If you scan any of the headlines in the Wall Street Journal or other financial or tech publications, you will undoubtedly find news of yet another tech company that has raised millions of dollars of equity funding—most likely from venture capital firms or angel investors. There are entire newsletters dedicated to announcing the latest deals, from seed rounds to series A, B, and C rounds.
If you work for a young startup in Georgia, it is exciting to think of the possibilities of future venture funding. Often, possible venture funding is a signal that you and your company have approached product-market fit and are on a trajectory of rapid growth. The possibilities are extremely promising.
That said, the mechanics of raising money are a different story. While many young tech startups opt for equity financing for their companies, it is recommended that you study a different path. Debt financing can be an effective tool to fund the growth of a young tech startup and it provides some significant benefits compared to equity financing. By understanding the value of debt financing and how it can help your startup, you will be in a better position to evaluate whether debt or equity financing is right for you.
To start off, it is important to be on the same page when it comes to debt financing. The basic definition is intuitive. Debt financing means that the entity taking on the financing receives a certain amount of money in exchange for a promise (in the form of a bond, bill, or note) to pay back that principal and interest to creditors. There are many different forms of debt financing—from SBA loans to convertible loans. To learn more about the wide array of options, you can click here.
The most prominent benefit of debt financing for a tech startup is that owners of the company are not giving up equity in exchange for funding. In essence, the startup’s owners are ensuring that they receive a larger slice of the equity pie while also taking on additional capital to help the business grow. If your startup becomes the next Facebook or Google, you will be extremely happy that you did not give up a percentage point or two of equity in an early financing round.
While the owners of a tech startup can ensure that they are protecting their equity stake in the business, the received capital does have some strings attached. In other words, there are some cons to taking on debt financing. The most prominent aspect of debt financing is that company owners need to pay back the money that is received (plus interest) on a predetermined schedule.
Since many tech startups have little (if any) revenue when they first start their business, they may struggle to find the revenue to pay back their creditors. In addition, companies taking on debt financing may struggle to pay their interest and principal if their company encounters hard economic times. This could even lead to a corporate default. Because of this, young, growing startups may find it more attractive to obtain equity financing so that they can use their limited (if any) revenue to invest in their business instead of paying off creditors.
Even though debt financing may be difficult to obtain for young startups, they may provide funding at lower rates than would be possible in an equity financing round. This is especially true in a macroeconomic environment that contains low interest rates. These lower rates will likely flow down to you, making a debt financing agreement less expensive. Debt financing can also be an attractive option if you are being presented with a suboptimal valuation in a new equity funding round or if you are seeking a premature liquidity event. Finally, it is also important to note that interest payments on debt are tax-deductible, which makes those payments that much easier for your company to bear.
So considering the pros and cons of debt financing, it is important to understand what you should look for if you are considering debt financing for your tech startup.
First, it is important to understand why you are pursuing debt financing in the first place. Is it because you want to protect the equity that you have in your tech startup? Are you trying to avoid the dreaded down round that will impact your company’s financial future in the next several years? Certain companies may be more receptive to debt financing than others. For example, debt financing may be more suited for startups that have sufficient forecasts of revenue and cash flows, as they will be better to plan for their upcoming interest payments.
Debt may not be as appropriate for startups that have highly variable revenue streams or companies with high churn (often found in marketplace companies). Ultimately, you should sit down with your team and have a debate on whether debt or equity financing makes the most sense for your company. That said, it is important to remember that the earlier the stage that your company is in, the more expensive your terms will be should you pursue debt financing.
From there, you and your team should think about how much debt that you should actually raise. This is a question that will obviously vary depending on your company’s financial situation. Nonetheless, you will want to gather with your team—including your CFO—and determine how you will want to allocate the capital that you receive. Importantly, you should participate in this exercise before you actually obtain debt financing. Blindly pursuing the cash without a detailed plan of how you will use the capital could be extremely harmful to the financial health of your company.
Finally, you will want to take a close look at the terms that are being offered. This is an extremely important part of this exercise. You will want to closely examine several things, including the amount of capital being offered, the interest rate that you will pay, whether the rate is variable or not, and the payment schedule for paying back your principal and interest. Paying attention to these payment terms is especially critical. If you have concerns about whether your business will be able to pay back the loan on schedule, you will want to either try negotiating the terms or perhaps even pass on funding from a particular lender.
Especially for new entrepreneurs, it is easy to forget that there are forms of financing beyond equity financing. While there is nothing inherently wrong with equity financing, it may or may not be appropriate for you or your company. Debt financing, in fact, may be a better way to obtain the capital that your company needs to grow and thrive. Ultimately, debt financing can be an extremely valuable tool in your startup’s toolkit. Don’t ignore this compelling option when you and your company are looking for more capital to grow.
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