What is debt financing?

Debt financing is a method where startups borrow capital from external sources with the agreement to repay the borrowed amount, plus interest, over time. Unlike equity financing, debt financing allows startup founders to retain full control of their business, as no ownership is exchanged. This strategy is particularly beneficial for startups aiming to fund their growth while avoiding equity dilution. 

How to get debt financing?

Debt financing can be a great way to secure the funds your startup needs without giving up ownership. However, it requires careful preparation and planning. Here’s how debt financing works and how you can approach it effectively:

Step #1: Understand the type of loans available

Determine the type of debt financing that suits your business needs. Consider factors such as:

• Loan amount: Determine the exact funding your startup requires.
• Repayment terms: Check the period and repayment frequency (monthly, quarterly, or annually).
• Interest rate: Compare rates from different lenders to find a feasible option.
• Loan type: Options may include term loans (fixed repayment schedules) or lines of credit (access funds as needed).

Step #2: Prepare financial documents

Gather key financial documents to present a clear picture of your business's financial health and valuation. These typically include:

• Business plan: A detailed plan outlining your goals and how you plan to achieve them.
• Profit and loss statement: A summary of revenues and expenses for a specific period.
• Balance sheet: A statement showing your assets, liabilities, and equity.
• Cash flow projections: Forecasts showing how you’ll manage repayments.

Organizing these documents makes it easier for lenders to assess your creditworthiness.

Step #3: Identify potential lenders

Explore different types of venture debt lenders to find one that aligns with your needs:

• Banks: Offer loans at lower interest rates but have stricter eligibility criteria.
• Non-bank lenders: May provide flexible loan structures but often charge higher interest rates. They might also negotiate for convertible debt (debt that can be converted into equity).

Compare offers from multiple lenders to identify favorable terms.

Step #4: Apply for a loan

When applying, submit the necessary documents and be ready to answer questions about your business operations, revenue, and repayment plan. Lenders typically evaluate:

• Revenue streams to confirm repayment capability.
• Existing assets (if applicable) for collateral purposes.

For early-stage startups without significant assets, lenders might focus on future cash flow projections.

Step #5: Review and finalize the loan agreement

Before signing, carefully review the loan terms. Pay attention to:

• Interest rate and fees: Make sure they align with your budget.
• Repayment schedule: Confirm the frequency and amounts of payments.
• Additional conditions: Understand any collateral or guarantees required.

Also, get instant clarification on anything unclear to avoid surprises later.

Advantages of debt financing

The pros of debt financing can be:

Retaining full ownership

One of the biggest advantages is that entrepreneurs don’t have to give up any part of their business. Unlike equity financing, also known as equity funding, where you sell shares and lose a degree of control, debt financing lets you maintain complete decision-making power. You retain all future profits and control over how your business is run, making sure that your vision stays intact.

Tax benefits

Interest payments on loans are usually classified as business expenses, making them tax-deductible. This can lower your taxable income and reduce the overall cost of borrowing. 

For instance, if you have a loan with high interest, the tax deduction can make the expense more manageable, freeing up resources for other priorities. Always check with a tax professional to understand how this applies to your business.

Predictable payments

Debt financing often comes with fixed repayment terms. You’ll know the exact amount you need to pay every month, including both principal (the borrowed amount) and interest. This predictability allows you to plan your cash flow and manage your finances more effectively, helping you avoid surprises that could disrupt your operations.

Building business credit

Successfully repaying loans on time helps build your business credit score. A strong credit profile makes it easier to qualify for future loans and negotiate favorable terms like lower interest rates on your business credit card. Additionally, good credit can improve your credibility with suppliers and other partners, creating more opportunities for growth.

Flexibility in loan options

Debt financing comes in various forms, such as term loans, lines of credit, and Small Business Administration (SBA) loans. You can choose a loan structure that best fits your needs, whether it’s for short-term cash flow or long-term investments.

SBA loans, for instance, offer competitive rates and extended repayment terms, making them an ideal choice for larger projects like expanding your business.

Disadvantages of debt financing

In contrast, some cons associated with debt financing may be:

Repayment obligations

No matter your business performance, you are legally bound to repay the loan. If your business underperforms or fails, you may need to use personal assets or liquidate business assets to repay the debt. Lenders often get priority in repayment during bankruptcy, which can leave little or no funds for you or your equity investors.

Interest costs

Borrowing comes at a price: interest. The total repayment amount is always more than the amount borrowed. If interest rates are high or the loan terms are unfavorable, this can significantly impact your profit margins. For example, loans with hidden fees or variable interest rates might become more expensive over time, increasing financial strain.

Cash flow pressure

Regular loan repayments require a steady income. Businesses with irregular cash flow or those in the early stages may struggle to meet these obligations. Missing payments not only incur penalties but can also disrupt your operations, as funds that could have been used for growth or emergencies are directed toward loan repayment.

Risk of default

Failing to repay a loan has serious consequences. It negatively impacts your business credit score, making it harder to secure future loans. Additionally, defaulting could lead to the loss of collateral—assets like equipment, property, or inventory that were pledged to secure the loan. In some cases, lenders might take legal action to recover the debt.

Challenges with qualifying

Lenders often have strict requirements for approval. These include a strong credit score, steady revenue, and operational history (usually one or more years). For new or small businesses, meeting these criteria can be difficult. If you don’t qualify for traditional loans, alternative financing options might come with higher interest rates and less favorable terms.

Alternatives to debt financing

When seeking funding for your business, debt financing isn’t the only option. Several alternatives can meet your specific needs and help you achieve your goals without the obligation of repaying loans with interest. Below are some alternatives to debt financing:

Merchant cash advances

A merchant cash advance offers immediate funds in return for a portion of your future sales revenue. It involves a flat fee, not interest, and repayments are made daily or weekly, depending on your sales.

This option works well for businesses needing quick cash flow for short-term needs, such as purchasing inventory or handling unexpected expenses. However, the flat fee may be higher than traditional loan interest rates, making it less appealing for some.

Equity financing

With equity financing, you raise money by selling ownership shares in your business to angel investors. In return, investors gain a stake in your company’s profits and losses. This method doesn’t involve repayment or interest but does reduce your ownership control.

Government grants

Government grants are funds provided by federal or state programs for specific purposes, such as innovation, research, or supporting underrepresented communities. These grants don’t require repayment, making them attractive. However, they are highly competitive and often come with strict eligibility criteria.

Convertible loans

A convertible loan allows investors to provide funding that can later be converted into private equity during a future investment round. While the company initially pays interest on the loan, it doesn’t dilute ownership until conversion. This option is common for startups seeking bridge funding.

Crowdfunding

Crowdfunding involves raising small amounts of money from many people through online platforms. In some cases, contributors receive rewards like products, while in equity-based crowdfunding, they gain a financial stake.

Leasing

With leasing, you rent equipment, vehicles, or other assets for a set period. Instead of purchasing, you pay regular fees, which keeps your upfront costs low. Leasing is ideal for businesses that need expensive tools without the burden of ownership.

Factoring

Factoring involves selling your unpaid invoices to a factoring company. The company provides immediate cash based on the invoice value and takes responsibility for collecting payment from your customers.

Wrap up

Venture debt financing offers startups a powerful way to access growth capital or working capital without sacrificing equity or control. However, it’s essential to evaluate the terms, maintain strong creditworthiness, and align financing strategies with your business goals.

If your startup is considering funding options, take time to assess your business model, specific needs and explore the benefits and risks of debt financing options. If you're looking for alternative options to fund your startup's growth, consider Rho's Corporate Cards.

With them, you can make the purchases you need to keep your business operations running smoothly without diluting your business, all while enjoying 1.25% cashback. Combined with Rho's expense management platform, you can make more strategic spending decisions and gain the insights you need to take control of your budget.

Want to learn more? Schedule time with a Rho finance expert.

Pia Mikhael is a guest contributor. The views expressed are theirs and do not necessarily reflect the views of Rho.

Any third-party links are provided for informational purposes only. The third-party sites and content are not endorsed or controlled by Rho.

Rho is a fintech company, not a bank. Checking and card services provided by Webster Bank, N.A., member FDIC; savings account services provided by American Deposit Management, LLC, and its partner banks.

Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.

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