Debt financing: A founder’s guide

Learn about debt financing for startups, including the different types available, the pros and cons, and when it makes sense to use it in your startup fundraising strategy.

What is debt financing?

Debt financing is when a company borrows money from a lender with the promise to repay the borrowed amount, known as the principal, plus an additional cost for borrowing, called interest, over an agreed-upon time. This method of funding allows founders to raise capital for their business without giving up ownership in their company. Debt financing options include loans, lines of credit, and bonds. As a founder, this is one of the two main paths for startup funding, the other being equity financing.

How does debt financing work?

In a debt financing, a company borrows money that it must pay back according to the repayment terms of their agreement. In addition to paying back the principal (the money borrowed), the company will also owe interest, which is the cost of borrowing money for the company.

Debt financing vs. equity financing

Types of debt financing

Bank loans

Companies can receive loans from financial institutions based on their business’s credit status and needs. In a bank loan, a company borrows a set amount of money, which it receives in a lump sum.

Private credit

Private credit, also called private lending or direct lending, involves loans that are not issued by banks. Instead, the loans are issued by other types of companies, including private equity firms, business development companies, or alternative asset managers.

Small business loans (SBA loans)

The U.S. Small Business Administration (SBA) helps small businesses, including startups, secure funding with reduced risk for lenders. SBA loans tend to have lower interest rates and longer repayment schedules compared to other debt financing methods.

Lines of credit

A line of credit is another way startups can borrow money. A company borrows money as needed and then repays the financial institution.

Bonds and notes

Companies can also obtain funding by issuing bonds or notes. The company sells bonds to investors and then must pay back the money by a certain date.

Convertible instruments: SAFEs and notes

Convertible securities, such as Simple Agreements for Future Equity (SAFE) and convertible notes, are a hybrid form of funding extremely common in early-stage fundraising.

Advantages and disadvantages of debt financing

Benefits of debt financing

• Ownership is not diluted.
• Tax deductions. The interest paid on debt is deductible as a business expense.
• Lowered cost of capital.
• Build credit.

Risks of debt financing

• You must pay the money back.
• High interest rates.
• Requires regular income.
• Credit score impact.

When to use debt financing in your startup journey

Seed and setup

At this early stage, your business is often pre-revenue and seen as high-risk.

Early growth and team building

Once your startup has found product-market fit and is generating some revenue, you may become eligible for a small business loan or a line of credit.

Growth and operational maturity

After raising a Series A or later round, venture debt becomes a powerful strategic tool.

How debt financing impacts your cap table

Traditional loans are recorded as a liability on your company's balance sheet and do not appear on the cap table itself, but if the loan includes warrants, those must be added to the cap table to accurately reflect potential future dilution.

How to prepare for debt financing

Getting ready to apply for debt financing is similar to preparing for an equity round. Lenders need to see that you are organized, professional, and have a clear handle on your company's finances.

Frequently asked questions about debt financing

Is debt financing a good idea for a startup?

Debt financing can be a strategic tool for growth if your company has predictable revenue or is close to its next equity round.

What is an example of debt financing for a business?

A common example is a startup taking out a term loan to purchase essential equipment for its lab.

Does debt financing affect ownership?

Traditional debt, like a bank loan, does not affect ownership. However, convertible instruments like a SAFE will eventually convert into equity and cause dilution in the future.

What are covenants in a loan agreement?

Covenants are rules and conditions set by a lender that a company must follow to avoid defaulting on its loan.

Can a pre-revenue startup get debt financing?

While traditional bank loans are unlikely for pre-revenue companies, startups often use convertible instruments like SAFEs.