When it comes to raising money for startups, debt financing is usually the last thing on a founder’s mind. However, debt either through venture debt or a convertible note is more common than you might think. Especially when founders don’t want to dilute themselves at the early stages of fundraising.
Besides, taking on the right amount of debt capital can give a business the boost it needs to establish a track record to get a better valuation in latter rounds. As such, there are some scenarios where debt financing might be just what your startup needs and here are a few tips to identify when this is the case.
Focus on Providing Financing
If your startup provides financing to others, then you probably won’t want to burn through the equity capital you have raised to provide loans. Instead, a better option is to use debt financing to expand your lending capabilities. This approach is not as unique, as companies such as Opendoor, SoFi, and Affirm have relied on this as a way to get the money they need to grow.
One thing to keep in mind with this approach is that you want to make sure that you are charging more for you are lending than what you need to pay to your creditors. As such, you shouldn’t just look at the interest rate you will need to cover but also the APR (Annual Percentage Rate).
For those who don’t know, the difference between interest rates and APR is quite simple. The interest rate is the amount of interest you will pay the lender for using their money. While this is normally expressed in annualized terms it is not the APR as the this includes any fees or charges tied to the loan.
This is an important distinction – especially if you are trying to leverage debt for a higher return. The reason is simple if the loans you originate do not include the total cost of the money you are borrowing, then you will end up losing money.
As mentioned, some founders turn to debt financing when they want to raise money, but they don’t want to run the risk of being diluted. While this normally happens during early fundraising rounds, it is not uncommon to use a debt round as a bridge between rounds as well.
In the case of the latter, the funds usually take the form of short-term loans which are either repaid before the next round is undertaken or from the proceeds of what is being raised. While this money is used to supercharge growth, it has the added benefit of helping the founder and their current investors to maintain control.
The reason is simple, equity investors usually want a seat on the board of directors as well as one of their people on the executive committee. While lenders just want to make sure that your company can repay the loan.
The result is that taking on debt means that you and your management team maintain full control of the company. However, this should not be taken for granted as debtors are the first to get paid if a company defaults and as such, you will want to make sure any money you take in the form of loans can be repaid as promised.
Want the Funds to Remain Off Your Balance Sheet
Debt shows up as a liability on your balance sheet. As such, some founders don’t like the idea of being seen to have taken on leverage as they believe it might dissuade equity investors from putting money into their company.
For this reason, some founders turn to off balance sheet transactions to provide the financing they need for their company. However, you don’t want to assume that this sort of financing is easy to obtain. Lenders welcome this option only when the founder’s team has attractive assets outside the company.
When this happens, lenders will set up what is known as a Special Purpose Vehicle (SPV) which is ties up the collateralized assets to ensure the lender can get their money back in the case of a default.
While and SPV is usually set up as a company, it is limited in scope and will be a wholly separate entity from the startup. However, a founder and their team will need to be mindful of how to account for the loan payments as the startup is usually generating the revenue needed to pay back the loan.
The lesson for your startup is that debt financing can help expand your pool of available capital, maintain control, or even keep your balance sheet clean.