In my experience working as a CFO consultant to startup companies, debt financing can be a part of the financing strategy, but not the principal part. One key factor to keep in mind is that debt providers are generally not interested in financing operating losses; this is for the equity investor. The debt provider is very interested in repayment of principal and interest and needs to see a source of such repayment before becoming interested in a loan of a substantial amount. Occasionally however, you may be able to convince a family member or friend to lend money, but this discussion is not focused on this source of funds.

If you want to borrow money for your startup from a financial institution, you may need to personally guarantee the debt. This should give you pause, since your personal assets will be at risk. I would avoid using credit cards to provide financing as the interest rate is quite high and this money is too easy to spend and very hard to repay.

If you can raise equity financing from known venture capital sources, there is a class of lender called Venture Lender that can offer "growth capital loans" that will layer on top of the equity financing. These loans can have flexible terms and offer a warrant to the lender for some percentage of the debt. This kind of loan makes sense under some circumstances and if considering a proposal from a Venture Lender, it is best to consider getting experienced financial advice on whether the proposal can work for your company and is competitive in price. A strong factor in favor of venture lending is that typical terms do not contain the covenants that bank lending requires.

A startup can also consider equipment financing if they need equipment in sufficient quantity to make the paperwork worthwhile. In Silicon Valley, equipment financing used to be quite common for startups with the equipment as collateral. However the lower costs today for computers, software and furniture and fixture make the need to finance these purchases less common. Typical terms are three years and may be obtained from banks as well as venture lenders. Critical is the quality of the collateral and the investors in your firm, as the term of the loan will likely exceed the ability for your firm to outlast your current funding. I support equipment lending when it can be arranged as it spreads the cost of longer lasting assets over their useful lives and allows working capital to be available for more immediate uses.

When your firm becomes revenue stage, you may find that traditional accounts receivable and inventory financing may be available from banks and other financial institutions. This financing is time based, i.e. the financing is for the period before collection of an invoice issued to a customer or during the time inventory is held for sale. So the financing is not permanent, but only when you have applicable transactions. Beware of bank covenants when signing a working capital loan agreement and make sure that the covenents do not prevent actual use of the financing.

Quite often in Silicon Valley, startup firms will offer to Angel investors a convertable note that will convert to preferred stock when a round with a venture capital source is arranged or a minimum of money is raised. This saves paperwork and keeps the transaction simple. But not all angel investors will accept this form of debt and may insist on a preferred stock issuance with a valuation instead. Again, consulting an experienced financial advisor or corporate lawyer makes sense when considering a convertable note.

Iris Sasaki

Owner, Iris Sasaki-HR, LLC

Posted on Sept. 28, 2010

Excellent answer. This not my area of expertise, however, to answer the question, typically a startup must go for debt funding as early as possible, before the company actually needs the money.

Gary Honig

President and Owner, Creative Capital Associates Factoring Co

Posted on April 25, 2011

By definition "debt financing" is available to any business with collateral to borrow against. Rick has done a fine job of outlining many of the issues and choices. But it is important to remember that using any form of outside capital is just a tool in the overall business strategy. Therefore it is critical to pick the right tool for the job. If a business is considering a major expenditure for manufacturing upgrade, then a term loan is preferable over a line of credit. There are various types of term loans; SBA guaranteed loans, real estate building or property loans, guarantor loans, stock backed loans etc. For working capital, a company in a massive growth spurt might be better off with some sort of asset based lending rather than a typical line of credit with a limit that will soon be outgrown.

So the process of choosing which type of debt financing is just as important as how and when to utilize it to grow your business.

Rick Kadet

Vice President, Senior CFO Consultant, The Brenner Group, Inc.

Posted on April 26, 2011

It is good to see this topic come up again as it was a question from March 2010. So I have looked through what I wrote at the time. I am currently helping a client company close a venture debt financing; the funds will be used to backstop the company until its anticipated venture round. This kind of funding is only available to companies with known investors, but a relatively high cost and with a warrant issued to the lender for preferred stock.

The climate for business debt from traditional sources remains difficult. I meet bank relationship managers who indicate that they are seeking old economy companies with profitibility and cash flow, not a good sign for startups. In a recent meeting with a major bank's technology department, the reliance on the quality of major investor in a startup company became even more clear in their willingness to extend credit. This furthers my contention above that debt markets are not the place for unfunded startups; it is better to push for venture or angel capital when unprofitable and growing.

Regulated lenders (i.e. banks) continue to be under the pressure of regulators. Loans must be documented by strong financials and forecasts and secured by assets worth something. But if you can qualify to borrow from a regulated lender, the interest rate will be quite reasonable. One client is borrowing several million under 5%. It is important when with a regulated lender to be sure you understand any covenants in the loan agreement, as you are in default when they are violated. These can be multiple kinds of rules including financial ratios and net worth requirements. Also discuss what is called the MAC clause, Material Adverse Change, which can allow the bank to foreclose.

I had occasion last year to try to help a company in the workout department of a major bank. If a bank makes a corporate decision to improve its balance sheet, it is the firms in the workout department that will suffer. Such was the case in this instance where bank management was not sympathetic to our attempts to improve profitability and cash flow of their client, wanting only to get it off their books. The result was not that pretty.