For tech startups that need capital to grow fast when opportunity arises, there are two main funding paths to choose from: debt or equity.
Equity funding from angel investors or venture firms, which requires selling a stake in the company in exchange for capital, is seen as high-risk, high-reward, and it comes with a certain prestige. Though equity funding does have advantages for certain startups, it also has disadvantages. Still, it’s often the first — and only — funding path that many entrepreneurs consider.
Debt funding, even with its distinct upsides and lower cost compared with equity funding, often carries an unwarranted stigma. Let’s dispel that here and now.
Capital is essential to drive operations and fuel growth. The pros and cons of the capital’s source, whether debt or equity funding, depend almost entirely on your startup’s unique business needs and goals. Founders often leverage both equity and debt along their journey to maximize the startup’s valuation.
Debt instruments tend to be far less understood than equity investments, but a savvy entrepreneur will come to recognize their value. Just as with a credit card or a home mortgage, a bit of fiscal knowledge will help you avoid unscrupulous lenders and manage debt without drowning in it.
Lighter Capital has more than a decade of experience helping tech startups grow successfully with non-dilutive debt financing. We’ve seen how bad debt can capsize a young startup, and we know it’s not always easy to spot.
Here’s how to recognize and avoid bad debt funding deals that could leave you and your startup underwater.
3 Ways Debt Can Sink Your Startup
1. Loan repayments burn up your fuel before you reach your destination.
Founders often make the mistake of looking for the lowest-cost debt capital without looking at how the repayments would affect their cash flow.
Think about a home mortgage. Though they would get lower rates and pay less overall with a 15-year mortgage, many people opt for a 30-year mortgage, because it’ll leave them with more available cash each month. (They can always make extra payments or pay the loan off early. So can you.)
Startup leaders have to look at debt capital the same way and ask: How will repayments affect my cash balance?
How to prevent it: Get a startup loan with the best “fuel economy.”
Shop around for financing to make sure you’re getting the best deal for your business. The challenge is comparing apples to oranges: No two term sheets are the same.
Here’s what to consider to avoid financially constrictive debt funding deals:
Term duration: Short-term loans (12 months or less) have some use cases, but most startups planning to invest capital in business growth will have to pay back the loan, with interest, before they see a return on their investment.
Term rates: Different types of loans can have different types of rates, depending on their structure. Term loans have an APR, while revenue-based financing features a repayment cap. Discount rates? Well, that’s something else entirely. Be sure you understand how the term rate works and how it affects your true cost of capital.
Repayment terms: Are your payments fixed or flexible? It’s important to dig into how repayments will affect your cash flow, and how flexible payments can fluctuate. Merchant cash advance (MCA) loans, for example, are typically based on daily sales. You might struggle to do the math if you have monthly recurring revenue (that’s intentional), but it’s sure to cost you a lot of money in interest.
With transparent and detailed information about loan terms, you can more accurately budget and plan how your startup will use the capital and repay the loan. You can compare/contrast both the cost of capital and ROI of different debt instruments—and that's important.
It’s also essential to thoroughly vet potential lenders, because some may present themselves as “innovative and convenient” to get you quick money that will be anything but cheap.
2. Restrictive covenants make it harder to change direction or right the ship.
Debt covenants are inherently risky for borrowers, even more so if the covenants are restrictive. Restrictive covenants limit what actions your business can take, and that can create new challenges for your startup.
Restrictive covenants are easy to violate unwittingly, and even those that seem innocuous can limit your startup’s ability to take creative or bold action.
How to prevent it: Take the helm, and steer clear of covenants.
Look for a lender who relies on the terms and conditions in the loan contract’s general operating requirements to ensure that borrowers maintain a healthy, sustainable business. Though covenants allow lenders to present more favorable terms, the borrower is on the hook if a covenant is breached, and that could result in your losing control of the business entirely.
At Lighter Capital, we fund clients that meet certain qualifications, and we structure our loans to align with their businesses, so they never have to sign covenants as part of their financing contracts.
3. Too much debt weighs you down like an anchor.
Not only is it risky to have more debt than you can reasonably manage in a growing startup, but also it looks bad to potential investors. Too much debt can lead to cash-flow problems that make it difficult to cover essential business expenses and, in some cases, can shutter a business permanently.
Say a growing startup generates $1.2 million ARR, and it gets a 12-month loan for $900,000. It will have to pay back that loan, plus interest, within a year. If its APR is a modest 12%, monthly payments will be about $80,000 a month and the business will spend nearly 80% of their annual sales revenue paying back the debt. The startup might have its most explosive year ever, but that loan will probably overstress the business, and it may not be able to make its payments on top of other business expenses.
How to prevent it: Don't embark on a funding expedition without a good financial compass.
It’s crucial you understand your startup's debt ratio before seeking funding. Start by calculating your debt ratio, and ensure you have a sense of how much additional debt you can manage, focusing on both your repayment obligations and the return you expect from your capital investments.
1. Calculate your debt ratio.
Your startup’s debt ratio can be calculated by dividing total debt by total assets. A debt ratio of greater than 1.0 or 100% means a company has more debt than assets; a debt ratio of less than 100% indicates that a company has more assets than debt.
Debt Ratio = Total Debt ÷ Total Assets
How much debt is too much?
While there are many factors to consider—and a “healthy amount” of debt depends on the company, industry, and prevailing interest rates—a debt ratio between 0.3 and 0.6 is often seen as the best balance of debt and equity. Lower debt ratios typically improve your business’s creditworthiness, but no debt or a limited debt history can increase your risk profile.
2. Don’t bite off more than you can chew.
Exercising caution when sizing your loan will help your company to grow sustainably under its own steam. It is important to follow these three borrowing guidelines:
Avoid overborrowing. It sounds obvious, but don’t borrow more than you need. Borrowing excessively means you'll be servicing debt on funds that aren't actively generating a return for your business.
Account for investment time. Typically, it takes about two quarters to deploy borrowed capital effectively, and a few more quarters to realize a return on that investment. To navigate this cycle comfortably, it's wise to ensure the term of your loan will cover your needs.
Allow extra time for employee investments. In many cases, startups use growth capital to make key hires. It's important to secure capital for at least a year if you're bringing on new employees. This allows for responsible capitalization while you source, train, and begin to see the results from your expanding workforce.
3. Plan for a lag in ROI after deploying capital.
Deploying new capital will increase your expenses; understand that your top-line revenue will probably take time to catch up.
Pay close attention to the term length and payment terms if you’re considering debt financing. As we mentioned earlier, payments on some short-term loans can easily burn up your free cash flow and put you in a financial pinch before you start seeing a rise in revenue from that capital investment.
Set realistic timeframes. Consider how long it takes to find and onboard a key new hire, as well as when you’ll benefit from their contributions. Likewise, a product launch can require multiple iterations; market adoption also takes time.
5 Tips for Managing Debt at a Growing Startup
As growth-stage startups strive to win market share, debt can be a powerful asset. Though acquiring and managing debt can be a risky endeavor, structured planning and tracking goes a long way to help founders minimize those risks.
Use the following tips to manage startup debt and maintain fiscal stability.
1. Set up a comprehensive debt spreadsheet.
This is the cornerstone of effective debt management. A well-organized spreadsheet provides a snapshot of your startup's outstanding debts, including details such as interest rates, repayment schedules, and total amounts owed.
2. Track your business growth.
Regularly tracking revenue, cash flow, and profitability enables you to assess your startup's financial health. By looking at these growth patterns, you can make informed choices on when to seek debt financing or other capital.
3. Budget thoughtfully.
A well-structured budget serves as a roadmap, helping you allocate resources efficiently, identify potential areas of overspending, and ensure that debt repayment remains a prioritized expense.
4. Cut costs.
Analyze your startup's expenses critically and identify areas where cost reductions are necessary. Redirecting these savings toward debt repayment helps reduce cash burn, increase gross margin, and strengthen your startup's financial health.
5. Craft a repayment plan.
By committing to a more accelerated repayment plan for term loans, startups can free up resources sooner for growth initiatives and reduce overall interest costs. You might also consider revenue-based financing, which offers flexible payments based on future revenues.
Learn more about debt financing for startups
It’s one of our most popular founder resources: Financing Your Startup Using Debt can help you make smarter fundraising choices.
Learn the ins and outs of debt financing so you can avoid tricky terms and conditions that might hold your startup back. See how to compare different types of startup loans, then work through specific financing examples to understand the real costs with this comprehensive guide for entrepreneurs.