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.

What are the biggest myths about debt financing?

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 is more expensive than equity

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. Which makes capital efficiency 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.

Why adding debt might be a good idea actually

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.

When should startups use debt financing?

Debt is ideal for startups when:

• Predictable cash flow: the business can handle regular repayments.
• Ownership retention: the company wishes to avoid equity dilution.
• Targeted investments: funds are needed for investments with a clear and predictable return, like purchasing equipment or expanding operations.

However, startups in the early stages with uncertain income may find equity financing more suitable, as it doesn't pressure cash flow and doesn’t require repayment.

Summary: Debt financing myths

In the past, debt financing was often viewed as a last resort for startups, overshadowed by venture capital. However, as the market shifts toward profitable growth and cost efficiency, startups are increasingly turning to debt financing as a complement to equity. Unlike equity financing, which dilutes ownership, debt financing involves borrowing money with a fixed repayment obligation, often at lower upfront costs. While equity may seem easier to secure, debt financing requires careful planning and capital efficiency but can provide more control and less dilution for founders.

Several myths persist around debt financing: it's not necessarily more expensive than equity, it’s not inherently complicated, and larger sums aren’t always better. In reality, debt financing can offer startups a flexible way to diversify their capital sources, providing a more predictable cost structure than equity while minimizing ownership dilution. As venture capital funding becomes harder to secure, debt financing is increasingly seen as an essential tool for startups focused on sustainable, profitable growth.

Q&A: Debt financing myths

What is meant by debt financing?

Debt financing refers to the process of raising capital by borrowing money, usually through loans, bonds, or credit lines. Unlike equity financing, where a company gives up shares in exchange for funding, debt financing involves a legal obligation to repay the borrowed amount, typically with interest, over a fixed period.

Why is debt financing bad?

Debt financing isn’t inherently bad, but it has its risks. The biggest downside is the pressure of repayment, regardless of business performance. If cash flow falters, meeting interest and principal payments can strain the business or even lead to insolvency. Excessive debt (over-leveraging) also reduces financial flexibility and can scare off future investors.

What is debt in finance with an example?

In finance, debt refers to borrowed money that must be repaid with interest. For example, if a company takes out a €500,000 loan from a bank to expand its operations, that loan is considered debt. The startup must repay it over time, typically in monthly installments, plus interest.

What is a debt financing strategy?

A debt financing strategy outlines how a company plans to use debt to fund its growth while managing risk. A sound strategy considers factors like the ideal loan size, repayment terms, interest rates, the timing of taking on debt, and what the funds will be used for. These are often targeted investments with clear ROI, such as scaling operations or entering new markets.