Your browser is currently blocking notification.
Please follow this instruction to subscribe:
Notifications are already enabled.

Debt Funding Guide For Startups

Debt Funding Guide For Startups

Debt financing requires the startup to pay back the money invested in instalments

Doing background checks on debt funding investors is vital for startups looking to raise funds

What are the criteria for a startup to successfully get debt funding?

fundraising 101 banner

A startup thrives on funding, right from its ideation phase to the point of reaching IPO offerings, mergers or acquisitions. During the pre-seeding or seeding stage, capital is usually paid from the entrepreneur’s pocket. However, it’s time to raise funds from external sources once the business starts rolling. If one decides to raise funds from the market, there are a lot of options to do that, such as debt funding, equity financing, crowdfunding or by being a part of government aids and initiatives to promote entrepreneurship.

While debt funding is provided as a loan and needs repayment, equity financing requires the startup to part with a share of the company against the funding by the investor. Crowdfunding, on the other hand, needs founders to share the startup’s business plan on a common platform and attract investors for funding against some benefits. So, it’s up to the startup to decide which option to pick for funding. depending on the respective pros and cons. However, here we will focus on the guide to debt funding for startups.

Why And When To Go For It?

Debt funding is the process in which an investor lends money to an entrepreneur for their business needs for a certain period at a given rate of interest. In exchange, the company sells the investors bonds that act as a certificate for the loan. Here, the startup has to pay the debt fund back on a pre-scheduled date along with the interest payment. Here, the investor’s gain is obviously the interest payment, which is usually set at a pretty high rate in case of startups, to compensate for the risk of business failure. Moreover, the business loan is provided against the company or startup’s assets as debt securities. So, in case of non-repayment, business failure, or bankruptcy of the startup, the investor or the bank can recover money by seizing assets.

Equity financing or venture capital (VC) funding, on the other hand, doesn’t require the startup to pay back the money invested. It might seem like the right choice of funding to a first-time entrepreneur. But there is one crucial clause that needs to be considered while making this pick. Equity funding requires the startup to part with a large chunk of equity, which the investor acquires against the funding they provide. This gives them a place in the board of directors of the startup, and thus, a say in business decisions. Since venture capital funding seeks earnings as big returns from the business, the investors attempt to ensure and secure that through dictating terms on the functioning and strategies of the company. This is where debt fund differs; here, the investor only gets the loan repaid with interest and therefore has no right to interfere in the business. Thus, the founder can freely run their startup and strategise their business the way they like.

Debt Funding Options For Startups

If startups choose debt financing as the mode of raising fund, it is extremely necessary for them to identify their needs and fund requirements first and then approach the investors accordingly. Unlike venture capital financing, debt funding is not classified according to stages of growth of the startup but the nature of its needs and tenure of the loan. Debt funding is thus classified into long-term and short-term loans, depending on its usage and terms associated.

  1. Long-term loan: A startup founder needs infrastructure, setup, equipment and bulk of raw materials to start their business. Usually, these require a huge amount of money in different stages, and the startup requires a long-term fund. In this case, long-term loans are taken from the investors for arranging capitals in initial years and adding on capital in later years of business. These loans have tenure of at least more than one year and, usually, have a high rate of interest. Since these long-term debt funds usually have long tenure and are often raised at the initial phase of business, the investors seek company assets as securities or collaterals and can also put forward certain terms and conditions, known as covenants.
  2. Short-term loan: Apart from capital costs, there are certain other expenditures that a company needs to take care of while running its business. Expenses incurred on salaries of employees, rents and maintenance fees, regular raw material requirement, etc. are termed recurring payment, which too needs funding. For this, the startup seeks short-term loans for a maximum tenure of one year. Since these loans are meant for a short period, interest rates are lower, with minimal or no collateral requirement.

Types of debt funds can be better explained through debt financing examples. Think of a startup that provides furniture and appliances on rent and operates through a mobile app. In this case, there will be various needs such as office setup, delivery arrangements, maintenance services, deployment of technology to run the app, maintaining the customer base, keeping track of their requirements, preferences and orders and managing inventory and delivery. Thus, long term debt funds take care of all these, as well as working capital. But there are recurring payments as well, like rents for office spaces, costs of management and maintenance of inventory and wages of employees. The startup can raise short-term debt funds for these expenditures.

Pros And Cons Of Debt Funding

Knowing what debt funding is or what debt fund is, as well as types of debt financing is not enough to decide whether to choose this route to raise funds. The startup must also know the pros and cons of debt funding and compare it with equity financing before they make the choice.

Advantages Of Debt Funding

  1. The most important benefit is that here, the investor doesn’t have a right over the company’s decisions. The startup gives company bonds to raise money in this case, which is basically a certificate of lending and not a company share. Thus, the investor’s role starts and ends with lending and its repayment and they have no right to interfere in the functioning, operations or business decisions of the startup. Thus, the founder gets to run their startup freely and retains autonomy over business decisions.
  2. Debt funding takes place for a stipulated period, thereby allowing the startup to enjoy the flow of money for the entire period. Compared to venture capital funding, this is surely an advantage as venture capitalists can make an early exit and withdraw rest of the funding promised if they anticipate loss.
  3. Another benefit of debt funding is that the money raised at any time can be used according to the founders’ and the business needs. Equity financing, on the other hand, is targeted at specific use-cases, and the investor can intervene if the money is being used otherwise.
  4. Startup debt financing can be raised at any stage of the business, depending solely on the usage of money and time required for repayment. This is a benefit as well, as equity funding differs at different stages of the business in terms of the nature of investment, terms and conditions and the investor’s mindset and dealings.
  5. Debt funds are provided at a fixed rate of interest. Compared to equity financing, this is profitable for entrepreneurs if the business earns returns at a higher rate. In the case of equity financing, the investors have to be paid higher dividends, in accordance with the profit made by the startup.

Disadvantages Of Debt Funding:

  1. The first and foremost disadvantage of debt funds is the compulsion of repayment, irrespective of the company’s condition. Unlike equity funding, here the startups need to pay back the money, along with interest, irrespective of whether the business has incurred loss or earned profits. For startups that have a higher probability of failing, this is a major concern.
  2. Startup debt financing is provided against the company or founder or promoter’s assets, which are treated as debt securities. Thus, if the business fails or there is bankruptcy, those assets can also be seized by the investor or the bank in case of non-repayment, leading to even higher loss. So, it’s not advisable to raise debt funds without adequate assets.
  3. Since investing in startups is usually a risky affair, startup debt financing is provided at a high-interest rate. Compared to venture capital funding, this is indeed a disadvantage as returns for equity financing vary according to the amount of profit. But with a fixed rate of interest that is high, losses will be more if the business doesn’t perform well.

Challenges For Startups In Raising Debt Funding

Understanding the process of startup funding is incomplete unless one views it from an investor’s perspective as well. When it comes to investing in startups, debt funding is, of course, the safest form for the investor. This is because while every business is volatile, startups are indeed the riskiest venture, and here, debt funding involves repayment along with interests at a fixed rate.

The success rate for startups has always been low. With the lack of money and inexperience of business strategies, there is no guarantee that all will fall into place and bring profits. Thus, returns from investment are not at all secured.

At this point, an assured repayment of the invested money along with interest payment is indeed profitable. And even if there is a failure in business, debt fund investors can recover their money by seizing the assets and selling them off. Thus, debt financing can be called a stable investment when it comes to getting the money back. Moreover, if the company goes bankrupt, the debt fund investors are the first ones to get money back, whereas venture capitalists are the last to get the money. It is for this concept of stability that even venture capitalists and firms keep debt financing deals in their investment portfolios to balance profit and loss incurred.

Despite that, finalising a deal needs some sort of assessment by debt fund investors as well. Startup debt financing requires investors to do a proper background check and assessment of the business plan. This is needed to avert hassles in future and maintain a good track record in debt funding. Thus, the investor needs to do a proper background check of the startup and its founders, in terms of documents, credibility and track record of repaying loans. They also need to carefully assess the business plan to gauge its validity, probability of success and strength of planned strategies.

How To Raise Debt Funding?

This is just the beginning when it comes to raising a debt fund. Next, he or she has to do a proper market survey to make a list of investors or firms that are into startup debt financing and have a good experience and track record. Startups can turn to individual investors in the market who provide debt funds, as well as venture capitalists that make startup debt financing deals to balance profit and loss in their investment portfolio. Banks, NBFCs and MFIs also provide debt funding.

To pick the right investor with a feasible rate of interest, the startup’s founders need to do a thorough background check for their credibility, and terms and conditions. The task that remains is persuading the investor, for which the entrepreneur needs to present a solid business pitch with the clarity of plan and strategies, company balance sheets, and a defined path of growth supported by data and documents. Investors, on the other hand, go through all the documents and verify the startup’s claims and credibility under the due diligence checks.

Why Debt Financing Is Critical At Times?

In India, where the concept of a startup is just a few years old, the thorough background checking and documentation are stringently maintained by banks, non-banking financial companies and microfinance units. With the startup ecosystem being in its early days, individual investors are still sceptical about investing in them and tend to refuse. Banks, big business groups and NBFCs also often display a lack of confidence in startups and tend to disapprove funding appeals. Thus, often, good businesses find it extremely difficult to get funding. Similar is the case when it comes to raising equity funding.

To sort this situation, the government of India has stepped in to encourage the youth for entrepreneurship and build a strong and wide ecosystem of startups in the country. Under the Pradhan Mantri Mudra Yojana, the government has introduced many schemes to provide easy loans to the young entrepreneurs at favourable interest rates, and terms and conditions. These loans are disbursed through banks and NBFCs after the business plan is submitted along with all the required documents. Once the loan amount is disbursed, banks and NBFCs are refinanced by the government designated NBFC, Mudra. Also, under the scheme, microfinance institutions have initiated microcredit schemes to provide debt funds to the startups. All the loans and microcredit schemes are designed to help entrepreneurs, with some offering easy terms and conditions and others doing away with the collateral system up to a certain amount that is possible.

There are also multiple private organisations, investment firms, business networks and top debt funds operating in the economy to support the new-age entrepreneurs in every way. Guidance in strategising business, technical support and infrastructural aid are being provided to the first-time entrepreneurs so that they grow and upscale their business successfully. Therefore, debt funding is playing a key role in the government of India’s strategy to uplift the economy through a strong startup ecosystem and an energised set of budding entrepreneurs.

Message From Our Partner

Gain insights from sessions designed for your role and industry with AWS Summit Online 2020.

Note: We at Inc42 take our ethics very seriously. More information about it can be found here.