Debt financing as a complementary or even alternative funding option for startups
Raising funds for a startup is never an easy task, irrespective whether you do it in your very early days of your venture or at a slightly more advanced stage. It genuinely comes as a very time-intensive challenge which likely shifts a significant focus of your activities towards such fundraising campaign. The common process of pitching, convincing investors, negotiating the deal terms and eventually the signing of the paperwork, simply takes a lot of your precious time. That’s also the reason why we strongly recommend to founders to bootstrap their business idea within their limitations before turning towards investors.
However, if you successfully managed to complete your desired fundraising campaign, your startup will eventually obtain the deeply desired cash injection. However, depending on the form of capital (equity, debt and / or mezzanine) the role of this new capital in your startup might vary significantly.
Since we all know that equity investments lead to a direct participation of the investor in the full up and downside potential of your startup, debt and mezzanine financing trade “preferred” liquidation treatment upon a startup’s default against a capped financial upside potential (e.g. interest payments).
Debt and mezzanine financing for startups come in various forms but in essence encompass the following three categories: convertible notes, revenue-/profit-participating loans as well as venture debt. The existence of such variations ultimately entitles startup founders and their management teams with the opportunity to rethink their fundraising strategies.
Nevertheless, your startup’s flexibility in respect of such fundraising options is also driven by your startup’s maturity. It does not need any mentioning that later stage startups dispose over more flexibility and options compared to pre-seed / early stage startups.
However if rightfully played, the use of debt and mezzanine financing results in lower overall financing costs as well as lower effective equity ownership dilution. Furthermore, debt and mezzanine financing forms tend to outperform equity investments in terms of fundraising closing duration.
Let’s have a look at the available debt financing options distributed over a startup’s development axis:
As you can see, there is no one-size-fits-all response to the questions whether your startup should opt for such debt and mezzanine financing. But especially for later stage startups, i.e. with existing cash flow streams, the combined use of equity and debt financing can be a vital option to either extend their financial runaway to achieve certain milestones or to even replace a classic equity fundraising by such alternative financing means. Obviously, the application of such alternative or complementary financing sources always needs to be checked against any additional requirements such as personal guarantees (founders) or asset collaterals.
Latest transaction data implies that debt financing becomes more and more en vogue for European startups and is expected to further evolve. This is also particularly due to the emergence of key players like European Investment Bank, Bootstrap Europe, Kreos Capital, TPG, etc.
If you are interested to understand more about debt financing for startups, the links below will certainly equip with more detailed insights:
- Deloitte & Tax Consulting Study on the European Venture Debt Market
- European Investment Bank (venture debt offer)
- Convertible loans: What to look out for
- Kaufman Fellows — Venture debt: A capital idea for startups
- Startup “Capital”
- Lighter Capital — Revenue-based financing investors
KSquared is a Zurich-based startup consultancy which helps startups to build sustainable businesses. We specialise in financing and business operations support and have successfully enabled various startups from a wide range of industries.
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