How to Fund A Startup Business: Debt Financing

As an entrepreneur, one of the first questions you thought about (or likely will think about) is arguably the most important question to answer before you launch:

“How am I going to get enough money to fund a startup business?”

While there are multiple mechanisms you can utilize in order to achieve your funding goals, understanding what is best for you and your business can be the difference between going big or going broke. As such, it is important seek guidance from trusted partners (attorneys, business advisors, accountants) in order to make quality informed decisions.

Over the course of the next several articles, Fourscore Law will identify and discuss common sources of funding businesses as well as touch briefly on the costs and benefits of each source of funding.

How to Fund a Startup Business: Debt Financing

One of the most well-established ways of funding your business is by taking on debt in some form or fashion. So, what is debt? In its simplest form, debt means something that is owed (a form of payment or performance) to another.

For a business, taking on debt does not necessarily imply the same negative connotations it may receive in the personal finance space. In fact, most financial experts agree that a healthy amount of debt can help optimize the balance sheet, cash flow, and leverage of a business.

With that said, here are some of the different forms of debt business may choose to take on:

1.      Unsecured Debt – is debt that is not backed by an underlying asset used to secure the obligations of payment or performance. The following example (hopefully) illustrates this point more clearly:

Cavewoman has a piece of stone she has made into a spearhead. Caveman does not have a spearhead, but needs it to go hunting. Cavewoman offers her spearhead to Caveman in exchange for Caveman returning it to her at the end of the day, along with a portion of the spoils of his hunt. Cavewoman does not ask to hold or seize any of Caveman’s property in order to ‘secure’ that she will get her spearhead back.

In the above scenario, if Caveman did not return the spearhead to Cavewoman, she would have no other assets of Caveman to give her “security” that she will get her spearhead back (or its economic equivalent). While it might be advantageous to be free from debt that attaches to assets owned by you or your business, unsecured debt tends to be provided in smaller dollar amounts as well as include higher interest rates to repay the debt, since the debt issuer has significantly greater risk of loss. If your business needs a significant cash infusion to get your products/services launched, or fulfill major purchase orders, this type of debt might not be the most advantageous for you. On that note, however, here are a few examples (and food for thought) of typical ways founders take on unsecured debt:

• Friends and Family - Friends and family tend to be some of the earliest adopters and advocates of a founder’s business. While the initial benefits are typically advantageous, founders should be considerate that taking on unsecured debt from friends and family may be one of the easiest ways to turn trusted relationships sour in the event things do not work out as planned.
• Private & Government Grants - Some (not all) grants offer non-dilutive loans or grants to founders or their businesses. This form of unsecured debt tends to be highly competitive, but the benefits could provide a sizeable chunk of non-dilutive cash in order to get the business running. If you are a female, minority or veteran entrepreneur and/or plan on starting your business in an economically suppressed region, there are a large number of grants specifically tailored to provide you with assistance.
• Certain Angels / Loan Providers - On certain occasions, a select number of angel investors or third party loan providers may allow a business to take on pure unsecured debt or bridge loans; however, they tend to attach additional obligations, such as agreements to provide future rights. As with any debt, founders should be aware that these types of arrangements tend to be for a shorter tenure (payment due within weeks or months), and may also include higher interest rates.
• More Sophisticated Arrangements - For larger organizations (multinational and middle-market companies), the unsecured debt arrangements can become much more complex. Certain entities may restructure and sell outstanding notes or debt of the business. They may also conduct short term overnight financing arrangements to manage cash flow and satisfy regulatory requirements. While these tools are generally reserved for more mature companies, founders should be aware that they exist and situate themselves accordingly in order to deploy these strategies if they are beneficial to the business.

2.     Secured Debt - is debt that is backed by an underlying asset used to secure the obligations of payment or performance. Taking a look back the the above example:

Cavewoman offers her spearhead to Caveman in exchange for Caveman returning it to her at the end of the day, along with a portion of the spoils of his hunt. However, Cavewoman requires Caveman to let her hold his club in order to ‘secure’ that she will get her spearhead back. If Caveman does not return her spearhead, Cavewoman can ‘seize’ the club and now becomes its rightful owner.

In the above scenario, Caveman had to offer up a piece of his property (the club) as collateral in order to give Cavewoman “security” that she will get her spearhead back or be compensated for Caveman’s failure to return the spearhead by seizing his club. Secured debt can be more restrictive to founders, especially if things go south; however, because of the added assurance that debt issuers will get their assets back, they tend to offer higher dollar amounts, longer repayment terms, as well as lower interest rates to repay the debt. These reasons induce many founders to take on secured debt. But, founders should weigh how any such secured debt obligations affect the business in the event things do not play out as intended for the business.  With that said, here are some of the most common ways founders take on secured debt:  

• Traditional Bank / SBA Loans - One of the most often utilized forms of secured debt, many founders look to their local banks in order to inject cash into the business. It is important for founders to acknowledge that banks are in the business of making money off interest rates and fees, typically for customers with a more conservative risk profile. If your business is considered “high risk” (i.e. technology, software, niche products), the terms of your loan may be less favorable than more traditional businesses. Whenever choosing to take on this type of loan, a founder should be mindful of fixed (defined interest rate) vs. variable (interest rate varies based on market demands) rate loans
• Secured Lending - Most businesses will employ some form of secured lending, which can follow traditional arrangements (e.g. automotive loans or mortgages), as well as leverage extremely sophisticated arrangements (e.g. stock loans). Given the variation of secured lending arrangements, founders should pay close attention to what assets are securing the loan (i.e. the collateral).
• Personally Guaranteed Loans - For young (often pre-revenue/pre-profit) business, many debt issuers will require personal guarantees from founders in order to secure the debt obligations of the business. The rationale here is that, presumably, the founders, are more credit-worthy than the business. In one sense, personal guarantees can help procure the necessary amount of funds needed to run the business; however, they also, in part, nullify one of the primary advantages to running a separate business, which is the separation of personal and business assets and liabilities. In the event you do take on a personal guarantee, make sure you understand the personal debt obligations and discuss the implications with your personal financial planner (as well as your spouse!).
• Lines of Credit - Many institutions and financial services companies will offer lines of credit for businesses to draw against. The plans tend to provide flexibility for founders to allocate resources to their businesses as they arise from time to time. Be cautious, however, to ensure that you are only taking on the line of credit you need in order to efficiently run the business. Having too high or low of an amount can disparately impact your business.
• Private Agreements - There is a select number of private debt issuers that prefer to offer pure debt arrangements to businesses rather than take on equity or some type of convertible equity arrangement. As a founder, entering into a secured debt obligation with a private party may be an attractive option, especially if you are concerned about equity dilution. This form of secured debt, however, is most appropriate for founders who know with a high degree of certainty that the business will be cash flow positive early on and is liquid enough to absorb standardized payment schedules.

If you would like to discuss specific questions about your business, contact us here.