Debt financing is one of the most common ways to get funding. In simple terms, debt financing means an entrepreneur takes out a loan from a financial institution, which he or she promises to repay within a predetermined period, and it is subject to an agreed interest rate. Debt funding can come from various types of funders, including banks, online and mobile lenders, peer-to-peer crowdfunding, impact investors, development finance institutions, microfinance institutions, and others. As entrepreneurs need to pay interest on their loans, typically in monthly instalments, debt financing is best suited to more mature start-ups with stable cash flows.
The amount of funding that an entrepreneur can expect to borrow depends on two factors: first, on the organisation he or she is turning to – a bank or impact investor will be able to offer a larger loan than a microfinance institution (MFI) or mobile lender platform; second, the size of the loan will depend on how much debt the start-up will realistically be able to take on. Early stage start-ups with no product and no customers, for example, usually cannot (and should not) borrow much, while more established companies with stable cash flows can tap into larger pools of credit. In order to apply for a loan, start-ups will need to show a business plan and financial projections; these are meant to explain how the borrower plans to repay the debt.
- When taking out a loan, borrowers typically focus on two key aspects of the financing structure: the interest rate and the tenor (the time until the entire loan must be repaid). The interest rates are seen to be correlated with the riskiness of the borrower – the less likely he or she is to pay back, the higher the interest rate a lender is going to charge, as a premium for taking on extra risk. The rates are also determined by the central bank’s prevailing interest rates in the country. In case of default, lenders get first claim on any assets owned by the business. As such, this is typically seen as a ‘safe’ financing structure from the lender’s point of view, when compared to equity investment.
- Debt financing can come in two forms: secured and unsecured loans. Secured loans are a financing instrument in which the entrepreneur offers some asset as collateral, making the loan less risky for the lender. This could, for instance, be a car or a debenture over assets that the lender will be entitled to take if the borrower defaults on the loan, offsetting some of the risk for the lender and thereby reducing interest rates. Unsecured loans do not have such protections for the lender, and therefore have higher interest rates.
No need to give up ownership in company
Often lenders will ask for collateral
Interest payments can be difficult to make for cash-strapped start-ups