Debt as Startup Capital

Continuing in Phase One of a four-part Funding Series:

Phase One - Structuring a Fundraise

• Part 1 - Startup Bootstrapping

• Part 2 - Debt as Startup Capital ( ←YOU ARE HERE 😀)

• Part 3 - Equity Funding for Startups

• Part 4 - Convertible Debt 

Phase Two - Investor Selection

Phase Three - The Pitch

Phase Four - Investor Outreach

Let's dive in!

Debt is the most common form of outside capital for new small business owners. While angel investors and venture capitalists get all the big headlines for funding exciting companies, it’s the debt providers that are behind most of the investment dollars that go into the 99% of companies that aren’t splashed across magazine covers and business websites. SBA Loans, Personal Loans to the business owner, merchant cash advances, equipment financing, personal credit cards, invoice financing, invoice factoring, are far more common sources of startup funding than venture capital, an angel investor, when it comes to early stage startup financing.

Options like business loans, larger lines of credit, factoring and other forms of startup financing are useful when there is a well-identified means to service the debt in place.

Key Takeaway – Debt is the most common type of financing however it only works if you have assets that can collateralize it in some form.  

The challenge in debt financing, like a startup loan, is that it requires some form of collateral (in most cases) to secure said startup loan. That collateral can come in many forms, from personal guarantees to company receivables to equipment and real estate. Therefore it is more typically an option for traditional businesses with tangible assets versus speculative businesses (think: Internet startups) that may have to wait years before any tangible asset is created. Getting a business loan as a startup is an uphill battle. A small business owner with a physical presence and tangible assets will have a much easier time getting small business loans than a digital only startup with nothing more than a business plan as collateral.

Overview of Debt Financing

What is Debt Financing?

A company receives capital and promises to repay the amount based on the terms agreed upon between the Lender and the Founder.

How Does Debt Financing Work?

An investor loans capital to the company with the expectation that the principal amount and any accrued interest is to be repaid at a later predetermined date.  The loan is typically “collateralized” by an asset that the lender can collect upon if repayment stops. It is generally based on the personal credit score and credit history of the Founder / Founders, as the company may not even have a business credit score yet.  

Example of Debt Financing.

The Angry Bean coffee company needs $50,000 in working capital according to their business plan.  The co-Founders use the equity of each of their houses as collateral against the $50,000 loan with the bank, along with their personal credit scores.  The loan is paid back like a typical loan would be, and if it’s not, the bank will attempt to use the equity in the co-Founders homes as repayment.

Unlike pursuing equity investors or venture capital firms who write very few checks, debt options are far more ubiquitous and well understood. The challenge around debt is that very few startups have assets to use as collateral for startup loans. Thus, once again, it’s why Bootstrapping is always Plan A.

There are quite a few debt options, though, so we will walk you through each so that you can understand how one might be more accessible than another for your startup or small business. 

When Debt Makes Sense

As with equity, there are a handful of scenarios where debt is the most useful option for financing your company. Things like how much funding you need, how fast you need startup funds, and how applicable your needs are for traditional loans all play a factor for an early stage business. 

When you need less than $50,000

Debt works particularly well for smaller startup amounts, typically a loan amount below $50,000, because those amounts are more in line with what the average person can collateralize themselves. Some options, such as the SBA loan program, can even offer loans with less personal guarantees or collateral. Also, amounts this small aren’t offered to startup founders by venture funds. This territory is best served by a business startup loan.

When you need capital quickly

Debt options tend to be far more readily available and can be turned around more quickly. Debt investors used more of an “application” style approach where they can process your request and turn it around in as little as a few days or as long as a month, depending on how complicated your ask is. Equity, by comparison, can easily consume 3-6 months and has no guarantee that you’ll have any money at the end of the term. So, if you need it fast, business financing options will be a better option than say, venture capital.

When you need the money for a very concrete, tangible reason

If your funding needs are in the physical realm—you just need real estate, for example, or computers or other equipment— a debt raise makes a lot of sense. You’ll have your collateral right there, and you’ll be in position to give your investors tidy timelines. 

When equity isn’t available

Equity investors from angel investors to venture capital tend to focus on a small number of industries that have exponential growth opportunities. This typically means some version of tech. If you’re looking to open an apparel company, your equity options may be few, as investors and venture capital see more upside in tech deals than apparel deals. Therefore a lender is a more likely ally.

When you don’t want to dilute your stake

Debt options typically don’t involve anyone taking a stake in your business unlike venture capital. It’s why you typically don’t hear about your local small business person (who started with loans) complaining about their last Board meeting with angry investors. If you’re particularly excited about retaining control of your startup (you probably should be) then debt is also pretty attractive. If you can get a startup loan, get a startup loan.

Challenges to Debt Funding / Startup Business Loans

While debt is more pervasive than equity, it does come with some of it’s own challenges that may be difficult for a first time Founder to overcome.

Collateral is the Name of the Game

Despite what you may think, banks and online lenders don’t make that much profit on a single loan, especially if a few go bad. It’s this simple – banks make so little on loans that each time a loan goes bad they have to have some asset to collect upon in order to make up for the loss. That’s why collateral is the name of the game.

Lack of collateral is not the end of the world: Lack of collateral doesn’t completely rule out the possibility of taking out a loan. But if you don’t have any collateral and you don’t plan on signing for the loan personally, your options are mostly limited to smaller loans like the SBA-backed options.

Personal Liability

Almost any form of credit that you’ll sign up for in the first few years of your startup is going to require a personal guarantee of some sort, no different than your car loan or a home mortgage. So keep that credit score in good order — bad credit can be a real barrier. Everyone is freaked out by this, understandably so, but it’s typical.

Over time you can begin to shift some of that liability from your personally guaranteed debt plans to one that is guaranteed by the company, but only when the company has proven it has sufficient collateral (think: billings, hard assets, real estate) to stand on its own. That will probably be a while. In the meantime, you’re on the hook personally. Established businesses with historical performance and not just financial projections find it far easier to raise money from business lenders and traditional financing.

Repayment is Real

Your credit card company may be OK with you making minimum monthly payments but chances are your lender will not. Commercial loans are setup with fixed monthly installments (like your car or home) which as they come due can be painful early on for a startup just struggling to get its first paying customers.

There are some credit products that allow you to pay back your loan as your cash flow improves (a “merchant cash advance” sometimes allows for this) but those are the rare exceptions.

Debt Funding Options

There are lots of options available for using debt to fund startup companies, and if you read nothing else in this section it’s worth just scanning these options so you’ll understand the landscape.

Debt Funding Product Landscape

Below is a list of various debt products available as startup or small business financing, including the typical amounts and requirements for each.

• Business Credit Cards

  • Up to $50k

  • Good personal credit

• Business Line of Credit

  • $50k - $500k+

  • Personal guarantee, good credit

• Commercial Mortgage

  • $500k - $10m+

  • Personal guarantee, cash invested, and real estate collateral

• Vendor Credit Line

  • $5k - $50k+

  • Good personal credit

• SBA Loan

  • Up to $25k

  • Personal guarantee, good credit

• Amex Charge Card

  • Up to $50k

  • Good personal credit

• Receivables Factoring

  • $10k to $250k+

  • 1-year History of Consistent Receivables

• Merchant Cash Advance

  • Up to $50k

  • 2-year History of Consistent Receivables
    

Business Credit Cards

Applying for a business credit card works almost identically to a personal card except that it is in the company’s name. Realize, though, that the card being in the “company’s name” doesn’t absolve you of liability. If the company runs out of money and the issuing bank is owed money, they will come after those who applied for the card personally to collect.

Business cards vary but generally offer initial credit balances ranging from $10,000 to $50,000.  Just like a regular credit card, they also give the business the option of making a minimum monthly payment which can help if it’s being used to manage cash flows for future receivables.

Business Line of Credit

Most small businesses at some point try to secure a business line of credit. It’s basically a graduation from the limits of a credit card to help fund the business. These are most commonly secured at your local bank after you’ve been in business for a couple years. The bank will offer a larger line of credit – typically between $50,000 and $500,000 once the underwriter can see that the company has consistent paying customers and fairly predictable cash flow.

There’s not much downside to a business line of credit since, like a credit card, you can pay it down and avoid future payments that spiral out of control. But just like any credit facility, it has to be used as a last resort versus a primary method of covering non-recoverable expenses like payroll and rent.

Commercial Mortgage

If you’re going to buy a building, you’ll need a commercial mortgage. A commercial mortgage mostly resembles a consumer home mortgage in that the entire product is tied to a single property.  

Similarly, the bank will require a down payment, usually a bit higher than what you’ll find to qualify for a home. These down payments can range from 20% on the low end to 30% or more on the high end. Also, banks will almost certainly require a personal guarantee for the loan for early stage businesses since other forms of collateral are rarely available for such a big loan in the early days.

Vendor Credit Line

One of the most consistently overlooked forms of capital are vendor credit lines. Companies who sell products primarily to small businesses – think Staples, Dell, even Home Depot – almost always have an in-house credit facility that tends to be easier to get and more generous than other debt providers.

These will still require a personal guarantee, however because the business itself has a vested interest in selling you more goods, they will often be a bit more aggressive at establishing a line of credit to help you afford meaningful purchases to your business.  

Startup Business Loan  / SBA (Small Business Administration)

Banks have access to the SBA Loan Program which provides a bit of extra collateral from Uncle Sam to subsidize the personal cost toward getting a small business loan. These loans are indeed small – typically below $25,000, but they are often the first real startup business loan options.

While the Government may be subsidizing some of the collateral, that doesn’t mean you’re off the hook on repayment. Banks will still require that you personally guarantee the loan to ensure you repay responsibly.

Amex Credit Card

We’d be remiss if we didn’t single out the American Express card as maybe the easiest access to quick business capital you can get. American Express issues a 30-day charge card (you have to pay the balance in 30 days) very frequently to brand new businesses.

Having an extra 30 days to pay your costs can have a massive impact on a small business. For example, you may use the card to pay for Google Adwords to get paying customers to your Website. You then collect their money today. 30 days later you pay American Express for the Google Ads that you ran. You’re actually collecting money faster than you’re paying it out. Even startups who have raised millions of dollars tend to have an American Express charge card.

Receivables Factoring

A lot of lenders will provide loans secured by the future receivables of your company, provided you have a strong track record of having receivables to begin with. For example, if you’ve been collecting $30,000 per month for the past 18 months (or longer), lenders will offer you a loan based on being able to collect against that $30k receivable number. Essentially, they know you’ve got cash coming in the door so they know there is a way to repay the loan.

That said, they also want to get paid first (before anyone, including you) and they tend to charge a fairly high interest rate for their services. Startups that use receivables factoring tend to use it to supplant uneven cash flow, such as seasonal business who does really well for half the year and runs slow the other half.

Merchant Cash Advance

This is the business version of a payday loan.  Just like a payday loan, it’s the last place you go for a quick infusion of capital and the requirements to pay back are extremely high.  To the defense of the merchant cash advance companies, the interest rates are high because the repayment rates are low – there’s a correlation there in being the last resort of a business for short term loans.

In order to qualify, your business will have to show that It has a consistent history of collecting receivables. This tends to favor companies that collect their revenues via credit card since the history of those transactions is easily available to the merchant cash advance company.

Continue to Part 3 - Equity Funding for Startups