When CEOs of early-stage companies think about growth capital, they rarely think of debt financing. Venture capital has a larger mindshare, and a lot of founders are anxious about taking money that has an interest rate or repayment cap attached. They shouldn’t be.
Financing a healthy growing company with debt isn’t the same thing as maxing out credit cards to fund the development of an untested product.
You have paying customers, maybe even a few enterprise accounts. You have revenue. You (hopefully) have an accounting function. This infrastructure makes debt manageable because you know your financial obligations ahead of time and you can plan for them.
While there are pros and cons to every capital source, startup debt financing offers many benefits, one of which is its much lower comparative cost.
Why is debt cheaper than equity?
Entrepreneurs tend to think of venture capital (VC) and other equity financing deals like free money. It’s not. In fact, if you plan to scale and exit, debt is almost always the cheaper option.
Try our equity dilution calculator to see how much you could save by using debt instead of equity at this stage of your journey ➔
Here's how to compare the costs. If your startup takes a five-year loan of $1 million at 20% APR, that $1 million will cost you $600,000 by the time you pay it off. But if you take $1 million from a VC at a $5 million valuation (and you sell 20% of your equity), then later get acquired for $15 million, those VCs get $3 million.
For that same infusion of growth capital, your cost is $600,000 for the debt and $3 million in the equity deal, a difference of $2.4 million.
A real-world example:
Numeracle recently raised $1 million of debt from Lighter Capital and grew their ARR from $1.5 million to $5 million in one year. Listen to Scott Sehon, Numeracle's CFO, run the numbers on what $1 million in equity would have cost them at their rate of growth.
We explore five more reasons debt is often better for startups than equity funding below.
5 Advantages of Debt Financing Over Equity Financing
1. Debt offers tax benefits that can offset costs
Assuming your company is out of the red, debt financing provides a few tax advantages that equity financing doesn't.
If your business uses accrual accounting, the interest portion of your payment runs through your profit and loss statement, which reduces your taxable net income. This means the effective cost of the borrowing is less than the stated rate of interest. Essentially, the U.S. government helps mitigate the cost of your loan.
2. Startup founders retain their ownership
Taking on equity investors means handing over ownership and control of your business — conforming to their expectations of how your company should grow. In the worst-case scenario, equity investors can oust you from your own company.
Lenders stay out of your way as long as you’re hitting your payments and staying in a position to continue doing so. No board seats, no control.
3. For businesses with sticky revenue streams, debt can be accretive
Jason Lemkin of SaaStr points out that if you’re an early-stage company with recurring revenue streams (like SaaS or subscription-based services), a minor amount of debt will actually increase your net cash flows and let you leverage your existing capital. With the extra cash you can make investments with a big ROI, like key hires or expanding into new markets, which can scale your growth further.
4. More time to actually run the company
Raising equity usually takes between six and nine months of coffee meetings, pitch presentations, and phone calls. Raising debt is much faster.
Debt capital saves you time once you get it, too — lenders don’t need to keep up with your every decision, and they don’t require board meetings. They won’t need to deliberate with you over every new hire or strategy. Unless you have restrictive covenants, you should expect a lender to stay out of your way while you steer the ship.
5. More control and leverage in equity rounds
For savvy entrepreneurs, debt is just one of many funding sources that can be used across the entire startup lifecycle to maximize ownership value and reach a successful exit. Raising debt, particularly in your early stages, doesn't mean you can't also raise equity when the time is right.
Debt financing can give you the fuel you need to gain traction on your own, not only making you more attractive to VCs but also giving you leverage to negotiate a higher valuation. If you've already raised VC money, you can use debt to extend your runway and buy yourself more time before your next priced equity round.
Debt Financing Disadvantages
For some startups, like those poised to disrupt a market, debt may not provide enough capital to achieve their goals. If you need to raise tens of millions of dollars to reach your next milestone, debt financing is probably not your best option.
Beyond that, the disadvantages of debt are similar to any loan — you'll pay interest on the debt, and there is a risk of defaulting if you can't make your payments. A little fiscal knowledge goes a long way, though.
Here are four useful tips for avoiding bad debt deals with higher risk:
Choose long-term over short. While it may seem more cost-effective, loans that have to be repaid in 12-months or less can burn up your cash before you start seeing an increase in revenue from your capital investments.
Understand how the term rates and repayment terms work. APRs, repayment caps, and discount rates each affect your true cost of capital differently. Make sure you understand what the loan will or could cost you and how repayments will impact your future cash flow.
Avoid debt covenants. Covenants increase your risk as a borrower, so look for a lender that provides debt financing without restrictive covenants.
Don't borrow more than you need. You don't want to be carrying and servicing debt that isn't generating a return for your business.
Ultimately, the funding option you pick today will determine what you can and can’t do with your business in the future.
It’s important in your early years — after launch and before complete traction — to be aware of all your financing options. Think about where you want your company to be in one, five, or ten years, and think about how much time or control or money you’re willing to give up getting there.
This post originally appeared on TechDay.
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