What Is Debt Financing? – Types, Sources, Pros & Cons

Usually, during the initial stages of the startup, the money comes from the pockets of founders and cofounders. But soon, as the startup grows, this money inflow isn’t able to keep up with the startup’s growth. It is when the founders need to make a tough decision of whether to raise money by diluting ownership (equity financing) or by taking loans (debt financing).

While equity financing requires no repayment and doesn’t even act as a liability to the startup, it dilutes the ownership and the decision-making process. This makes many founders choose debt financing as a capital financing method, that requires repayment along with interest.

What Is Debt Financing?

Debt financing is the method of raising capital by selling debt instruments to individuals or institutional investors.

By purchasing such instruments (notes, bills, and bonds), the investors become the creditors to business and receive a promise to receive payments (with interests) based on the debt financing agreement.

Characteristics Of Debt Financing

Unlike equity financing where company’s shares are sold to the investors, debt financing doesn’t dilute the ownership of the company and the founders maintain their decision-making rights. But it comes at the cost of an additional liability in the form of a loan to the business.

  • The investor is the creditor: Debt financing involves taking loans from investors (usually banks, high net-worth individuals, angel investors and groups, and venture capital firms, etc.). Such investors become creditors to the business who have the right to get repaid even if it requires to sell business’s assets.
  • Investment is a liability: The business signs an agreement with the investors promising them to repay the loan along with agreed-upon interest within the specific time period. This forms a liability to the business.
  • Ownership isn’t dissolved: Taking monetary investment in the form of debt doesn’t dissolve the ownership of the founders and they enjoy full control over the business.

How Does Debt Financing Work?

Debt financing involves selling of fixed income instruments like notes, bills, and bonds to the investors to obtain capital investment required for the business to run, grow, and expand. These instruments come with a promise of repayment along with the agreed interests at some agreed date in the future. If the company goes bankrupt, these lenders have a higher claim on the liquidated assets than the shareholders.

Generally, startups go for debt financing when their valuation is hard and equity financing isn’t possible. Such funding is provided after considering the –

  • Creditworthiness of the founders,
  • Creditworthiness of the business,
  • Future potential valuation of the business, and/or
  • Current growth graph of the startup and its future milestones.

Debt instruments come with a stipulated date pre-scheduled for repayment and both the parties are required to follow it strictly. Moreover, certain assets are kept as a security against such debt or certain terms and conditions are mentioned, called covenants. In case the startup fails to repay the debt, the investor usually gets the rights to recover his investment by seizing the collateral assets or through other means decided in the terms.

Types Of Debt Financing

Debt financing can be categorized into different types depending upon the time-period between the investment and repayment and the type of loan granted.

  • Short-Term Loan: Money borrowed to meet the working capital costs and short-term expenditures like administrative costs, rents, maintenance, etc. come under the head of short-term loans. Usually, the company’s assets are not kept as securities for short-term debts.
    • Bills: These debt investments mature within a year and don’t come with interest payments. Rather, they are sold at a discount to their face value, and investors get the full amount upon maturity.
    • Revolving Loan: Often provided by the financial institutions or an investor as a line of credit that the startup can withdraw, repay, and repeat over and over again. 
    • Cash Flow Loan: Such loans allow the company to borrow money based on its projected future cash flow, which is held as security. Unlike usual instalment loans, startups repay such loans as they earn revenue that was used to secure the loan.
  • Long-Term Loan: It’s the investment, extending for more than a year, required to develop and work on the infrastructure, growth, and other long-term strategies. Such loans require the startup to keep the company assets as securities or collaterals along with accepting certain terms and conditions, called covenants.
    • Notes: Notes are debt instruments with maturity from two to ten years. They pay interest periodically (annually or semi-annually).
    • Bonds: Bonds are debt instruments having maturities of greater than ten years. They pay interest periodically (annually or semi-annually).
    • Mezzanine Financing: It’s a hybrid of equity and debt financing where the lenders provide the companies with a loan with specific terms that include repayment in the form of equity interest if cash flow isn’t available. In simple terms, the mezzanine lender has a warrant enabling him to convert the security into equity at a predetermined price per share if the borrower company fails to repay the loan on time or in full.
    • Convertible Notes: Convertible note is a hybrid-debt-equity-investment, ranging from 18 to 24 months, used to invest in early-stage startups that the investor can choose to convert into common shares at a later time or an event when it is easier to determine the company’s valuation.

Sources Of Debt Financing

Different types of debt financing come from an equally different number of sources. These are –

  • Banks and Financial Institutions: Banks and credit unions provide both short term and long term secured loans to the business.
  • Individual Private Investors: Private investors are usually among the friends, family, and fools who trust in entrepreneur with their money and invest considering the entrepreneur’s credibility along with the business.
  • Angel InvestorsThese are high net-worth individuals who invest during the early stages of the startup. Usually, they invest using convertible notes or convertible equity contracts, but there are also times when they offer just debt.
  • Venture Capital Firms: These are professional investment firms formed by the association of high-net-worth individuals, angel groups, angel investors, and corporations who invest in high-potential startups.
  • Crowdfunding PlatformsPlatforms like Lending Club, Prosper, etc. form middlemen that help the business raise small amounts of money from a large number of investors to fulfil its debt investment needs.

Debt Financing Pros And Cons

Debt financing comes with its own set of advantages and disadvantages.

Debt Financing Advantages

  • Ownership Rights Are Not Diluted: The investors who invest in the form of debt become the creditors of the business and have no right in the decision making of the business.
  • It’s Faster Than Equity Financing: Equity financing takes considerable time as it involves pitching, negotiations, term sheets, etc. Debt financing, on the other hand, is a comparatively faster process.
  • The Options Are Flexible: Debt financing comes with varied options depending upon the type of loan required and the time period for which it is required.

Debt Financing Disadvantages

  • Is A Liability: The biggest disadvantage of debt financing is that it’s a liability that needs to be written off on or before the due date. 
  • It’s Expensive: The interest on debt can rise up to 30% of the principal amount that can prove to be very expensive to the business.
  • Hard To Qualify: Debt financing requires numerous background checks, business credibility checks, individual credibility checks, along with other formalities that make it hard to qualify for the same.

Equity Financing vs Debt Financing

Both equity and debt financing come with their favourable and unfavourable terms that may suit or not suit the business.

Debt Financing
Equity Financing
Is a liability
Isn’t a liability
Investor Status
The investor is the creditor
The investor becomes a shareholder of the business.
Qualification Requirements
It requires good creditworthiness of the startup and the people behind it.
It requires a competent team, a validated market opportunity, a well-defined business model, and a growth plan.
Effect on cash flow
It requires the startup to pay periodic interests and affects the cash flow of the business.
It doesn’t require the startup to pay periodic interests on investment so it doesn’t affect cash flow.  

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