When startup founders think about raising growth capital, debt financing isn't usually the first thing that comes to mind. Venture capital (VC) has a larger mindshare, and some entrepreneurs get anxious about taking money that has to be paid back. They shouldn’t be.
Your startup has paying customers, maybe even a few enterprise accounts. You have revenue. You hopefully have an accounting function. This infrastructure makes debt manageable because you know your financial obligations ahead of time and you can plan for them. Financing a healthy growing company at this stage with debt isn't going to strain your cash flow — unless you let it — or put you at a competitive disadvantage.
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In fact, successful founders who bootstrapped prior to raising venture capital are often surprised by how well their companies performed when they had just enough cash in the bank compared to when they had millions from equity investors.
In a recent episode of Lighter Capital's Bootstrapped podcast, Jive Software's founding CEO Dave Hersh said, "Looking back, the periods of disciplined austerity were our most productive. The periods when we raised and spent a bunch of [VC] money were the periods when things went sideways."
Rupert Mayer, bootstrapper turned angel investor (and former Lighter Capital client), shared a similar experience on another episode of Bootstrapped. "We thought it was a given we would keep growing like crazy — even faster — with that money, but we didn't. We spent the money way too fast...we burned millions in cash and barely added a million in growth," he said.
There are pros and cons to every capital source, of course, but many startup founders are less familiar with the many benefits of debt financing, one of which is its cost. Compared to equity, debt is significantly cheaper.
Why is debt cheaper than equity?
Entrepreneurs tend to think of venture capital and other equity financing deals like free money. It’s not. In fact, if you plan to scale and exit, debt is almost always the cheaper option.
Here's how to compare the costs. If your startup takes a five-year loan of $1 million at 20% APR, that $1 million will cost you $600,000 by the time you pay it off. But if you take $1 million from a VC at a $5 million valuation (and you sell 20% of your equity), then later get acquired for $15 million, those VCs get $3 million.
For that same infusion of growth capital, your cost is $600,000 for the debt and $3 million in the equity deal, a difference of $2.4 million.
Try our equity dilution calculator to see how much you could save by using debt instead of equity
A real-world example:
Numeracle recently raised $1 million of debt from Lighter Capital and grew their ARR from $1.5 million to $5 million in one year. Listen to Scott Sehon, Numeracle's CFO, run the numbers on what $1 million in equity would have cost them at their rate of growth.
We explore five more reasons debt is often better for startups than equity funding below.
5 Advantages of Raising Debt vs Equity for Startups
1. Startup founders retain their ownership
Taking on equity investors means handing over ownership and control of your business. It also means conforming to their expectations of how your startup should grow. In the worst-case scenario, equity investors can oust you from your own company. Debt lenders stay out of your way as long as you’re making your payments and staying in a position to continue doing so. No board seats, no control.
2. For businesses with sticky revenue streams, debt can be accretive
Jason Lemkin of SaaStr points out that if you’re an early-stage company with recurring revenue streams (like SaaS or subscription-based services), a minor amount of debt will actually increase your net cash flows and let you leverage your existing capital. With the extra cash you can make investments with a big ROI, like hiring or entering into new markets, which can scale your growth further.
3. More time to actually run the company
Raising equity takes at least six to nine months of coffee meetings, pitch presentations, and phone calls — and you don't always get an offer, let alone one with terms you like. Raising debt takes a fraction of that time. Debt capital saves you time once you get it, too. Lenders don’t need to keep up with your every decision, and they don’t require board meetings. They won’t need to deliberate with you over every new hire or strategy. Unless you have debt covenants, you should expect a lender to stay out of your way while you steer the ship.
4. More control and leverage in equity rounds
For savvy entrepreneurs, debt is just one of many funding sources that can be used across the entire startup lifecycle to maximize ownership value and reach a successful exit. Raising debt, particularly in your early stages, doesn't mean you can't also raise equity when the time is right. Debt financing can give you the fuel you need to gain early traction on your own, not only making your business more attractive to VCs but also giving you leverage to negotiate a higher valuation. If you've already raised VC money, you can use debt to extend your runway and buy yourself more time before your next priced equity round.
5. Debt offers tax benefits that can offset costs
Assuming your company is out of the red, debt financing provides a few tax advantages that equity financing does not. If your business uses accrual accounting, the interest portion of your payment runs through your profit and loss statement, which reduces your taxable net income. This means the effective cost of the borrowing is less than the stated rate of interest. Essentially, the U.S. government helps mitigate the cost of your loan.
Shopping for debt your startup?
Don't sign a loan agreement until you've read our debt buyer's guide. We give you 10 questions to ask that will help you navigate tricky terms and conditions so you and your startup can avoid unexpected costs and unnecessary risk.
Debt Financing Disadvantages
Is your startup poised to disrupt a market? Debt may not provide enough capital to achieve your goals. If you need to raise tens of millions of dollars to reach your next milestone, debt financing is probably not your best option.
Beyond that, the disadvantages of debt for startups stem from the risks of borrowing money. Just like any loan, you'll need to pay back the capital with interest and make your payments on time. A little fiscal knowledge goes a long way, though.
Here are four useful tips for avoiding bad debt deals and minimizing your financial risk:
Choose long-term over short. While it may seem more cost-effective, short-term business loans that have to be repaid in 12-months or less can burn up your cash before you start seeing an increase in revenue from your capital investments.
Understand how the term rates and repayment terms work. APRs, repayment caps, and discount rates each affect your true cost of capital differently. Make sure you understand what the loan will or could cost you and how repayments will impact your future cash flow.
Avoid debt covenants. Covenants increase your risk as a borrower, so look for a lender that provides debt financing without restrictive covenants.
Don't borrow more than you need. You don't want to be carrying and servicing debt that isn't generating a return for your business.
Ultimately, the funding option you pick today will determine what you can and can’t do with your business in the future.
It’s important in your early years to be aware of all your startup financing options. Think about where you want your company to be in one, five, or ten years, and think about how much time, control, and money you’re willing to give up getting there.
Learn more about debt financing for startups
It’s one of our most popular founder resources! Financing Your Startup Using Debt can help you make smarter fundraising choices.
Learn the ins and outs of debt financing so you can avoid tricky terms and conditions that might hold your startup back. See how to compare different types of startup loans, then work through specific financing examples to understand the real costs with this comprehensive guide for entrepreneurs.