When To Raise Debt Funding: Guide For Startups

As we have seen earlier, 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.

The debt being the term for lending money, debt financing is the case where the investor provides the funds to the startup as a loan. The startup has to pay the investor interest at an agreed rate, which is basically a return for his investment. Also, like loans, here the investor gets a bond issued by the startup as a certificate of his lending. Hence, the startup gets debt funding through the selling of bonds.

In case of raising debt fund, the startup needs to pay back the principal loan amount along with the interest. Here, the investor does not acquire a share of the company and thus has no right to interfere in business decisions or strategies taken. Despite sourcing funds from outside, here the founders or promoters enjoy an autonomous position in the decision-making and are not answerable or accountable to investors in terms of the business roadmap as long as the debt is being repaid. Debt funding provides more flexibility to prioritise business goals.

Timing Is Everything In Debt Funding

Unlike equity or venture capital, debt funding has a stipulated date pre-scheduled for repayment and mentioned in the bond and investors usually prefer to follow it strictly. Also, debt funding is provided against keeping assets as security or inserting certain terms and conditions in the deal, known as covenants. In case, the entrepreneur fails in the repayment, the bank or investor can seize the collateral assets or follow the conditions specified to compensate the losses. It is therefore extremely necessary to go for debt funding, only when the startup can comfortably repay the amount.

Deciding when to raise debt further depends on the types of debt financing and methods of debt funding. Having an understanding of these helps the startup analyse its need and choose the type and method of raising debt.

Debt funds are classified into long-term and short-term debts depending on the nature and tenure of use. Long-term debt financing is usually meant for a huge bulk of funds required for capital costs, setting up the business and infrastructure, buying major equipment, upgrading business or adding further capital for business expansion or growth. Here the repayment period is usually more than a year and often a long period of years, and is associated with a high rate of interests and keeping assets as security or collaterals.

Short-term debt funds, on the other hand, are used by startups to spend on recurring costs like buying raw materials, paying rents or maintenance charges and salaries of employees. Here, the repayment period is usually less than one year and no or minimal collateral is required.

To choose when to raise debt, the startup needs to analyse its own position to comply with the clauses that come along. Long-term debts are advisable only when the startup has assets at hand to allocate as security for getting the debt funding. In case, it is not in a position to raise debt against securities, it’s better to go for equity finance or venture capital funding to avert risking assets. The startup’s founders or promoters need to identify the areas of expense and gauge his own ability to repay, in order to decide the type to debt to raise. This is of immense importance to ensure the right kind of debt financing so that the fund is utilised efficiently and the business also does not bear the brunt.

Debt Funding Market Trends For Startups

But going by the market trends, experts are increasingly suggesting another route for startups. According to many analysts, the best time to raise debt financing is either shortly after an equity funding round, between two equity rounds. This has some merits, compared to the other cases. Firstly, a business is usually at a good pace immediately after the equity round, and here debt funding can inject further momentum. Secondly, having an equity round means the due-diligence process has been freshly carried out. So, if a debt financing follows, the investors here can consider the freshly available due-diligence results and that would take less time in processing the deal.

Also, debt financing in between two equity rounds can save some amount of company equities from being acquired by the venture capitalists. Thus a 20-30% debt financing here would help the founders or promoters retain equity while at the same time raise capital.

Raising debt funding in India is a costly affair when it comes to startups. As the concept is relatively new, the investors often consider it risky to go for debt financing deals with first-time entrepreneurs or founders that have a higher probability of failing in the venture. Hence, the rate of interest, covenants, security requirements and collaterals demands are often very high, making debt funding a difficult option. The situation changes in the case of experienced founders and growth-stage startups that have started earning profit or have steady revenue. A fall in the rate of interest makes it easier for startups to decide on the timing of debt funding.