lender and agrees to pay the lender a percentage of its revenues or profits as a form of repayment. Royalty financing will typically be provided as a percentage of total historical revenues. This is great for startups as it prevents them from needing to make fixed payments every month. However, the debt still needs to be repaid, and royalty-based financing providers will still have liens on the company (unlike equity investors). In addition, because these lenders are taking more risk, it tends to be a more expensive form of capital than most other debt investors.
  5. Hedge Funds, Private Equity Groups, and Family Offices - Hedge funds, private equity groups and family offices can all make forms of debt investment into startups (as well as other companies) although the structure of these investments can vary wildly from one situation to the other.

We know debt can be intimidating, but with the right parter, using leverage can be a great way to access flexible capital and amplify returns for your equity holders. Please reach out if you have any questions about how to use debt for your company.

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