Navigating debt financing
Co-written with Stephanie Combe, VP Finance at Alma
In this article, we dive into the ins and outs of debt financing in a high-interest environment. We'll break down various borrowing options, explore their risks and benefits, and discuss when is the best time to raise debt for start-ups and scale-ups. We also touch upon how to manage the borrowing process to optimize time and terms.
Why consider debt?
Borrowing debt is a way to fund oneself without giving away equity. Debt can be useful, for instance, to extend a company’s runway to hit key milestones to unlock future equity funding or reach profitability, pursue M&A opportunities, or grow faster.
However, like any financial instrument, debt comes with its own set of risks and challenges. Debt must eventually be repaid, which can add an extra layer of pressure if things don’t go as planned. If not managed properly, it can force a business to shut down. Without debt, you can always downsize your team and stay lean until you find PMF. But once you’ve taken out a loan, you cannot miss the installments.
Additionally, in a liquidation or acquisition scenario, lenders have liquidation preference over investors and the team, which can result in an exit that is not as attractive as expected for founders and employees.
What type of debt is better?
There isn’t a one-size-fits-all solution when it comes to debt. There are a few options depending on your situation and purpose.
When considering debt financing, it's always worth exploring innovation financing options, such as public funding from institutions like France’s BPI. Public funding can be particularly valuable, as it can sometimes be used as collateral to secure additional bank debt. Additionally, public institutions usually offer long repayment durations and repayment delays during the first 2-3 years—designed for early-stage startups that will not be profitable in the short term.
If possible, avoid venture debt—it typically comes with higher interest rates and shorter repayment terms, making it a viable option only if a clear next funding event is on the horizon. Many companies use it as a bridge to hit key milestones to unlock a future equity round, but it should be approached with caution.
Traditional bank debt typically offers longer-term repayment conditions, yet the process can be time-consuming and requires covenants, collateral, or cash in the bank. Credit lines are especially useful in intensive M&A scenarios or highly seasonal businesses. Credit lines can provide flexible funding but must be managed carefully to avoid over-leverage.
How much to borrow?
Always ensure that the amount you borrow is a reasonable percentage of your company's total cash reserves to protect its financial stability. See example below.
The amount you can borrow will also be determined by the financial institutions evaluating your project, with the criteria usually being a combination of your cash balance, fixed assets, financials, previous borrowing history, and the current macroeconomic situation.
A practical example:
Let’s use the example of a Series B scale-up that recently raised a $50M Series B.
Public borrowing: $6M
Duration: 8 years
Interest rate: 4%
Repayment grace period: 2 years
Traditional bank 1: $2M
Duration: 5 years
Interest rate: 5.5%
Repayment grace period: 0 months
Collateral: $2M covered by public borrowing institution
Traditional bank 2: $2M
Duration: 5 years
Interest rate: 5.5%
Repayment grace period: 0 months
Collateral: $2M covered by the EIF
Total borrowing of $12.5M, representing 20% of existing cash reserves.
Disclaimer: Borrowing terms may vary depending on the country, company specifics, and macroeconomic environment.
Find more literature on the topic here.
Managing the process
For early-stage companies, the best time to take on debt is typically right after an equity round, as the cash in the bank serves as leverage for better terms. If you are not planning to spend the funds immediately, you can offset interest costs by investing unused funds in fixed-term bank deposits.
Before engaging with any financial institutions, the first step is to consult the Board of Directors to determine whether exploring debt financing is a viable option. This early conversation is crucial, as the traditional borrowing process can be very time-consuming—potentially taking nine to twelve months with conventional banks. Addressing this with your board early on helps avoid wasting time on a process that may ultimately be rejected.
It is essential to engage with multiple banks simultaneously. Doing so provides insight into the terms and conditions you should aim for. Additionally, it is common for banks to collaborate and offer joint loans to mitigate their individual risk exposure.
An option is to work with an advisor who has direct connections with financial institutions. These advisors typically charge a success fee of 2-5% of the funds raised. They line-up the meetings with the relevant banks and assist in negotiating terms.
Negotiating the terms and conditions
If we take the example of borrowing traditional debt for a scale-up, the main terms to be careful with are, first, the interest rate and borrowing amount. If the company just raised an equity round, the cash in the bank can be leveraged to aim for a lower interest rate.
The second is the repayment schedule: this is especially important for early-stage startups, as the next funding event or profitability may be a long time away.
In turn, if the company has the option to borrow from a public institution, it should also ask them if they can be used as collateral for future borrowing with other financial institutions. This becomes a key negotiation point during the process. Also, if the company is based in Europe, the European Investment Fund (EIF) can act as a guarantor for innovative companies.
Final thoughts
Deciding whether to take on debt depends on the company’s unique situation and long-term goals. While debt can provide the necessary capital to fuel growth without sacrificing equity, it also introduces risks that must be carefully managed.
Overall, borrowing public funds with advantageous terms is the safest choice for companies with cash reserves, proven PMF, and a clear plan on how the funds will be invested.