Debt Financing Startup: Why Debt Funding Maybe Better Than Equity

Abstract

Interest Category

Debt financing startup, investments, startup funding

Debt financing startups

We hear a lot about startups these days. A startup is a very young company that is in its infancy stage. They are small and financed or operated by one individual or a handful of founders. Their aim is to introduce product or services that are not being offered in the market or create a superior version of a product or service that is already in existence.

Equity funding and debt financing 

Traditionally, equity funding was the most used option when financing a startup. Equity funding is where founders raise the money from investors who then receive a share of profits earned. Debt financing, on the other hand, is only borrowing money without sharing any portions of the profit.

Types of debt financing

There are two categories of debt financing – Long-term debt financing and short-term debt financing. Debt financing works to the advantage of new companies as it is cheaper and helps them keep the ownership rights.

While purchasing assets like equipment, buildings, land or machinery, long-term debt financing are used. The repayment of the loan can be done for a period greater than a year. The lenders expect some assets to be secured in order to avail of this loan. Short-term debt financing is used when money is needed for the day to day expenses of the business. This could be for the purchase of supplies or payment of wages. The loan is for a short period, which is less than a year.

Advantages of debt financing startup

There are many advantages of debt funding over equity. One of the prime benefits of debt funding is non-dilution of ownership in the business. The lender can claim the loan amount plus the interest, like any other loan. They have no stake in the profits of the company.

If the startup is successful, the founders or owners reap benefits of the profits unlike equity funding, where profits must be shared with the lenders. It is easier for startups to plan repayment as there is visibility of the loan amount and principle to be repaid.

There are no compliance issues when it comes to raising debt capital, so it becomes the easier option. As the business is entirely autonomous, there is no need to get approvals from the shareholders.

Read more – Debt funding for startups by Meera Siva

Debt financing, however, has some drawbacks. Debt, unlike equity, has to be repaid at some point. Debt financing comes with interest and in a difficult financial period, high-interest rates increase the risk of insolvency.

Startups need to maintain cash flow to manage repayment of both the principal and interest and can pose to be a challenge to some. Startups are also likely to face restrictions in pursuing alternate options for financing.

When a company has a larger debt-equity ratio, it is often considered a risky venture by lenders and investors. Debt financing carries the requirement to pledge assets as collateral and owners need to make guarantees for loan repayments.