Introduction to Debt Capital

Debt and equity are two common options for financing a startup, each with their own benefits and drawbacks. Debt capital is borrowed money that must be repaid with interest, while equity involves selling a portion of ownership in the company to investors.

In this blog, we will explore the key differences between debt and equity, as well as the pros and cons of corporate vs. asset-backed debt. We will also provide tips for reaching out to debt investors and building strong relationships with lenders. By understanding the various options available and the factors to consider, startups can make informed decisions about their financing strategy and optimize their chances for success.

Debt vs. Equity

Debt capital refers to the money a company borrows from lenders, such as banks or bondholders, which must be repaid with interest over a set period of time. Debt can take many forms, such as loans, lines of credit, or bonds. The lender does not gain ownership in the company but rather is repaid with interest. Debt is also the seemingly preferred method of funding by most Unicorns. Big names, like Uber, AirBnB, and China’s Didi Chuxing all thrive on debt capital.

Equity, on the other hand, refers to ownership in a company. When a company sells equity, they are selling a portion of ownership to investors in exchange for capital. Investors who purchase equity, such as venture capitalists or angel investors, become shareholders in the company and have a say in decision-making. Equity does not have to be repaid like debt, but it does dilute the ownership of existing shareholders.

How Do They Differ? 

Debt and equity serve different purposes in financing a company, and both have their tradeoffs. While venture lenders may use equity as a primary form of validation for underwriting early-stage startups, debt can provide more flexibility, less dilution, and faster access to capital than equity, making it a better option to finance a predictable future. However, the right mix of debt and equity will depend on the company’s specific circumstances, as there are key differences to consider between the two.

Debt is senior to equity in the capital structure, and debt lenders have priority in claims on a company’s assets in the event of bankruptcy. The cost of debt comes from annual interest and one-time expenses, while equity dilutes ownership for founders and transfers decision-making power to new investors. Debt offers a wider range of solutions that can be prepaid or refinanced, but debt arrangements may limit flexibility with covenants and interest payments.

Raising corporate debt is typically faster than raising equity, but debt may include covenants that require the borrower to fulfill certain conditions to maintain good standing with the lender. While debt is minimally dilutive to ownership, breaching a covenant or an inability to pay interest or principal payments may give the lender the right to push the company to file for bankruptcy. Therefore, it’s important to understand the risks and obligations that come from covenants and other debt terms.

It’s also worth noting, here, that debt and equity also differ in what is require of startups after a debt deal.

Corporate Vs. Asset-Backed Debt

When it comes to financing a startup, there are two main options: debt and equity. Debt capital is borrowed money that a company must repay with interest, while equity is ownership in the company given to investors in exchange for funding.

While debt is commonly associated with corporate debt or venture debt, fintech companies are increasingly using debt to embed financial services as an ancillary or core product. For fintech lending platforms, capital is like inventory that funds loan origination and generates revenue. Asset-backed debt, while more expensive than corporate debt, is often preferred because financiers only have a claim on a set pool of assets rather than all company assets.

Using off-balance sheet asset-backed debt, such as in a warehouse special purpose vehicle (SPV), can further protect the company from losses if a particular pool of assets underperforms, as the risk lies within a separate entity. For instance, if a fintech platform used BNPL receivables as collateral, those receivables are held in an SPV. If customers don’t repay their BNPL installment loans, the asset-backed financier can only claim the assets in the SPV. There are various debt facilities available under both corporate and asset-backed debt.

Understanding Lenders

The world of private debt has exploded in recent years, with assets under management now ranking it as one of the top three private markets, following venture capital and private equity. This category includes credit funds, asset-based financiers, and recurring revenue advance providers, among others. However, with so many options available, it can be challenging to determine which lenders are the right fit for your startup. To help navigate the complex landscape, it’s crucial to understand the different types of facilities and filter through potential investors based on their willingness to invest at different stages. In this context, building strong relationships with debt financiers is critical.

The Lender Landscape

Private debt has emerged as one of the top three private markets in terms of assets under management (AUM), following venture capital and private equity. Private debt comprises credit funds that focus on term loans and lines of credit (with over $190B globally), asset-based financiers who provide warehouse facilities and forward flow agreements, and recurring revenue advance providers who offer direct financing to SaaS startups with recurring revenue streams.

To navigate the complex network of lenders, it’s essential to determine the type of facility required (corporate or asset-backed) and then filter through potential investors based on their willingness to invest at different stages.

We’ve categorized key lenders into early-stage (pre-seed to Series B) and later-stage (Series C+) groups based on the category of debt they offer, as well as whether they are traditional banks, credit funds, or fintech startups. It’s worth noting, too, that the strategies to raising debt capital differ for early stage and late stage startups.

Reaching Out to Debt Investors

Debt financiers are more than just a source of funding; they are long-term strategic partners who will support you through both good times and bad. It’s crucial to have a lender that has a strong relationship with your existing equity investors. These investors can recommend lenders that they have strong relationships with, and they can also help you negotiate favorable terms.

When looking for debt options, it’s a good idea to start a dialogue with a mix of banks and credit funds. This will help you find the best match for your needs and achieve optimal pricing and terms. Keep in mind that building a relationship with your lender is important, and you should aim to work with someone who understands your business and can offer value beyond just financing.

Before you start reaching out to debt investors, though, you’ll want to make sure you’re an expert when it comes to debt facility and navigating term sheets.

4 Tips for Reaching Out

Reaching out to and setting up meetings with potential debt investors is a skill set in itself and could be an entire post (or series of posts). That said, there are some more obvious steps founders can take to ensure that the process is more fruitful: 

1. Do your research: Before reaching out to any lenders, do your research on the lender and make sure they are a good fit for your company. Look at their website, read their investment thesis, and find out what types of companies they typically work with.
2. Get an introduction: If possible, try to get an introduction to the lender through a mutual connection, such as an existing investor. This can help build trust and credibility right from the start.
3. Craft a clear and compelling pitch: When reaching out to lenders, make sure your pitch is clear, concise, and compelling. Highlight your company’s strengths, your growth potential, and why you need the debt capital.
4. Be prepared to answer questions: Lenders will likely have questions about your company’s financials, your risk management strategies, and your plans for growth. Be prepared to answer these questions in detail.

Final Thoughts

Debt and equity each have their own unique advantages and disadvantages, and the right financing mix will depend on a startup’s specific circumstances. While debt can provide more flexibility, less dilution, and faster access to capital, equity offers the potential for higher returns and strategic partnerships. When it comes to debt financing, corporate and asset-backed debt each has its own tradeoffs, with asset-backed debt often preferred for its limited claims on company assets. To succeed in the complex landscape of private debt, startups must understand the different types of facilities available and build strong relationships with potential investors. By following these tips and understanding the risks and obligations of debt financing, startups can make informed decisions and secure the funding they need to achieve their goals.

Frank Gogol

A seasoned SEO expert, Frank has a long history of working with and for startups. Starting in mid-2018, Frank served as the SEO Strategist for Stilt, a fintech startup that provided fair loans for immigrants in the US and other underserved markets. While with the company, he scaled site traffic from zero to more than 1.5 million unique visits per month, driving the bulk of the company’s lead generation until it was acquired by J.G. Wentworth in December 2022. As employee #5 at Stilt, Frank was witness to, and part of, the successful building and sale of a fintech company, uniquely positioning him to create content for founders about all things startups.

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