Debt financing receives less publicity than venture financing and is a little less glamorous. But, when accessed intelligently, debt can help founders retain more ownership of the company – which is a significant perk. This blog post will outline debt financing basics and will define key terms.
Debt financing defined
Debt financing refers to financing provided when debt instruments are sold to investors. These debt instruments include loans from family and friends, bank loans, investor loans, convertible notes, short-term debt agreements, and hybrid debt/equity instruments like SAFEs and Convertible Notes.
Benefits of Debt Financing
Here’s a quick rundown of the benefits of debt financing for startup founders:
- Debt financing allows founders to retain control over their company – or, at least, it allows you to retain your equity.
- It doesn’t require founders to cede ownership or appoint particular persons to the board of directors.
- Interest payments may be tax deductible.
- You can improve your business credit.
- Debt obligations are (usually) predictable.
- Your lender typically doesn’t have a claim on future profits.
Drawbacks of Debt Financing
But, debt financing isn’t without its pitfalls. These are the most common drawbacks of debt financing for startups:
- You have to pay it back.
- While you retain ownership, you may sacrifice some control – especially where restrictive covenants are written into the loan document. It’s not uncommon to see loan agreements where startups need to consult with the investor before making business decisions, including whether to buy and/or sell assets.
- You may need to provide collateral, and that collateral might be your IP.
Common Types of Debt Financing Accessed by Startups
Startup Debt Financing: Family & Friends Loans
Family and friends financing, also referred to as a ‘family and friends round’ refers to loans from investors known to the founder(s). These loans are typically one of the first investment resources to be tapped by startup founders.
Quick Tip: Knowing your investors personally doesn’t mean you should treat the loan informally. It’s important that you properly document the loans and sign formal loan agreements for each. These documents help set expectations with your family and friends and protect both parties if any disputes arise in the future.
Hybrid Financing: Convertible Notes & SAFEs
Convertible notes are a short-term debt instrument that converts to equity (in the form of preferred stock) if a seed round is completed before the loan is paid back.
Startups and investors are very comfortable with convertible notes. So much so that these documents come in template form across multiple websites. This is one of the major benefits of this type of financing. Another is that it typically provides one to two years of runaway upfront.
The main drawback to convertible notes, like with all debt instruments, is that you’ll need to pay the loan back if you don’t do an equity round within the agreed term. While this type of funding is fairly flexible, it will impact your startup’s decision making. Convertible notes, when paid back, are like a balloon payment. So, you’ll need to consider the payback timeline when making decisions about your startup’s finances.
SAFEs are relatively new and really only offered in Silicon Valley at the moment. In past years, founders would not need to pay the loan back if no equity round was undertaken. As a result, you’d have people who would use SAFE after SAFE without ever doing an equity fundraising round. To combat this practice, today’s SAFEs include repayment provisions with a triggering event other than equity rounds. Despite this, founders tend to prefer SAFEs over convertible notes where possible because they’re comparatively straightforward.
What’s the difference between SAFEs and Convertible Notes? And how do you choose?
SAFEs are streamlined documents designed to be simple. They don’t have maturity dates or interest rates. So, they tend to be preferred by founders. But they aren’t commonly used outside of Silicon Valley. Geography is often a deciding factor!
Traditional Debt Financing Basics: Formal Loans
Founders typically won’t get access to traditional debt financing until the company is a bit more established. Banks tend to be fairly risk averse and would want the company to be in a position to prove some financial stability, alongside holding assets that could be used as collateral.
This is why restrictive covenants are commonplace in traditional loan agreements for startups. Unfortunately, these terms can prevent founders from running the company in the way they’d like. Also rather unfortunately, many founders take the financial terms of the agreement at face value. They don’t look to the other terms which can contain these serious restrictions. These provisions in the agreement can restrict how you run your company and when and why you can buy or sell assets. In fact, they can restrict almost anything. This type of control with a loan agreement typically happens if you don’t retain an attorney.
Moreover, if you breach the loan agreements there can be serious consequences. Security may be taken for the loan which can include property and your equity interests in the company.
That’s why our top tip for founders looking to obtain a loan agreement either with a bank or another investor is to get an attorney. By retaining a lawyer, you have a professional on your side who can advocate on your behalf. Your attorney will have more experience handling these negotiations and will be more likely to return with an agreement that has more favourable terms for your startup.
That said, bank loans are typically a very cheap form of financing for startups – so long as you choose a reputable provider. This is a significant benefit and one that is often well worth accessing once your startup is in a position to do so.
Debt Financing is More Flexible Than You Might Think
Startups that are at the revenue stage are in a position to get very creative with their financing. There are creative instruments that allow for finance based on tertiary debt.
Accounts receivable financing uses your accounts receivable as collateral. These are typically used by companies with regular revenue but where that revenue is seasonal/time dependent. You can read more about it here.
Invoice factoring is the sale of accounts receivable to a third-party at a discount to accelerate the receipt of cash. This type of debt is relied on heavily in the tech/SaaS sphere, where startups can bring products to the market very quickly. The discount forms the fee payable to the buyer. And the amount of the discount changes based on the creditworthiness of the startup. You can read more about it here.
MRR lines of credit
This is a working capital loan, where the amount available is directly tied to monthly recurring revenue. The downside is that it’s bank debt – so it includes restrictions, including operational oversight. MRR lines of credit are almost exclusively for SaaS companies, specifically ones with low annual churn rates. Ideally under 5%, but certain economic conditions may allow for up to 15%. Subscription and membership-driven companies can also qualify, but should be breaking even, or very near it. As for ARR, it should be above $3M. Generally MRR lines of credit are for bridging larger fundraising efforts, primarily because the terms can be as little as a year. You can read more about them here.
Considerations for Startups When Taking On Debt
Generally speaking, startups will access these debt instruments as soon as they are available (and the need arises). Before you seek financing, you need to consider:
- How adverse are you to giving away equity in your startup right now?
- Will you be undertaking an equity financing round in the near future?
- Are you in a position to qualify for traditional debt financing?
- How important is it to you to know exactly how much you need to pay monthly on any debt instruments you obtain?
- Are you in a position to make these monthly payments?
- Do you have any collateral you’re comfortable providing to obtain a loan?
- What company assets do you intend to buy/sell for the duration of the loan?
Answering these questions will help you determine what financing avenues suit your startup – and whether it’s the right time. Though, we always recommend seeking professional advice from a finance expert before taking on debt.
Top Tips for Startups Taking On Debt
- Always work with an attorney.
When dealing with investors, you’re (usually) dealing with highly sophisticated businesspeople. Having an attorney on your team means you have access to a professional who is sophisticated, familiar with these types of documents, and able to advocate on your behalf. You’ll get a better deal with an attorney.
- Don’t seek debt financing when you’re desperate.
This will put you on a fast track to unfavorable terms. You should plan your financing to the largest extent possible.
- Work with a finance advisor to manage your startup debt.
Living paycheck-to-paycheck is always stressful, but even more so when you have employees and business creditors to pay. You should consult with a financial advisor as early as you can afford it, and certainly before taking on any debt.
- Pay attention to the small print.
Investors will always try to increase the favorability of the terms they are getting. Before signing off on any debt, you should question whether you’re okay with all the terms. If you don’t understand them, you shouldn’t sign anything until you do – again, it’s best to ask an attorney to take a look, advocate on your behalf, and explain the effects of the agreement to you.
- Manage Your Spending.
Budgeting is key in any business, but even more so for startups with little disposable income. Only take on the debt that makes sense and only spend the money you need to spend.
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