As a startup founder already gaining traction, you need funding as working capital for day-to-day operations, expanding your team, and entering new markets. Instead of seeking investors, which would lead to offering your startup shares, you opt to borrow money.
You contact a lender, a bank that agrees to provide the funds you will repay over a specific period with interest.
This process is a debt financing round. It is a way to fund your startup by borrowing from lenders or investors while you maintain complete control and instead offer to make repayments with interest.
Are you a business owner, financial officer, entrepreneur, or finance student seeking to understand debt financing rounds as an alternative funding option? This article covers everything you need to know, addressing questions such as, what is the debt financing approach?
Key takeaways
- A debt financing round involves borrowing from financial institutions or investment firms to repay with interest over a specified period.
- Debt financing requires you to pledge collateral such as property or equipment to secure a loan.
- Startups prefer debt financing over equity for reasons including maintaining ownership and control, immediate access to capital, tax-deductible interest payments, and the absence of profit sharing.
- Principal, interest rate, maturity date, covenant, and collateral requirements are key components of debt financing rounds.
- Before considering debt financing, assess your company's revenue stability, cash flow, growth trajectory, cost of capital, financial health, and market conditions.
Definition and purpose of debt financing rounds
A debt financing round is a type of funding where a startup borrows from financial institutions or investment firms, with an agreement to repay with interest over a specified period. This type of financing provides capital for startups to cover costs such as acquiring equipment, expanding teams, enhancing operations into new markets, or even engaging in mergers and acquisitions.
Debt financing requires you to pledge collateral such as property or equipment to secure a loan, unlike equity financing, which involves raising capital by selling shares to investors. While debt financing enables you to maintain complete control of your business, it requires careful financial management to ensure the business can meet its debt obligations without risking its long-term stability.
Debt financing over the short-term
Businesses use short-term debt financing to fund temporary working capital demands, such as wages, inventory, and maintenance expenses. Meanwhile, you repay the loan within a year. A common type is a line of credit secured with collateral. Startups or businesses use it to address cash flow challenges.
Debt financing over the long-term
Businesses use long-term debt to buy assets like buildings, equipment, and machinery. Here, you use the asset as collateral to secure the loan with a repayment period spanning up to 10 years, with fixed interest rates and predictable monthly payments.
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Written by Omoruyi Edoigiawerie, a seasoned startup attorney with over a decade of experience. Learn more.
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Debt financing vs Equity financing
As you try to understand a debt financing round, you should know what sets it apart from the alternative option: equity financing. This section covers the key differences and similarities between debt and equity financing.
Differences
| Debt Financing | Equity Financing |
| Fixed repayment period | No obligation to repay |
| You maintain control of your business | Shareholders have voting rights |
| You can deduct interest payments from your taxes. | No tax benefits on dividend payments |
| No profit-sharing involved | Shareholders receive a share of the profits as dividends. |
| Carries lower risk for the lender | Investors take on more risk. |
| Debt is better when avoiding risk | equity suits those willing to take on more risk. |
Similarities
- Both forms of financing provide capital for businesses to fund operations and projects, among others.
- Businesses maintain positive relationships with both lenders and equity investors.
- Both forms involve a cost of capital: interest for debt and returns for equity.
- Legal regulations and agreements governed debt and equity.
- Investors examine the company's financial health and future potential.
Why companies choose debt financing over equity
In 2023, debt financing in the African startup space reportedly grew to $1.1bn while equity funding declined.
An excerpt states, “Actually, debt is king in 2023, with nearly $1.1bn in debt raised as of November 30 compared to $676m and $257m at the same time in 2022 and 2021, respectively. For every $1 of equity announced, 70¢ in debt were raised in 2023 so far versus 19¢ in 2022 and 7¢ in 2021.”
Startups prefer debt financing over equity for reasons including maintaining ownership and control, immediate access to capital, tax-deductible interest payments, and the absence of profit sharing. Also, the fixed repayment terms in debt financing make financial planning easier, while equity financing involves uncertain returns for investors.
Key components of debt financing rounds
This section highlights the key components of debt financing rounds, their role in structuring the agreement, and their impact on repayment obligations and risk.
- Principal: This is the initial money you borrowed from the lender, which you must repay in full. Note that the higher the principal, the greater the debt burden and the potential financial stress on the business.
- Interest rate: This is the percentage you pay for borrowing. It determines the cost of borrowing. A higher interest rate increases the principal you repay, which may affect your business cash flow and profitability.
- Maturity date: The maturity date is the loan repayment deadline. A shorter maturity date increases your immediate financial burden because it requires quick repayment, while a longer maturity date allows for repayment over a longer period. Meanwhile, it may commit your business to debt for an extended period, limiting your financial flexibility and future borrowing capacity.
- Covenants: Debt covenants are restrictions set by lenders or investors on lending agreements to limit the borrower's actions and require meeting specific financial and operational conditions. It can limit the borrower’s flexibility in making some decisions, such as restricting additional borrowing or major expenditures.
- Collateral requirements: Collateral are the assets a borrower pledges to a lender as security for a loan. If a borrower doesn't meet repayment obligations, the lender can seize and sell the collateral to recover the outstanding debt.
Types of debt financing
Having defined debt financing, its purpose, and its components, it’s important to explore its various types to help you decide what aligns with your business’s financial strategy. Below are some types of debt financing.
- Term Loans: Term loans involve borrowing large funds from a bank or financial institution with fixed or variable interest rates. You repay over a specific period, which may be monthly.
- Lines of credit: A line of credit is a flexible loan that allows your business to access a specific amount of funds as needed. You only pay interest on the amount you use, making it ideal for managing cash flow, covering short-term expenses, or addressing unexpected costs.
- Convertible Debt: This loan offers flexibility for both the borrower and the investor. It is a short-term debt that can be converted into equity at a later stage, usually during a subsequent financing round.
- Bonds: You can raise capital by issuing bonds. A company sells bonds to investors and agrees to pay periodic interest (coupon payments) and return the principal amount upon maturity. The interest rates are often lower than those for term loans or lines of credit.
Advantages and disadvantages of debt financing
Debt financing is a common method for businesses to secure funds, offering benefits and drawbacks. This section explores its advantages and disadvantages to help determine if it aligns with your business financial strategy.
| Advantages | Disadvantages |
| Debt financing allows businesses to maintain complete control without diluting ownership. | Borrowers must make regular, scheduled payments regardless of business performance. |
| Interest payments on debt are usually tax-deductible, reducing the overall tax liability for the borrower. | Interest payments can significantly reduce business profitability. |
| Timely debt repayment can improve the borrower's credit rating, which makes future borrowing easier. | Debt repayment may pressure business cash flow, especially during financial difficulties. |
| Debt financing offers a fixed repayment structure for better financial planning and budgeting. | Failure to meet repayment obligations can damage creditworthiness and future borrowing capacity. |
| Debt financing provides immediate access to capital, allowing businesses to fund operations, expand, or invest in new projects. | Variable interest rates can increase the cost of borrowing over time based on market conditions. |
How to decide if debt financing is right for your business
As a startup founder, deciding on debt financing requires careful consideration rather than a snap decision. There are some factors to consider before you explore this financing option. This section will walk you through key considerations and help you assess whether debt financing is for your business.
- Revenue stability: You should assess your revenue stability and predictability to ensure you can sustain periodic repayments. Startups with reliable income are better positioned to consider debt because they can meet fixed repayment obligations.
- Cash flow: Ensure you do a cash flow analysis. This will help you to determine whether you can generate sufficient cash flow to cover interest payments and loan principal. Positive cash flow shows that a company’s liquid assets are increasing, enabling it to cover obligations, reinvest, reward shareholders, cover expenses, and protect against financial challenges.
- Growth trajectory: Consider whether the borrowed funds will contribute to your startup’s growth. Debt financing is good for startups with clear growth strategies, such as expanding operations and launching new products.
- Cost of Capital: Consider the cost-effectiveness of debt financing against alternatives like equity. For instance, debt offers tax-deductible interest and maintains ownership control, but you should compare the interest rates with potential returns on equity financing.
- Financial health: You should also consider whether your debt-to-equity ratio aligns with industry standards. A high ratio may indicate over-leverage, increasing financial risks. A balanced capital structure is important.
- Market conditions: You should analyze how external economic and industry factors could affect your ability to service debt. A stable economy helps debt repayment, but recessions can affect a business's ability to meet debt obligations.
Examples of debt financing in action
This section explores successful companies that have leveraged debt financing.
- Uber
For Uber, raising funds through debt is preferable to seeking more investors, which would dilute existing ownership stakes.
The ride-hailing company, valued at $146.56 billion, often uses debt as a strategic financial tool. In 2016, the company reportedly secured a $2 billion leveraged loan. As of March 2022, it reported $9.53 billion in total debt and $4.18 billion in cash, leaving a net debt of approximately $5.35 billion. Subsequently, in Q2 of the same year, the company generated massive free cash flow. Within this period, Uber expanded into new markets. The company’s total debt on the balance sheet as of September 2024 is $12.66 Billion. Uber’s continual interest in debt financing shows it benefits the company.
- Apple Inc.'s
In 2013, Apple Inc., a tech company, reportedly issued $17 billion in bonds despite having a large cash reserve. The company opted for debt financing at low interest rates, using the funds to support its $100 billion shareholder return program. This allowed the company to avoid significant repatriation taxes.
FAQs about debt financing rounds
What is a debt financing round?
Debt financing round is a method of funding where a business raises capital by borrowing funds from lenders or investors to be repaid at a specific period with interest.
What are the types of debt financing?
The types of debt financing include term loans, bonds, convertible notes, and lines of credit.
What are the three main terms for debt financing?
The three main terms for debt financing are interest rate, maturity date, and collateral requirements.
Conclusion
Understanding a debt financing round is not taxing as long as you take note of the major aspects highlighted in this article. You must realize that this financing option requires only collateral, which could come in any form compared to equity, where you will have to offer shares.
Debt financing allows you to maintain complete control of your business and even provides immediate access to capital, allowing the company to fund operations, expand, or invest in new projects.
Before considering this financing option, assess your company's revenue stability, cash flow, growth trajectory, cost of capital, financial health, and market conditions.
However, you need to know that debt financing also has disadvantages, such as making regular, scheduled payments regardless of business performance; repayment may pressure your business's cash flow, especially during financial difficulties. Failure to meet repayment obligations can also affect future borrowing capacity.
Ultimately, making the right decision requires weighing the advantages and disadvantages carefully. You should also consult financial advisors to ensure debt financing aligns with their business goals and financial capacity.
