Bootstrappers know all too well that launching a new business with limited funds requires astute strategies. While a well-capitalized venture with several million dollars in the bank can behave like a large, established company from the jump, a bootstrapped startup has to manage cash more carefully, growing at a rate they can afford and control.
Growing under your own steam may sound like a risky bet — providing an open window for competitors to overtake you in the market — but even in the tech industry, first-mover advantages are short-lived.
Controlling growth is not only financially prudent, but also it provides opportunities for entrepreneurs to develop leadership skills and overcome potentially crushing business problems along the way. Additionally, bootstrappers have to achieve healthy margins early on to cover costs and finance growth — and that’s a recipe for success!
But what do you do when you need to extend your startup’s runway so you can scale quickly and capture more of the market?
Some founders may choose to spend months pursuing equity funding from angel investors and venture capitalists, while others leverage debt financing to grow quickly without giving up equity or control too soon.
Raising equity may seem like the ultimate vote of confidence for a growing startup and the best path to a successful exit, but there are also many debt financing advantages for startups.
If you’re looking for an alternative to venture capital to grow your startup, this is a great place to start!
In this guide, you’ll learn:
What is debt financing?
It’s best to start with the basics. Debt financing is a method for raising capital in which a business or entrepreneur borrows money from a lender or bank, then repays it at a later date, with interest, according to the terms in the repayment agreement.
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Why do startups use debt financing?
New businesses are seldom profitable out of the gate — tech startups, in particular, can take much longer to reach profitability. So, unless you have your own capital stream to tap into, you’re going to need an outside investment to launch your idea. When it’s time to move fast and seize an opportunity, nearly all startups need an injection of growth capital at some point to extend runway and make investments in:
Marketing
Sales
Product development
Customer success
Talent acquisition and strategic hires
Infrastructure to scale, and more
Debt financing vs. equity financing
For early-stage startups, debt capital costs far less than equity. Many entrepreneurs don’t learn this valuable lesson until they make an exit and watch their sweat equity disappear into the hands of investors. Raising debt is almost always cheaper — and easier — than raising equity. You can spend months pitching investors for equity funding that never comes. In fact, only about 5 in 10,000 startups, 0.05%, successfully raise venture capital.
So, if you want to have more time for driving business results that increase your startup’s value, without diluting your equity, debt financing is your win-win option.
Try our equity dilution calculator to see how much an equity raise can change your ownership value at exit compared to a debt raise.
Every startup funding source has its pros and cons. Equity financing, in which you raise money by issuing stock to investors, has potentially big payoffs if you can reach a successful exit, but it comes with significant opportunity costs. Debt financing, on the other hand, must be repaid and does have risks; however, when used strategically, it offers distinct advantages that can fuel success and increase your ownership value — at a much lower total cost than equity financing.
The advantages and disadvantages of debt financing tend to be murkier compared to their equity counterparts, but they don’t need to be!
Debt financing advantages
Startups can typically access debt capital quickly, while retaining both equity and control of the business. With reasonable terms and interest rates, you can fund your short-term working capital needs and drive steady long-term growth at a low cost, which looks very attractive to investors down the road.
The full list of advantages includes:
Raise capital at a lower cost
Fund your runway quickly to enable growth
Access additional capital as your business expands
Build business credit and lower future borrowing costs
Simplify budgeting and cash flow management
Bridge funding to an equity round to avoid a down round
Boost your startup’s valuation
Retain valuable equity
Increase your ownership value at exit
Run your business on your terms
Weather an economic downturn or recession
Debt financing disadvantages
Just like you would with any loan, you’ll need to make on-time payments to your lender to pay it back. If you’re not careful and you agree to loan repayment terms that don’t jive with your startup’s income or revenue stream — maybe you have a bad month or your business peaks at certain times of the year — your payments can create financial strain on your business. Worse, you could default and that can be far more costly, especially if you secured a loan with personal assets.
The list of debt financing disadvantages includes:
Usually smaller funding amounts
Qualification requirements may be prohibitive to certain business models
May require securing the loan against personal assets
May require restrictive covenants that impede growth and force less competitive business strategies
Can be hard to sport deceptive terms and hidden costs that may have long-term impact on your startup’s success
Making on-time payments can potentially burn up your free cash flow and strain the business
Risk of default, penalties, and late fees
Don’t let the cons scare you off — for the fiscally responsible and knowledgeable entrepreneur, debt financing risks should be minimal, making it a smart and affordable alternative to equity financing.
Can debt harm a startup? Sure it can if you don’t plan ahead and get the right financing for your business needs. Before we can show you how to do that, you’ll need to get familiar with the different types of debt financing.
Types of debt financing available to startups
Today, there is a wide variety of debt instruments available to startups, which is where things get more complex — the good news is more debt financing options mean you’re more likely to find a solution for your startup with far greater upside than downside.
Debt financing solutions follow one of three general structures: term loans, revolving loans, and cash flow loans. Lenders offer many different debt solutions within those types of loan facilities that suit different use cases and qualifications.
Let’s explore how each type of debt financing works as well as some examples.
How does a term loan work?
A term loan, also called an installment loan, is one of the most prevalent debt financing options — your startup gets the funding upfront from a lender and you repay it, with interest, over a fixed payment schedule. Term loans can be secured or unsecured.
Examples of term loans for startups:
Traditional bank loans for businesses
Small business loans (SBA)
Revenue-based term loans
3 important things founders should know about term loans:
Most tech startups don’t meet the requirements for bank and SBA loans — they’re not only difficult to get but also likely to include personal guarantees and debt covenants.
While term loans may offer the cheapest capital, repayment terms are also the least flexible, and that can put extra stress on a growing startup.
Payback terms matter. Loans that may look inexpensive when you compare interest rates might burn up your free cash and prevent you from deploying the funds effectively. More on this shortly.
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How does a revolving loan work?
A revolving loan is credit issued by a lender that you can draw from and use as needed — withdraw, repay, withdraw again, and so on. You only pay interest on the funds you use, and your credit line resets once you’ve repaid what you borrowed. Compared with a term loan, a revolving loan gives startups more flexibility to fund short-term working capital needs and make repayments, but typically has a higher interest rate and may include additional fees.
Examples of revolving loans for startups:
Business credit card
Business line of credit
Monthly recurring revenue (MRR) line of credit
3 important things founders should know about revolving loans:
For occasional payments that require liquidity, like variable payments to a particular vendor or acquiring inventory prior to sales, these are short-term working capital funds you can tap into if you need them, but not the type of debt you should use to fund your runway for long-term sustainable growth.
Business lines of credit usually come with higher limits and lower interest rates than business credit cards. Tech startups should carefully investigate the terms of an agreement from an online lender, which is likely to have lower limits and much higher interest rates compared to the harder to get lines of credit from traditional banks.
If you carry a balance on a business credit card, it can quickly become a very costly source of debt, racking up interest and possibly late fees if you fall behind — just like a regular credit card.
How does a cash flow loan work?
With a cash flow loan, a lender determines the loan terms based on an assessment of your startup’s cash flow or revenue. You receive an advance of funds based on your business’ incoming cash flow and pay it back with interest. While interest rates tend to be higher compared to traditional bank loans for businesses, this unsecured loan is useful for growing tech startups that aren’t profitable and don’t have hard assets to qualify for cheaper capital.
Examples of cash flow loans for startups:
Revenue-based financing (RBF)
Accounts receivable (A/R) financing or invoice loan
Merchant cash advances (MCA loans)
3 important things founders should know about cash flow loans:
Because it’s based on your business’ future cash flow, revenue-based financing can make it easier to grow a young startup that may have lumpy or inconsistent cash flow without adding financial stress, and without diluting equity.
Cash flow loan terms can vary drastically between lenders, even for similar-looking products — don’t gloss over the length of the loan, payback terms, fees, warrants, covenants, and anything else in the fine print. An interest rate, alone, can be deceiving.
APRs on merchant cash advances can reach 30%. These are the “payday loans” of the small business world and often lead to more financial troubles down the road; consider other options before an MCA loan if you’re in a pinch.
Short-term vs. long-term debt
Loans are considered short-term if they have a repayment period that’s 12 months or less, while long-term debt is typically repaid over more than a year.
Mentioned previously, the length of your payback period and your payment terms (frequency and amount) could not be more important when getting debt funding for your startup. If your loan payments eat up your free cash, you may never get to deploy that capital like you intended and you risk putting your startup in a difficult financial position that can be hard to pull out of.
Which is better for startups: short or long-term debt?
Long-term debt is almost always the better option for a startup that needs to fund its runway for growth. Short-term debt can be a good solution in certain scenarios but is typically less advantageous.
Think about your mortgage...
It’s easier to manage the lower monthly payments over 30 years instead of much higher monthly payments over 15 years — if you lose a job, lose an income stream, see your taxes increase dramatically, or encounter any other financial hardship, you have more cushion with a 30-year mortgage and you can always pay it off early. A 15-year mortgage should have a lower interest rate and lower total cost, but it will demand a lot more of your cash every month.
When should startups consider using short-term debt?
Short-term loans can help a startup bridge funding to an equity raise or an acquisition that is expected to occur in under a year. Generally, entrepreneurs have better funding options when they plan ahead — a line of credit, for example, can be your best break glass in case of emergency fund to draw on if you find yourself in an unexpected cash crunch or need a little extra working capital.
Beware of quick and easy cash – if it looks too good to be true, it probably is!
Merchant cash advances, and even some short-term revenue loans, can look attractive on paper, but in reality, their rapid pay-back terms put too much of a strain on your future cash flows.
If you must use short-term debt to cover costs, borrow the absolute minimum and prioritize its repayment.
What about venture debt?
Venture debt describes loans to venture capital-backed startups — it was coined by Silicon Valley Bank (SVB) and defines a specific type of debt financing product for tech startups that uses a venture capital or an equity investment as validation of a company’s creditworthiness. Venture debt is typically used to extend a startup’s runway after an equity raise, giving it more fuel to grow and increase its valuation before the next raise. Venture debt lenders typically take stock warrants in either common or preferred stock to offset risk so they can charge lower interest rates on loans.
It's been said, "There is no venture debt without venture capital."
That was the conventional wisdom, at least.
Venture debt, redefined:
More and more, venture debt is used as an umbrella term for numerous debt financing instruments that enable startups to grow — no VC required. This includes non-dilutive growth capital solutions such as revenue-based financing, revenue-based term loans and more.
How do you choose a debt financing solution for your startup?
Not all debt is created equal. And certain debt solutions are better in particular situations. You of course want to get a fair deal on the money you’re borrowing, but the fastest, cheapest money isn’t always the best — you have to evaluate your ability to put that capital to work for your startup to meet your goals and make your loan payments. You also need to consider the potential risk and total cost of any loan that requires fees, collateral, covenants, or warrants.
To steer clear of bad debt and deals that could drag you down, follow these 7 guidelines when you're looking for debt capital to grow your startup:
Mind your cash flow: investigate how your repayment schedule could burn up your free cash
Long-term over short. Unless you need a bridge, aim for growth
Fast, easy cash can be tempting, but it comes with a high cost and high risk
Flexible repayment terms can save the day and help you scale
Don’t bet your house on your business with a personal guarantee
Don’t agree to covenants may force you to lead your startup in the wrong direction
Warrants can be more costly than you expect, so look for non-dilutive options
Ultimately, plan ahead, understand your options, and don’t let an attractive interest rate seduce you. And remember, it’s best to borrow money when you have money — you’ll not only get the lowest possible interest rates and terms, but you’ll also be ready for a rainy day, or even to weather an unexpected storm if necessary.
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