In the startup world, debt financing had a less-than-stellar reputation. Large venture capital rounds were popular. They garnered significant media attention. Zero interest rates and digital euphoria, venture capital funds in a frenzy, ambitious founders – financing for startups with venture capital was further accelerated by the impact of the pandemic. 

Equity was considered “affordable” and valuations soared to unprecedented heights. Debt financing was thought to be the choice only for startups that couldn't convince VCs.

Currently, the startup industry is undergoing a challenging phase. It's not just due to the plummeting venture capital funding volume – compared to 2020 and 2021, funding amounts have significantly decreased in the past 18 months. It's also due to the reevaluation of metrics. While back then all eyes were focusing on growth only, today, profitable growth and cost efficiency top the priority list. 

All these developments have led startups to reassess their financing instruments. Debt financing as a complement to equity is gaining increasing importance.

What is debt financing?

Debt financing enables a company to raise capital by using debt instruments like loans or credits. Unlike equity financing, which involves issuing stock, debt financing requires repayment. While lenders in equity financing receive shares in the company, debt financing involves a fixed obligation to repay the borrowed amount. Small and emerging companies often rely on debt financing to acquire the resources necessary for growth.

How debt financing works

When a company needs funds, it has three options: sell equity, take on debt, or use a combination of both. Equity represents ownership in the company, giving shareholders a claim on future earnings without the obligation to repay. However, in the event of bankruptcy, equity holders are last in line for repayment. Alternatively, companies can raise capital by issuing shares in a public offering, known as equity financing.

Another option when seeking funding is debt financing. This involves borrowing money that must be repaid, typically with interest. Debt can come from various sources, including bank loans, bonds, or credit lines. Unlike equity, debt does not dilute ownership but creates a legal obligation to repay. In the event of bankruptcy, debt holders are prioritized for repayment, often before equity holders. While debt can fuel growth, it also carries risks; excessive borrowing can strain cash flow and impact financial stability. In simplified terms, debt financing describes a company's debts to creditors. This includes liabilities and provisions. Unlike equity, debt financing must be repaid. Debt financiers do not participate in the profit or loss of a company.

At re:cap, we engage with hundreds of companies on their debt funding. From these discussions, we know that there are still many myths surrounding debt financing, especially when compared to equity. Here are the three most common ones.

Myth 1: Debt financing causes costs, equity doesn’t

Equity incurs no costs? Debt financing, on the other hand, results in high costs?

That's incorrect – yet, many founders assume so. Capital causes costs, regardless of its form. The cost of capital only occurs in different ways.

The costs of debt financing are transparent and known upfront. When obtaining a loan for their startup, founders immediately know the interest rates they can expect during the repayment phase. These are contractually defined. Startups can better plan their costs, such as the impact of monthly repayments on their cash flow.

Distinguishing direct and indirect costs

With equity, costs are initially not visible. By selling shares at a certain valuation, the "true" capital costs lie in the future – until the exit or IPO. Surprises can occur if founders have already relinquished substantial portions of the pie to investors before. Unlike debt financing, costs do not arise immediately. However, they are often much higher in most cases.

Additionally, startups surrender control and decision-making power to external parties, which is another cost factor that many founders underestimate.

Myth 2: Debt financing is complicated, equity is a walk in the park

Obtaining equity is often simpler for founders. They engage with investors, pitch their business, give up company shares, and receive equity. The money enters their bank account, where it remains without incurring costs through interest. 

With equity, founders have more freedom in the use of funds. It is available for all projects and does not need to be used capital-efficiently. Startups can use it to boost their growth or develop new products.

Understanding different mechanisms

Debt financing is different. For those accustomed only to equity, debt financing may seem complicated at first. Debt financing cannot simply sit idle in the account. Companies need to work with it. If it remains inactive in the account, it incurs unnecessary capital costs and creates no value.

On the other hand, taking on debt financing requires structure and planning. Investments with a more predictable return on investment, such as market expansions, M&A, or marketing campaigns, are suitable.

This necessitates founders to engage in financial planning beforehand. They analyze their finances and the capital's usage more thoroughly than with equity – capital efficiency is now a crucial factor.

However, debt financing is not inherently more complicated than equity. The approach is different, and many founders and startups are not yet accustomed to it.

Myth 3: The bigger the debt (ticket), the better

Do startups really need the largest possible sum of capital? Many founders aim to gather a substantial amount of debt financing. This has its reasons. It allows them to avoid dealing with the "annoying" topic of financing for a certain period, providing sufficient cash runway.

However, this approach is seldom wise. The problem lies in startups, accustomed to equity and its mechanisms, applying the same mechanisms to debt financing. This doesn't work due to the incurred costs. Gathering large sums results in high capital costs. With debt financing, costs in the form of interest come into play promptly and need to be repaid. The higher the raised amount of capital, the higher the repayments.

A bad idea: taking more than needed

It’s more complicated with equity. If one takes on more capital at the same valuation than needed, they sell more shares of their company, incurring higher costs. However, if startups take on more capital at a higher valuation, problems may arise in a later phase if the initially defined company valuation has not been achieved.

Having a large sum in the account provides founders with security. However, this security diminishes when costs become burdensome, either immediately or at a later date. For startups, this means understanding capital needs and only taking on the sum they can actually invest.

Conclusion: why adding debt might be a good idea

There are still a lot of myths and misconceptions about debt financing buzzing around. But it has gotten better. Many founders and startups see the value in raising debt. 

Debt financing has long been burdened with the stigma of being "too complicated", "too expensive", or "only relevant for large companies." For some founders, debt financing is still an unfamiliar term. However, perceptions are changing. Many young companies are gradually recognizing the benefits of debt financing – despite the myths that persist.

Debt financing diversifies the capital stack, reducing dependence on venture capital and allowing for more control over the company. It can be used for investments where equity is less suitable. Founders delving into debt financing can improve their competitive position. 

For those focusing on cost-conscious, profitable growth, and aiming for medium- to long-term break-even, debt financing is becoming indispensable. VC financing has become more challenging, and down rounds are more frequent. Debt financing provides a complementary solution, bridging the gap until the next equity financing round, improving financial situations, and diluting their shares less.