Debt financing may seem counterintuitive for startups, because it involves paying back interest on borrowed money, which usually only more mature companies are capable of. Nevertheless, debt presents a strategic approach that can complement equity funding. Startups can leverage debt to

• bridge funding gaps,
• ‍extend their runway,
• finance expansion initiatives,
• and weather difficult economic times without compromising their equity ownership.
  

In recent years, more startups have encountered this funding source. In 2023, European tech companies are projected to secure approximately $1.5 billion in debt financing. This is 3.4% of the total capital invested as equity. After an all-time high in 2021, debt funding is again in line with the amounts raised in 2019 and 2018.

When to consider a startup loan

Still, startup loans can be a valuable source of funding for young companies. But it's crucial to strike the right balance between maximizing financial resources and maintaining control over the company. Early-stage startups often prioritize bootstrapping or seeking equity financing, but startup loans can become a viable option as the company matures and demonstrates traction. 

Once a startup has established a solid foundation, validated its product or service, and generated revenue, it may be ready to consider taking on debt. At this stage, most companies have a better track record and are more likely to repay their debt. 

Other than that, startup loans are particularly well-suited for companies seeking funding for specific purposes with a clear goal and return on investment, such as:

Working capital

Acquiring inventory, paying salaries, or covering other operating expenses can be challenging for young companies. Startup loans can provide the necessary working capital to fuel business operations and ensure smooth functioning.

Large one-time expenses

M&A, purchasing equipment, machinery, or office space can be essential for expanding operations or enhancing production capabilities. Startup loans can help finance these investments.

If you want an example of how to finance such large one-time expenses with debt, see how Event Inc Group is using re:cap to refinance its M&A business.

Expanding market reach

Entering new markets or expanding into new verticals can require additional capital for marketing, sales, and infrastructure development. Startup loans can support these expansion efforts, allowing the company to reach a wider customer base.

If you are looking for an example of how to enter a new market with the support of debt capital, see how Exporto is using re:cap to boost its internationalization.

Mitigating market fluctuations

Seasonal shifts or economic downturns can disrupt cash flow and hinder business growth. Startup loans can provide a safety net during these periods, ensuring the company can maintain operations and weather the storm.

What are the challenges when accessing startup loans?

Not every startup is eligible for debt funding. There are limitations when it comes to the company phase or providing securities, such as:

• Early-stage challenges: Securing a startup loan can be challenging for early-stage companies (pre-seed and seed) with limited financial history and track records. Yet, alternative lenders may offer more flexible eligibility criteria and accommodate startups with strong potential.
• Collateral requirements: While some startup loans may not require collateral, others may demand securities such as equipment or real estate. This can be a limitation for young companies with limited assets.
• Interest rates and fees: Startup loans typically carry higher interest rates and fees compared to traditional bank loans due to the perceived higher risk associated with early-stage ventures. Founders should carefully assess the cost of capital. 

Types of startup loans

Several types of startup loans are available, each with its unique features and eligibility criteria:

Venture debt

As startups mature, venture debt financing may become an option. These loans are typically provided by specialized venture debt firms. Those risk loans are used to bridge the gap between two equity financing rounds. Usually, venture debt comes with a high cost of capital (interest rates between 15-20%), causes dilution of shares through warrants or equity kickers and includes covenants.

Venture debt is growing in popularity among startups. In 2022, there were 16 transactions in Germany and 337 across Europe. In each case, these were the strongest years so far.

Convertible loans from angel investors

Some angel investors offer debt financing options, providing startups with capital without diluting equity. These loans often have flexible terms and may be structured as convertible loans, which can convert into equity at the next equity fundraising.

Alternative debt financing

Innovative financing options like alternative debt funding are gaining traction. They are tailored to the specific needs of startups. Its providers leverage technology and data-driven approaches to assess risk based on financial metrics, recurring revenue, customer base, and unit economics. This approach provides startups with debt capital when needed – without the risk of overfunding and excessive capital costs.

Revenue-based financing (RBF)

With revenue-based financing, investors receive a fixed percentage of the company's future revenue in exchange for their investment, making it a non-dilutive option. A potential fit for startups with recurring revenue streams.

Bank and business loans

Bank and business loans are the most traditional way for a startup to raise debt. However, such loans might not be viable for all startups due to limited revenue, lack of securities, and missing profitability. In Germany, only 12.8% of the startups use this financing source.

Term Loan

A loan with fixed repayment terms and interest rates provides predictability but locks the company into the loan for several years. They can be suitable for startups with stable and very certain revenue growth.

Government Grants

Loans provided by governments or institutions are typically for R&D projects. Favor startups with close ties to science or innovation.

Key considerations before pursuing startup loans

Startup loans can offer valuable financing options for young companies. However, founders should carefully consider a few things. 

Understanding debt 

Startup loans, like any form of debt, carry obligations. Founders must assess their company's cash flow capacity and debt servicing capabilities to ensure the loan term and repayment schedule align with their business. 

Fortunately, modern debt providers embrace a customer-centric approach, offering flexible repayment options and grace periods that cater to the unique needs of startups. These accommodations empower founders to adapt their repayment plans to the ebb and flow of their business cycles, ensuring a balance between debt obligations and operational priorities.

Keeping an eye on interest and fees

Apart from repayment terms, founders must also delve into the difficulties of interest rates and fees associated with startup loans. Understanding the interest rate structure, fees, and prepayment penalties is crucial to assess the overall cost of capital.

Diversifying the capital stack

Taking on debt can be a strategic move that demonstrates a startup's maturity and commitment to sustainable growth. By diversifying the capital stack beyond equity financing, startups signal to potential investors their ability to access and manage multiple funding sources.

This diversification also enhances the company's financial stability, as it reduces reliance on a single source of funding. In the event of an equity fundraising setback, the startup can still rely on its debt obligations to continue operations and pursue growth initiatives.

Startup loans bring something new to the table

Startup loans, when approached with consideration and an understanding of financial implications, can be a powerful tool for growth and achieving long-term success. By evaluating loan terms, interest rates, and repayment options, coupled with a strategic approach to diversifying the capital stack, startups can harness the benefits of debt financing while mitigating potential risks.

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FAQ to startup loans

How can I get a startup loan without giving up equity?

Most startup loans are structured to prevent you from losing shares. That is the nature of debt capital. There are exceptions, such as venture debt or convertible loans. Look for alternative debt funding options that are truly non-dilutive without any warrants or convertibles.

What are the best startup loans for pre-seed and seed-stage companies?

Usually, debt is made for more mature startups, generating predictable revenue. However, you can focus on loans that are specifically tailored to early-stage startups, such as convertible notes or revenue-based financing (RBF). Evaluate the terms and conditions of each loan carefully to ensure it's a good fit for your business.

How can I find a startup loan that is a good fit for my business?

First, research different lenders and loan products to compare terms and conditions. Then consider your business's stage of development, financial health, and growth plans when making your decision.

What are the interest rates and fees associated with startup loans?

Interest rates for startup loans typically range from 8% to 20%, depending on the debt product or loan structure. Interest rates and fees are often higher for early-stage companies due to the perceived riskiness of their investments.

How can I use a startup loan to grow my business?

Debt can be used in many different ways. It’s common to use it for investments with a predictable return on investment, such as M&A, investments in marketing and sales activities, or to finance expansions.