Debt Funding for Startups: Everything You Need to Know
Debt funding for startups refers to the variety of ways that a new business may be lent capital in order for it to get out of the startup phase and flourish.3 min read
2. Venture Debt Funding
3. Other Debt Funding Options
Updated November 23, 2020:
Debt Funding Overview
Debt funding for startups refers to the variety of ways that a new business may be lent capital for it to get out of the startup phase and flourish. Doing so is extremely important for new, growing companies, as is securing the right amount of funding. Too little, and the business will not be able to get off the ground; too much, and the business may be overburdened by it and unable to efficiently grow. Additionally, an entrepreneur must consider the future cost of a large amount of initial investment funding; it may come to pass that their financial success is much diluted do to a great share of the company being owned by other investors. Luckily, there are several ways to avoid this situation.
Venture Debt Funding
Venture debt funding is a type of debt funding tailored for equity-backed businesses that do not have the cash flow or assets required for traditional debt funding. This kind of funding tends to be structured as a combination of limited equity investment warrants and a loan. The term for such loans will usually be for three years along with warrants for stock in the company. If such funding is properly used, it can reduce dilution while accelerating a company’s growth at a limited cost.
That said, venture debt does come with some drawbacks, as well. If misused or entered into under unfavorable circumstances, venture debt can lessen a business’s flexibility or be an obstacle to future equity. Other negatives could include:
- Financial covenants. A venture debt loan could be tied to a business’s accounts receivable or cash balance, which could be risky for a young company, as having much-needed loans recalled at that stage could be highly damaging.
- Default clauses. A lender could insert language in the loan agreement to allow them to demand loan repayment if certain income requirements or growth metrics are not met. They could also demand loan repayment even due to events outside of the company’s control, such as the loss of another investor.
- Back-end loaded deals. A venture debt loan might offer a lower interest rate in the early stages but then require larger payments later on, which could place a severe financial strain on a growing company.
Other Debt Funding Options
Other options for funding your business in its early stages include, but are not limited to, the following:
- Loans. Loans are a commonly used and well-known way of obtaining capital and can be an ideal way to get your business off the ground if you can get a loan on favorable terms. This, however, can be a challenge, since new businesses are often seen as a high-risk investment, especially if you are a first-time business owner. Because of this, banks may be especially difficult to obtain loans from, but other potential sources include other commercial lenders, individual lenders, and the U.S. Small Business Administration.
- Revenue-Based Financing. Revenue-based financing involves a business agreeing to share a percentage of its future revenue in exchange for an investor’s capital upfront. The loan payments will be tied to monthly income, with more profitable months yielding higher loan payments. Thus, this type of financing can often yield an uneven cash flow in the early stages when revenue can vary widely. Several banks and lenders specialize in this kind of financing. The pros of this method include gaining financing without yielding control or equity; the cons of this method include higher effective interest rates than a traditional bank loan.
- MRR Line. For SaaS (Software as a Service) companies specifically, a MRR (Monthly Returning Revenue) line may be an option. MRR lines are available to SaaS companies with low churn and a good credit profile, and through them, you can receive up to three to five times your company’s MRR to aid in accelerating growth. The pros of this method are that MRRs are designed specifically for SaaS companies and offer a relatively cheap, safe source of money. The cons are that you will most likely have to offer a personal guarantee against the MRR line and that you will have to already have a decent revenue stream before you can be considered for one.
If you need help understanding issues relating to debt funding for startups, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.